Syriza and the French indemnity of 1871-73

European nationalists have successfully convinced us, against all logic, that the European crisis is a conflict among nations, and not among economic sectors. Today’s Financial Times has an article discussing the travails of Greece’s new Finance Minister, Yanis Varoufakis as he takes on Germany:

In a small but telling sign of the frosty relations between Berlin and the new Greek government, the German finance ministry last week criticised Mr Varoufakis for failing to follow through with a customary courtesy call following his appointment. Mr Schäuble, meanwhile, has warned Greece not to attempt to “blackmail” Berlin with demands for debt relief.

This is absurd. The European debt crisis is not a conflict among nations. All economic systems— and certainly an entity as large and diverse as Europe— generate volatility whose balance sheet impacts are mediated through different political and economic institutions, among which usually are domestic monetary policy and the currency regime. With the creation of the euro as the common currency among a group of European countries, monetary policy and the currency regime could no longer play their traditional roles in absorbing economic volatility. As a result, for much of the euro’s first decade, a series of deep imbalances developed among various sectors of the European economy. Because Europe’s existing economic and political institutions had largely evolved around the national sovereignty of individual countries, and also because the inflation and monetary histories of individual countries varied tremendously before the creation of the euro, it was probably almost inevitable that these imbalances would manifest themselves in the form of trade and capital flow imbalances between countries.(1)

We have a great deal of experience in modern history with the kinds of imbalances from which Europe suffered and continues to suffer, and from the historical precedents three things are clear. First, the imbalances that led eventually to the current crisis had their roots in hidden transfers between different economic sectors within Europe, and not between countries. It is only because of deep institutional differences among the member countries that these imbalances manifested themselves largely in the form of trade imbalances between the different countries in Europe. These hidden transfers artificially forced up the savings rates in some countries and, for reasons that I have discussed elsewhere, it is a matter of necessity, well understood in economics (although too often forgotten by economists), that artificially high savings rates in one part of an economic system must result in higher productive or non-productive investment (in advanced countries usually the latter) or artificially low savings in another part of that system.

Second, deep distortions in savings and investment historically have almost always led to an unsustainable increase in debt, and Europe was no exception. For many years European debt has risen faster than European debt-servicing capacity, but the gap between the two has not been recognized and written down, and instead manifests itself in the form of excessively high and rising debt burdens whose costs have eventually to be assigned.

Third, and most worryingly, it has always been easy for extremists and nationalists to exploit the grievances of the various economic groups to distort the meaning of the crisis. One way is to transform it into a class conflict and another way is to transform it into a conflict among member states. Resolving a debt crisis involves nothing more than assigning the losses. In the current crisis these costs have to be assigned to different economic sectors within Europe, but to the extent that the assignation of costs can be characterized as exercises in national cost allocation, it is easy to turn an economic conflict into a national conflict.

Most currency and sovereign debt crises in modern history ultimately represent a conflict over how the costs are to be assigned among two different groups. On the one hand are creditors, owners of real estate and other assets, and the businesses who benefit from the existing currency distortions. One the other hand are workers who pay in the form of low wages and unemployment and, eventually, middle class household savers and taxpayers who pay in the form of a gradual erosion of their income or of the value of their savings. Historically during currency and sovereign debt crises political parties have come to represent one or the other of these groups, and whether they are of the left or the right, they are able to capture the allegiance of these groups.

Except for Greece, in Europe the main political parties on both sides of the political spectrum have until now chosen to maintain the value of the currency and protect the interests of the creditors. It has been the extremist parties, either on the right or the left, who have attacked the currency union and the interests of the creditors. In many cases these parties are extreme nationalists and oppose the existence of the European Union. If they succeed in taking control of the debate, the European experiment will almost certainly collapse, and it will take decades, if ever, for a European union to revive.

But while distortions in the savings rate are at the root of the European crisis, many if not most analysts have failed to understand why. Until now, an awful lot of Europeans have understood the crisis primarily in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility. This interpretation is intuitively appealing but it is almost wholly incorrect, and because the cost of saving Europe is debt forgiveness, and Europe must decide if this is a cost worth paying (I think it is), to the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost. As my regular readers know, I generally refer to the two different groups of creditor and debtor countries as “Germany” and “Spain”, the former for obvious reasons and the latter because I was born and grew up there, and it is the country I know best. I will continue to do so in this blog entry.

It is a horrible irony that while the view that the European crisis is a conflict between prudent Germany and irresponsible Spain could easily tear apart the European experiment, it terribly muddles Europe’s actual experience and may create a false impression of irresponsibility. To see why, it is useful to start with a little history. Nearly 150 years ago Spain’s “Glorious Revolution” of 1868 saw the deposition of Isabella II and the collapse of the first Spanish Republic. More importantly for our purposes it also unleashed within continental Europe a conflict over the succession to the Spanish throne which ultimately, through a series of circuitous events, resulted in France’s declaration of war on Prussia in July 1870. This was widely seen in France as a chance partially to even the score over Prussia’s victory during the Napoleonic wars, but in the end France’s revanchist fantasies were frustrated. By early 1871, the French army  was roundly defeated by Prussia, which during that time had unified the various German states as the German Empire under the Prussian king.

There were at least two important results of France’s military defeat. Of minor importance for the purpose of my blog entry, but interesting nonetheless for those obsessed with modernism and with France’s late 19th Century cultural history, like me, the Franco-Prussian War will always be remembered for its role in the subsequent creation and collapse of the Paris Commune. This event left its mark on the thinking of many cherished artists and intellectuals, from Manet and Rimbaud to Proudhon and Haussman.

But the other, to me, very interesting and far more relevant consequence was the French indemnity. As part of the privilege of conquest and as a condition for ending the occupation of much of northern France, Berlin demanded war reparation payments originally proposed at 1 billion gold francs but which eventually grew to an astonishing 5 billion, at least in part because of an explicit decision by Berlin to impose a high enough burden permanently to cripple any possible French economic recovery.

To give a sense of the sheer size of this payment, usually referred to in the literature as the French indemnity, this was equal to nearly 23% of France’s 1870 GDP.(2) Germany’s economy at the time, according to Angus Maddison, was only a little larger than that of France, so Germany was the beneficiary of a transfer over three years equal to around 20% of its annual GDP. This is an extraordinarily large transfer. I believe the French indemnity was the largest reparations payment in history — German reparations after WWI were in principle larger but I don’t think Germany actually paid an amount close to this size, and certainly not relative to its GDP.

Transfer beneficiary

Astonishingly enough France was able to raise the money very quickly, mostly in the form of two domestic bond issues in 1871 and 1872, which were heavily over-subscribed. One of the most complete studies of the French indemnity, I think, is a booklet by Arthur Monroe published in 1919.(3)  According to Monroe, the first issue of 2 billion in perpetual rentes was issued in June 1871, a mere 48 days after the treaty was signed, and was heavily oversubscribed. The second issue was even more successful:

Thirteen months after announcing the first loan the government opened subscriptions for a second, this time for three billions, again in 5 per cent rentes, but issued at 842. The response to this was astounding, for more than twelve times the amount desired was subscribed, more than half of the offers coming from foreign countries.

Monroe goes on to note that “it is no small compliment to the credit of France at this time to note that about one-third of the foreign subscriptions were from Germany,” so when we think about the net transfer to Germany, it was less than 5 billion francs. Although Monroe says that more than half the subscriptions came from outside France, and one-third of those were German, with twelve times oversubscription there is no way for me to estimate how much was actually allocated to German purchasers so I have no estimate for the amount by which the 5 billion should be adjusted.

The payments were made in the form of bills of exchange and to a lesser extent gold, silver, and bank notes, and Berlin received the full payment in 1873, two years before schedule. It was during this time that Germany went fully onto the gold standard, and obviously enough the massive indemnity made this not only possible but even easy. It also guaranteed currency credibility almost from the start, and it may jolt modern readers to know that at the time monetary credibility was not assumed to be part of the German DNA, so the additional credibility was welcome.

What does all of this have to do with Syriza? A few weeks ago I was discussing with a group of my Peking University students Charles Kindleberger’s idea of a “displacement”, and I proposed, as does Kindleberger, that the 1871-73 French indemnity is an especially useful example of a displacement from which we can learn a great deal about how financial crises can be  generated.(4)  It then occurred to me that the French reparations and their impact on Europe could also tell us a great deal about the euro crisis and, more specifically, why by distorting the savings rate wage policies in Germany in the first half of the last decade would have led almost inexorably to the balance of payments distortions that may eventually wreck the euro.

It is a nice accident that the French indemnity accelerated Germany’s adoption of the gold standard, because massive transfer payments from Germany to peripheral Europe were probably necessary for many of these countries to adopt the euro, in some  ways their own version of the gold standard. Before jumping into why I think the French indemnity is relevant to the Greek crisis, I want to make three quick points:

1.  I went into more detail on how France raised the money than might at first seem necessary for the purpose of this blog entry because it actually illustrates a potentially useful point. In the first third of my 2001 book,(5) I discussed extensively the historical role of global liquidity on the evolution of national balance sheets and sovereign debt crises. One important point is to distinguish between financial crises that occur within a globalization cycle and those that end a globalization cycle. Whereas the latter are often devastating and mark the end for many years of economic growth, the former — like the 1994 Tequila crisis or the 1997 Asian crisis, or even the 1866 Overend Gurney crisis — may seem overwhelming at first, but markets always recover far more quickly than most participants expect. When markets are very liquid, and in their leveraging-up stage, they can absorb large debt obligations easily, and because they can even turn these obligations into “money”, they almost seem to be self-financing.

The 1858-73 period was one such “globalization period”, with  typical “globalization” characteristics: explosive growth in high-tech communications and transportation (mainly railways), soaring domestic stock and real estate markets, booming international trade, and a surge in outflows of capital from the UK, France, the Netherlands and other parts of Europe to the United States, Latin America, the Far East, the Ottoman Empire, and other financial “frontiers”. I would argue that this is why, despite Berlin’s expectation that the indemnity would cripple the French economy, it was surprisingly easy for France to raise the money and for its economy to continue functioning. Germany, similarly, struggled over many aspects of the WWI reparations, but after 1921-22, when global markets began their decade-long globalization boom, driven by extraordinarily high US savings (and characterized by the familiar globalization sequence: electrification of American industry, the spread of telephones, automobiles, radios, cinema, and other communications and transportation technologies, booming international trade and capital flows, the Florida real estate mania, stock market booms, and, of course, the rise to fame of one Charles Ponzi), Germany found it relatively easy to raise the money that famously became part of the reparations recycling process — until, of course, the 1930-31 global banking crisis, after which Germany was forced into default. This may be relevant as we think about any possible future European sovereign bond restructuring. Any attempts to assess their impacts based on historical precedents must distinguish between periods of ample liquidity and the radically different periods of capital scarcity. Once the liquidity contraction begins, every debt restructuring will be brutally painful, unlike now when they are absorbed almost without a thought.

2.  I explain in my book that the French indemnity actually increased global liquidity by expanding the global supply of highly liquid “money-like” assets. Of course Germany’s money supply increased by the amount of the transfer (not the full amount, because part of the subscriptions actually came from Germany), but this was not offset by an equal reduction in France’s money supply. The creation of a huge, highly liquid, and highly credible instrument, the two French bond issues, involved the creation of “money” in the Mundellian sense. While the transfer of money from France to Germany might have seemed systemically neutral, in fact it resulted in a systemic increase in global “money”.

3.  From an “asset-side” analysis, as I discuss in my January 21 blog entry, the transfer of capital over three years from France to Germany equal to more than 20% of either country’s annual GDP would have had very predictable impacts — they should have been very negative for France, as Berlin expected, and very positive for German. In fact the actual results were very different. This is because there are monetary and economic conditions under which liability structure matters much more, and conditions under which it matters much less. Economists and the policymakers they advise are too quick to ignore these differences, perhaps because there is not as well-formulated an understanding of balance sheets in economics theory as in finance theory, so that when someone like Yanis Varoufakis proposes that there are ways in which partial debt forgiveness increases overall economic value, instead of merely creating moral hazard, worried economists often recoil in horror, while finance or bankruptcy specialists (and an awful lot of hedge fund managers) shrug their shoulders at such an obvious statement.

It is mainly the third of the above three points that is relevant for the current discussion about European sovereign obligations. One might at first think that France’s indemnity, at nearly 23% of GDP over three years, might have been devastating to the economy. It certainly left France with a heavy debt burden, but its immediate economic impact was not nearly as bad as might have been expected. Wikipedia’s assessment is pretty close to the consensus among historians:

It was generally assumed at the time that the indemnity would cripple France for thirty or fifty years. However the Third Republic that emerged after the war embarked on an ambitious programme of reforms, introduced banks, built schools (reducing illiteracy), improved roads, spreading railways into rural areas, encouraged industry and promoted French national identity rather than regional identities. France also reformed the army, adopting conscription.

Far more interesting to me is the impact of the indemnity on Germany. From 1871 to 1873 huge amounts of capital flowed from France to Germany. The inflow of course drove the obverse current account deficits for Germany, and Germany’s manufacturing sector struggled somewhat as an increasing share of rising domestic demand was supplied by French, British and American manufacturers. But there was a lot more to it than mild unpleasantness for the tradable goods sector. The overall impact in Germany was very negative. In fact economists have long argued that the German economy was badly affected by the indemnity payment both because of its impact on the terms of trade, which  undermined German’s manufacturing industry, and its role in setting off the speculative stock market bubble of 1871-73, which among other things unleashed an unproductive investment boom and a surge in debt.

Do capital inflows cause speculative frenzies?

As Germany began to absorb the inflows, its current account surplus of course reversed into deficits, which by definition means that there was a large and growing excess of investment over savings. Part of this was caused by rising German consumption, but much of it was caused by surging investment. Unlike in peripheral Europe 135 years later, the capital inflows were not mediated through commercial banks into the pockets of households, businesses, and local governments but rather ended up wholly in the hands of Berlin. Germany in the 1870s had an opportunity denied to peripheral Europe in the 2000s, in other words, to control the use of the massive transfer. I will get back to this point a little later.

As money poured into Germany the German economy boomed, along with German consumption, investment (a growing share of which went into projects at home and abroad that turned out in retrospect to be overly optimistic), and into the Berlin and Viennese stock markets. By early 1873 more experienced German, Austrian and British bankers were quietly warning each other of a speculative mania, and they were right. The stock market frenzy culminated in the 1873 global stock market crisis, which began in Vienna in May, shortly after the beginning of the 1873 World Fair, and rapidly spread throughout a world brimming with liquidity (a large part of the first French indemnity payments went directly to London to pay outstanding German obligations). By September the crisis reached the United States with the collapse of Jay Cooke and Company, one of the leading US private banks, and for the first time in history the New York Stock Exchange was forced to close, for ten days. The subsequent global “Long Depression”, which lasted until 1896, was felt especially severely in Germany, one of whose first reactions was the collapse of the railway empire of Bethel Henry Strousberg, a  major industrialist at the time whose prehistory included a stint in jail for absconding from a previous job as financial agent with other people’s money (petty criminals who become industrial magnates seem to be another characteristic of globalization periods).

Within a few years of the beginning of the crisis attitudes towards the French indemnity had shifted dramatically, with economists and politicians throughout Germany and the world blaming it for the country’s economic collapse. In fact so badly was Germany affected by the indemnity inflows that it was widely believed at the time, especially in France, that Berlin was seriously contemplating their full return. The great beneficiary of French “largesse” turned out not to have benefitted any more than Spain had benefitted from German largesse 135 years later.

This is interesting. The German economy responded to French capital inflows in almost the same way that several peripheral European economies responded to  large German capital inflows 135 years later. It might seem an unfair comparison at first because the 1871-73 transfer to Germany was huge, but it turns out that the magnitude of the French transfer into Germany was broadly similar, in fact probably smaller, to the inflows into peripheral Europe. By the way I should point out that I use Spain to represent peripheral Europe not just, as I stated earlier, because I was born and grew up there, and so know it well, but also because Spanish government polices were in many ways among the most “responsible” in Europe, and so cannot really be blamed for the aftereffects. Spain’s debt and its fiscal accounts were far stronger than the European average and stronger than those of Germany in most respects.

It is hard to imagine that the amount of inflows into Germany from 1871 to 1873 could have been comparable to the inflows Spain experienced, but if anything they were actually smaller. Here is why I think they were. From 2000-04 Spain ran stable current account deficits of roughly 3-4% of GDP, more or less double the average of the previous decade. Germany, after a decade of current account deficits of roughly 1% of GDP, began the century with slightly larger deficits, but this balanced to zero by 2002, after which Germany ran steady surpluses of 2% for the next two years.

Everything changed around 2005. Germany’s surplus jumped sharply to nearly 5% of GDP and averaged 6% for the next four years. The opposite happened to Spain. From 2005 until 2009 Spain’s current account deficit roughly doubled again from its 3-4% average during the previous five years. The numbers are not directly comparable, of course, but during those four years Spain effectively ran a cumulative current account deficit above its previous 3-4% average of roughly 21-22% of GDP. Seen over a longer time frame, during the decade it ran a cumulative current account deficit above its earlier average of roughly 31-32% of GDP.

These are huge numbers, and substantially exceed the French indemnity in relative terms. Of course the current account deficit is the obverse of the capital account surplus, so this means that Spain absorbed capital inflows above its “normal” absorption rate equal to an astonishing 21-22% of GDP from 2005 to 2009, and of 31-32% of GDP from 2000 to 2009. However you look at it, in other words, Spain absorbed an amount of net capital inflow equal to or substantially larger than Germany’s absorption of French reparations during 1871-73. It is not just Spain. In the 2005-09 period a number of peripheral European countries experienced net inflows of similar magnitude, according to an IMF study, including Portugal, Greece and several smaller east European countries.

By the way in principle it isn’t obvious which way causality ran between capital account inflows and current account deficits (the two must always balance to zero). In 1871-73 it is obvious that German capital inflows drove current account deficits. In 2005-09 European countries might similarly have run large current account deficits because of the capital inflows imposed upon them, but it is also possible that they had to import capital by eagerly borrowing German money in order to finance their large current account deficits. To put it differently, German money might have been “pushed” into these countries, as the “blame Germany” crew has it, or it might have been “pulled” in, by the need to finance their spending orgies, as the “blame anyone but Germany” crew insist. For those who prefer to think in more precise terms, Germany either created or accommodated the collapse in Spanish savings relative to Spanish investment. For those — including, distressingly enough, most economists — who believe a country’s savings rate must be driven only, or mainly, by domestic household preferences, please refer to “Why a savings glut does not increase savings“.

The structure of the balance of payments itself does not tell us conclusively which caused which, German outflows or Spanish inflows, and no one doubts that there was a strong element of self-reinforcement that was an almost automatic consequence of the payments process, as I have discussed in the January 21 entry on this blog. If it were the latter case, however, it would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time. It would be even more remarkable, had they done so, that they could have all sucked money out of a reluctant Germany while driving interest rates down. It is very hard to believe, in other words, that the enormous shift in the internal European balance of payments was driven by anything other than a domestic shift in the German economy that suddenly saw total savings soar relative to total investment. I have discussed many times before what happened in Germany that resulted in the savings distortion that convinces me that the flows originated in Germany, as it has many others.

What is interesting is how similar the consequence of the inflows were even though Berlin was able to control the disbursement of the inflows in a way of which Madrid could only dream. And yet from 1871 to 1873 the German economy experienced one of the most dramatic stock market and real estate booms in German history, and although the flow of funds into government coffers rather than through banks to businesses and households ensured that the subsequent rise in German consumption was not nearly as extreme as it was in Spain, Germany did engage in a frenzy of investment at home and abroad in which a substantial share of the inflows was effectively wasted in foolish investment. Of course unlike Spain today, there never was any question about Germany’s obligation to repay the transfer. It had come, after all, in the form of reparations demanded by a victorious army, and not in the form of loans. In fact it took the massive US lending to Germany in the 1920s for German investment misallocation to lead to wholesale default on external debt.

Syriza’s challenge

It is useful to remember this history when we confront the consequences of Greece’s recent elections. Syriza’s victory in Greece has reignited the name-calling and moralizing that has characterized much of the discussion on peripheral Europe’s unsustainable debt burden. I think it is pretty clear, and obvious to almost everyone, that Greece simply cannot repay its external obligations, and one way or another it is going to receive substantial debt forgiveness. There isn’t even much pretence at this point. This morning financial advisor Mish Shedlock, sent me (as a joke? as a sign of despair?) German newspaper Zeit‘s interview with Yanis Varoufakis entitled “I’m the Finance Minister of a Bankrupt Country”.

Even if the question of who is to “blame”, Greece or Germany, were an important one, the answer would not change the debt dynamics. It would take the equivalent of Ceausescu’s brutal austerity policies in Romania, which were imposed during the 1980s in order for the country fully to repay its external debt, to resolve the Greek debt burden without a write-down. Given that Ceausescu’s policies led directly to the 1989 revolution, which culminated in both Ceausescu and his wife being executed by firing squad, the reluctance in Athens to imitate Romania in the 1980s is probably not surprising.

But to say Greece simply cannot repay isn’t the end of the story. As Europe moves towards a more rational debt policy with Greece, I would say that there are three important things to remember:

1.  There is an enormous economic cost, not to mention social and perhaps political, to any delay. I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring. Greece’s debt overhang imposes rising financial distress costs and increasingly deep distortions in the institutional structure of the economy over time, and the longer it takes to resolve, the greater the cost.

I think most analysts understand that costs will rise during the restructuring process. I am not sure they understand, however, that delays will impose even heavier costs during the many years of subsequent adjustment. There is a lot of bad blood and recrimination among the various parties. I suspect that some of those who oppose Syriza are probably revolted by the thought that a rapid resolution of the Greek crisis would rebound to Syriza’s credit, but they must understand that dragging out the restructuring process will impose far greater long-term costs on the Greek people than they think.

My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume.

2.  From what I read, much of the focus of the restructuring will be aimed at determining an acceptable and manageable debt-servicing cashflow for Greece. There is a mistaken belief that this is the only “real” variable that matters, and the rest is cosmetics. I don’t agree. Greece’s nominal debt structure will not just affect the debt-servicing cashflows but will also determine future behavior of economic agents.

There are at least two important functions of an economic entity’s liability structure. One is to determine the way operating profits or economic growth is distributed among the various stakeholders, or, put differently, to determine economic incentive structures. The other is to determine the way external shocks are absorbed. This is why the restructuring process is so important and can determine subsequent economic growth. The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value. Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value (this rather obvious point is almost never implemented because economists have difficulty in conceptualizing and modelling reflexive behavior in dynamic systems). Rather than let economists work out the arithmetic of the restructuring based on linear estimates of highly uncertain future cashfllows, whose values are themselves affected by the way debt payments are indexed to these cashflows, Greece and her creditors may want to unleash a couple of options experts onto the repayment formulas and allow them to calculate how volatility affects the value of these payments and what impact this might have on incentives and economic behavior.

3.  In fact the overall restructuring must be designed so that the interests of Greece, the producers who create Greek GDP, and the creditors are correctly aligned. To date sovereign debt restructurings have almost never included the instruments that reflect the instruments in corporate debt restructurings that accomplish this alignment of interests, largely because these instruments have not been “invented”. Among other things the negotiating committee might want to dust off the GDP warrants that were included in Argentina’s last debt restructuring.

If the restructuring is well designed, within a year of the restructuring I think we could easily see Greek growth surprise us with its vigor. I was delighted to see that Greece’s new Finance minister agrees. An article in Monday’s Financial Times starts with the claim that “Greece’s radical new government revealed proposals on Monday for ending the confrontation with its creditors by swapping outstanding debt for new growth-linked bonds, running a permanent budget surplus and targeting wealthy tax-evaders.” Today’s Financial Times has an article by Martin Wolf that mentions the benefits of “a growth linked bond”. In The Volatility Machine I spend chapters explaining how to create liability structures that minimize external shocks, align the interests of creditors and citizens, and improve the quality of payments for creditors, and I show why these make a restructuring much more successful for all parties concerned. This is just basic finance theory. Yanis Varoufakis should really take the lead in designing an entirely new form of sovereign debt restructuring, not just for Greece but for the many countries, in Europe and elsewhere, that will soon follow it into default.

Enough people seem to hate or fear Syriza that there will be little attempt to approach Greece’s problems with enough imagination to give either party what it needs, but in fact with the right cooperation, imagination, and intuitive understanding of how balance sheet structures change overall value creation, a Greek debt restructuring could leave both sides far better off than either side might imagine. Of course if done right this matters far more than for just its impact on the Greek economy. While everyone probably agrees that Greece simply cannot proceed without debt forgiveness, less widely agreed, but no less obvious in my opinion, is that there are a number of other European countries that also need debt forgiveness if they are to grow. Because I was born and grew up in Spain, and my French mother founded and ran a successful business there which my family and I still own, I am confident that I know the country well enough to say that even with some impressive reforms having been implemented under Mariano Rajoy, Spain is nonetheless one of these countries. I suspect that many other countries including Portugal, Italy, and maybe even France are too.

I also know, however, that Spanish debt prospects are an extremely sensitive and emotional topic, and I will be roundly condemned for saying this. Today’s Financial Times has a very worrying article explaining why Madrid wants to be seen among the hardliners in opposing a rational treatment for Greece: “when it comes to helping Greece, there will be no such thing as southern solidarity or peripheral patronage.” This is the reverse of what it should be doing. In an article for Politica Exterior in January 2012, I actually proposed, albeit without much hope, that Spain take the lead and organize the debtor countries to negotiate a sustainable agreement, but in its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the “virtuous” countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter.

As it is, and for reasons that may have to do with recent history, Francisco Franco, and the psychological scars he left among those of my generation, any discussion in Spain is likely to be subsumed under non-economic considerations, especially angry denunciations of moral virtue and moral turpitude. These non-economic considerations are not irrelevant. In fact some of them are very important and even admirable. But they must be understood within a more neutral context.

As far as I can tell there are at least four important reasons that opponents of debt forgiveness, not just in Germany but also in Spain, have proposed as to why demands for debt forgiveness would be a long-term disaster for Spain:

1.  Spain’s economic future depends on its remaining a member of Europe in good standing. To demand debt forgiveness (let alone a renegotiation of the currency union) would cause a financial crisis and relegate Spain to backward country status.

2.  If Spain fails to honor its debt commitments it will be considered forever an unreliable prospect and will be frozen out of future investment and trade.

3.  More importantly, it would be morally wrong. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity.

4.  Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless invest projects. It got itself into this mess only because of the very poor economic policies a corrupt Madrid implemented. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of tis leaders, but ultimately they are responsible.

These four arguments, which are the same arguments made about other highly indebted European countries, have been made not just by the greedy Germans of caricature, but also, more importantly, by indignant locals. They genuinely believe that their country behaved stupidly and must pay the price, and it is hard not to respect their sincerity.

Blaming nations

The last of the four points is I think the most powerful of the arguments and among the most confused, and it is the one I hope I have at least partly addressed with my discussion of the French indemnity, and that I will discuss more below, but I should briefly address the first three, and of course while I refer to Spain, in fact much of what follows is as true of Greece and other heavily indebted European borrowers as it  is of Spain:

1.  There is no question that a renegotiation of Spanish debt or of its status within the currency union would be accompanied by economic hardship and perhaps even a crisis. But compared to what? The Spanish economy is already in disastrous shape and there is compelling historical evidence that countries suffering under excessive debt burdens can never grow their way out of their debt no matter how radical and forceful the reforms.

This means that by refusing to negotiate debt forgiveness, not only must Spain be prepared to live with unbearably high unemployment and slow growth for many years, which would undermine the social, political and financial institutions that are the real determinants of whether a country is economically advanced or economically backwards, but in the end after many years of suffering Spain would be forced into debt forgiveness anyway, only now with an economy in far worse shape. Historical precedents also suggest that while the real reforms Madrid has implemented seem to have failed, in fact it is the debt constraint that has prevented their impacts on productivity from showing up as economic growth. I suspect that many of these reforms have actually been very positive for Spain’s long-term productivity. In that sense I think Mariano Rajoy and his government have put in an impressive performance. Unless Madrid waits too long, they may very well even unleash tremendous growth once debt is written down, but until the debt is resolved, they will not seem to have worked. Throughout modern history even “good” reforms have failed to generate growth in nearly every previous case of overly indebted countries, unless of course those reforms sharply reduce outstanding debt.

Some economists argue the facts on the ground already contradict my pessimism. Last week Madrid announced excitedly that GDP grew by 1.7% last year, its fastest pace in seven years. The Financial Times pointed out that Spain was well-positioned in 2015 to continue to take advantage of lower energy costs, a weaker euro, and a cut in personal and corporate taxes, to which I would add lower metal prices, massive QE, and stronger than expected consumption. But even if these tailwinds are permanent, and they clearly are not, nominal GDP growth is still much lower than the growth in the debt burden. This is as good as it gets, in other words, and it is not good enough. As the debt burden continues to climb, and as social and political frustrations mount, Spain will slide inexorably backwards into the backward-country status it wants so badly to avoid. 

2.  There is overwhelming evidence — the US during the 19th Century most obviously — that trade and investment flow to countries with good future prospects, and not to countries with good track records. The main investment Spain is likely to see over the next few years is foreign purchases of existing apartments along the country’s beautiful beaches. Once its growth prospects improve, however, with among other things a manageable debt burden, foreign businesses and investors will fall over each other to regain the Spanish market regardless of its debt repayment history. This is one of those things about which the historical track record is quite unambiguous.

3.  It was not the German people who lent money to the Spanish people. The policies implemented by Berlin that resulted in the huge swing in Germany’s current account from deficit in the 1990s to surplus in the 2000s were imposed at a cost to German workers, and have been at least partly responsible for Germany’s extremely low productivity growth — most of Germany’s growth before the crisis can be explained by the change in its current account — rather than by rising productivity.

Moreover because German capital flows to Spain ensured that Spanish inflation exceeded German inflation, lending rates that may have been “reasonable” in Germany were extremely low in Spain, perhaps even negative in real terms. With German, Spanish, and other banks offering nearly unlimited amounts of extremely cheap credit to all takers in Spain, the fact that some of these borrowers were terribly irresponsible was not a Spanish “choice.” I am hesitant to introduce what may seem like class warfare, but if you separate those who benefitted the most from European policies before the crisis from those who befitted the least, and are now expected to pay the bulk of the adjustment costs, rather than posit a conflict between Germans and Spaniards, it might be far more accurate to posit a conflict between the business and financial elite on one side (along with EU officials) and workers and middle class savers on the other.  This is a  conflict among economic groups, in other words, and not a national conflict, although it is increasingly hard to prevent it from becoming a national conflict.

But didn’t Spain have a choice? After all it seems that Spain could have refused to accept the cheap credit, and so would not have suffered from speculative market excesses, poor investment, and the collapse in the savings rate. This might be true, of course, if there were such a decision-maker as “Spain”. There wasn’t. As long as a country has a large number of individuals, households, and business entities, it does not require uniform irresponsibility, or even majority irresponsibility, for the economy to misuse unlimited credit at excessively low interest rates. Every country under those conditions has done the same. What is more, even if the decision about the disbursement of the inflows could have been concentrated in the hands of a single, responsible entity, the experience of Germany after 1871 suggests that it is nearly impossible to prevent a massive capital inflow form destabilizing domestic markets. Germany, after all, was much better placed than Spain later was for two important reasons. First, unlike Spain today, Germany was not saddled with an enormous debt obligation which it had to repay. Second, in 1871-73 the transfers went straight to Berlin, which was able fully to control the disbursements. In 2005-09, on the other hand, the transfers to Spain left behind an enormous debt burden and were discrete and widely dispersed in ways that were almost certainly biased in favor of the most optimistic or foolish lenders and the most optimistic or foolish borrowers.

And this is a point that’s often missed in the popular debate. Over and over we hear — often, ironically, from those most committed to the idea of a Europe that transcends national boundaries — that Spain must bear responsibility for its actions and must repay what it owes to Germany. But there is no “Spain” and there is no “Germany” in this story. At the turn of the century Berlin, with the agreement of businesses and labor unions, put into place agreements to restrain wage growth relative to GDP growth. By holding back consumption, those policies forced up German savings rate. Because Germany was unable to invest these savings domestically, and in fact even lowered its investment rate, German banks exported the excess of savings over investment abroad to countries like Spain.

Why didn’t Germans, rather than Spaniards, take advantage of the excess savings to fund a consumption boom? The standard response is to point to German prudence and Spanish irresponsibility, but it must be remembered that as German and Spanish interest rates converged (driven in large part by German capital flows into Spain), because they adopted a common currency at a time when Spanish inflation had been higher than German, the real interest rate in Spain was lower than that of Germany. As German money poured into Spain — with Spain importing capital equal to 10% of GDP at its peak — the massive capital inflows and declining interest rates ignited asset price bubbles, and even more inflation, setting off in Spain what Charles Kindleberger called a “displacement”. This locked Spain into a classic self-reinforcing cycle of rising asset prices and declining interest rates.

What is more, under normal (i.e. pre-euro) conditions the Spanish peseta would have dropped and Spanish interest rates risen, but the conditions of the euro prevented both adjustment mechanisms, and to make things worse this gave Berlin’s policies far more traction than anyone expected, locking Germany into an over-reliance on capital exports to Spain, the obverse of Germany’s current account surplus. German workers gave up wage growth in order to eke out employment growth, which itself depended on an ever rising surplus. Throughout it all there was little productivity growth as German companies reduced their investment share in the economy.

Meanwhile German banks, flush with the higher savings that low wage growth, rising surpluses and growing corporate profits all but guaranteed, continued eagerly to export into Spain the savings they simply could not invest at home. So why didn’t ”Spain” step in and put an end to this process by refusing to borrow German money? Because, again, there was no “Spain”. There were millions of households and business entities all of whom were offered unlimited amounts of lending at very low or even negative interest rates, and under the conditions of euro membership Madrid could not intervene. If German and Spanish banks blanketed the country with lending proposals, Madrid could do nothing to stop it (at least not without raising domestic unemployment and igniting the  ire of Brussels and Berlin). As long as there were some greedy, overly optimistic or foolish borrowers (and in a country of 45-50 million people how could there not be?), German and Spanish banks fell over themselves to make loans. The money had to be absorbed by Spain and there was no mechanism to ensure the quality of its absorption.

Above all this is not a story about nations. Before the crisis German workers were forced to pay to inflate the Spanish bubble by accepting very low wage growth, even as the European economy boomed. After the crisis Spanish workers were forced to absorb the cost of deflating the bubble in the form of soaring unemployment. But the story doesn’t end there. Before the crisis, German and Spanish lenders eagerly sought out Spanish borrowers and offered them unlimited amounts of extremely cheap loans — somewhere in the fine print I suppose the lenders suggested that it would be better if these loans were used to fund only highly productive investments.

But many of them didn’t, and because they didn’t, German and Spanish banks — mainly the German banks who originally exported excess German savings — must take very large losses as these foolish investments, funded by foolish loans, fail to generate the necessary returns. It is no great secret that banking systems resolve losses with the cooperation of their governments by passing them on to middle class savers, either directly, in the form of failed deposits or higher taxes, or indirectly, in the form of financial repression. Both German and Spanish banks must be recapitalized in order that they can eventually recognize the inevitable losses, and this means either many years of artificially boosted profits on the back of middle class savers, or the direct transfer of losses onto the government balance sheets, with German and Spanish household taxpayers covering the debt repayments.

Who is fighting whom?

I am not rejecting the claim that “Spain” acted irresponsibly, in other words, only to place the blame on “German” irresponsibility. But it is absolutely wrong for Volker Kauder, the parliamentary caucus leader of German Chancellor Angela Merkel’s Christian Democrats, to say, according to an article in last week’s Bloomberg, that “Germany bears no responsibility for what happened in Greece. The new prime minister must recognize that.” There was indeed plenty of irresponsible behavior on both sides, during which time wealth was transferred from workers of both countries to create the boom and to absorb the subsequent bust, and wealth will be transferred again from middle class households of both countries to clean up the resulting debt debacle.

Put differently, there is no national virtue or national vice here, and there is no reason for the European crisis to devolve into right-wing, nationalist extremism. The financial crisis in Europe, like all financial crises, is ultimately a struggle about how the costs of the adjustment will be allocated, either to workers and middle class savers or to bankers, owners of real and financial assets, and the business elite. Because the major parties have refused to acknowledge the nature of this allocation process, and have turned it into a fight between a creditor Germany, on the one hand, and indebted peripheral European countries on the other, I was able to make in 2010-11 one of the easiest predictions I have ever made in my career — whichever extremist parties, whether of the right or of the left, who first went on the offensive against Germany, the bankers and the currency bureaucrats, I predicted, would surge in electoral popularity and would eventually reformulate the debate.

That is why the question of debt forgiveness must be reformulated by the centrist parties first. Fundamental to the argument that Spain (or Greece, or anyone else) has a moral obligation to repay in full its debt to Germany are two assumptions. The first assumption is that “Spain” borrowed the money from “Germany”, and that there is a collective obligation on the part of Spain to repay the German collective. The second assumption is that Spain had a choice in what it could do with the German money that poured into the country, and so it must be held responsible for its having mis-used hard-earned german funds.

The first assumption is, I think, easily dismissed. Germany exported capital because by repressing wage growth, Berlin ensured the high profits and low consumption that forced up its national savings rates. Instead of employing these savings to invest in raising the productivity of German workers (in fact domestic investment actually declined) it offered them either to fund German consumption at high real interest rates (and there were few takers), or through German and Spanish banks this capital was offered to other European households for consumption or to other European businesses for investment. The offers were taken up in different ways by different countries. In countries where the offered interest rates were very low or negative, the loans were more widely taken up than in countries where real interest rates were much higher. To ascribe this difference to cultural preferences rather than to market dynamics doesn’t make much sense.

What started slowly quickly accelerated, again for reasons of market dynamics. As the huge inflow into Spain set off stock market and real estate booms, some Spanish households, feeling wealthier, borrowed to increase their consumption, and many Spanish households and businesses borrowed to buy real estate. In the subsequent frenzy, credit standards collapsed as Spanish and German banks fought to gain market share, and as optimism soared, consumption grew to unsustainable levels, until eventually Spain was so overextended that it collapsed. The same story can be told elsewhere. In fact this is what happened in Germany after the French indemnity.

As for the second assumption, that Spain had a choice, this too should be quickly dismissed. Clearly Spanish households and businesses in the aggregate behaved, in retrospect, with astonishing abandon. But could they have done otherwise — did they have a choice? Almost certainly not. Germany did not when it received the French indemnity, and I don’t think there are many, if any, cases of countries that were able to absorb productively such massive inflows. In every case I can think of, massive capital inflows were accompanied by speculative bubbles and financial crises. Even the US in 19th century — urgently needing foreign capital to finance a massive amount of productive investment that could not be financed out of domestic savings, making it the best candidate possible to receive massive foreign inflows — was not able to absorb surges in inflows without seeing the creation of bubbles, investment scandals, and financial crises. Is it reasonable to insist that Spain’s failure to choose a path that no other country in history seems ever to have chosen indicates greater irresponsibility on the part of the borrowers than of the lenders? As long as there is a widely diverse range of views among Spanish individuals and businesses about prospects for the future, as long as there is a mix of optimists and pessimists, or as long as there are varying levels of financial sophistication, I think it would have been historically unprecedented if at least some Spanish entities did not respond foolishly to aggressive offers of extremely cheap credit, especially once this cheap credit had set off a real estate boom.

In summary, I think there are several points that those of us who want “Europe” to survive should be making.

1.  The euro crisis is a crisis of Europe, not of European countries. It is not a conflict between Germany and Spain (and I use these two countries to represent every European country on one side or the other of the boom) about who should be deemed irresponsible, and so should absorb the enormous costs of nearly a decade of mismanagement. There was plenty of irresponsible behavior in every country, and it is absurd to think that if German and Spanish banks were pouring nearly unlimited amounts of money into countries at extremely low or even negative real interest rates, especially once these initial inflows had set off stock market and real estate booms, that there was any chance that these countries would not respond in the way every country in history, including Germany in the 1870s and in the 1920s, had responded under similar conditions.

2.  The “losers” in this system have been German and Spanish workers, until now, and German and Spanish middle class savers and taxpayers in the future as European banks are directly or indirectly bailed out. The winners have been banks, owners of assets, and business owners, mainly in Germany, whose profits were much higher during the last decade than they could possibly have been otherwise

3.  In fact, the current European crisis is boringly similar to nearly every currency and sovereign debt crisis in modern history, in that it pits the interests of workers and small producers against the interests of bankers. The former want higher wages and rapid economic growth. The latter want to protect the value of the currency and the sanctity of debt.

4.  I am not smart enough to say with any confidence that one side or the other is right. There have been cases in history in which the bankers were probably right, and cases in which the workers were probably right. I can say, however, that the historical precedents suggest two very obvious things. First, as long as Spain suffers from its current debt burden, it does not matter how intelligently and forcefully it implements economic reforms. It will not be able to grow out of its debt burden and must choose between two paths. One path involves many, many more years of economic hell, as ordinary households are slowly forced to absorb the costs of debt — sometimes explicitly but usually implicitly in the form of financial repression, unemployment, and debt monetization.  The other path is a swift resolution of the debt as it is restructured and partially forgiven in a disruptive but short process, after which growth will return and almost certainly with vigor

5.  Second, it is the responsibility of the leading centrist parties to recognize the options explicitly. If they do not, extremist parties either of the right or the left will take control of the debate, and convert what is a conflict between different economic sectors into a nationalist conflict or a class conflict. If the former win, it will spell the end of the grand European experiment.


I leave my readers with three questions that I hope we can discuss in the comments section:

1. If a huge amount of capital, equal say to 10-30% of a country’s annual GDP, is forcibly distributed to an enormous group of entities within that country in a short time period, and if the only way in which to distribute this capital is through a wide variety of banks, with biases such that the more optimistic and irresponsible the bank, the more it profits, and the more optimistic and irresponsible the borrower, the more it receives, is it meaningful to refer to either side as behaving “irresponsibly”, and if so, which side? Does this sound like a loaded question? If it is, can it be rephrased in a less loaded way?

2. There have been many cases of large capital recycling in history — just in the last 100 years I can think of the recycling of the US trade surplus to Germany and other countries in the 1920s, the petrodollar recycling to Latin America in the 1970s, and the recycling to the US of the Japanese trade surplus in the 1980s and the Chinese trade surplus in the 2000s. These were all accompanied in the recipient country by stock, bond and real estate bubbles and by overconsumption and wasted investment. Have there been cases of large capital recycling that did not end in tears for the recipients? If so, how were they different?

3. What about the other side of the recycling? In most cases the recycling country also experienced bubbles and rising debt. Have there been cases that did not also end in tears and if so, how were they different?


(1) The imbalances themselves occurred in forms that are widely understood and for which we have many historical precedents. I discussed these in my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton University Press, 2013). I am far from the only one to have done so. Martin Wolf’s excellent The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis (Penguin Press, 2014) presents a schematic account of the causes of the crisis, and in The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013) Peter Temin and David Vine set out with great clarity the framework within which Europe’s internal imbalances had inexorably to lead to the current outcome.

(2) Michael B. Devereux and Gregor W. Smith, “Transfer Problem Dynamics: Macroeconomics of the Franco-Prussian War Indemnity”, August, 2005, Queen’s University, Department of Economics Working Papers 1025

(3) Arthur E. Monroe, The French Indemnity of 1871 and its Effect (The MIT Press, 1919)

(4) Charles Kindleberger, A Financial History of Western Europe, (Routledge 2006)

(5) Michael Pettis, The Volatility Machine: Emerging Economics and the Threat of Financial Collapse (Oxford University Press, 2001)

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 Add your comment
  1. I wonder if the good professor had spent too much time in the communist china, since he now see things through the lens of class struggle instead of the clash between nations.
    Joke aside, the write is very insightful. I do wonder how the problem will be resolved eventually and how a small investor can take advantage of the situation.

    • Not completely a joke, Yu Feng, because I have already been accused of a wide variety of mutually incompatible ideologies. My main point is that we know quite a lot about financial crises. Among other things we know that they are often, perhaps usually, the consequence of distorted transfers between different economic groups, but because financial and economic institutions coagulate around national lines, it is easy to confuse the economic groups for national groups. This seems to be happening in Europe and it does not help the debate.

      There are many ways small investors can benefit but as a long-time trader I know that the vague generalities that pass for investment advice are pretty useless. Investment opportunities depend on asset specifics. My most sophisticated clients never want my investment advice. They just want me to get the macro right, and they figure out how this affects the specific assets that they understand.

      • With the greatest respect, Mr. Pettis, it is not your sophisticated clients who need investment advice. It’s the rest of us, who are trying to make our savings last at least as long as we do, who need help to invest wisely. Those of us, for example, who struggle to understand your very clear writing and grasp the content of this blog post, because we lack the background (the “language” if you will) in economics and finance that so many of your readers undoubtedly possess.

        • Dear Carla, re-read this great piece and observe: winners in Asia from 1996 to 1998 ? winners in Argentina from 1998 to 2001? Investing away from those countries! Not sofisticated clients can learn from history and should buy USD denominated bonds of non European countries, and AFTER the Euro collapse wait a few months and buy anything in the victim’s countries ( Spain &co), sofisticated ones do know what they do! ( do they?!?)

        • Excellent work, professor. It helped me see things from a new perspective.

          @Carla: I’m happy to share my investment strategy. In light of the present Euro crisis…

          #1. Go long a select Greek bank of systemic importance. I chose ALPHA BANK (US symbol ALBKY). a) short term – sell when there is joy about some settlement or b) ride the wave, hoping that it won’t end in nationalization.

          #2. NBG.PA it’s NATIONAL BANK OF GREECE’s preferred $ 25 stock. They bought some back and it’s trading near $ 9. Buying it back would make sense and strengthen their capital. There is an article on “Seekingalpha” about this.

          #3. Going short on the DAX. Contrary to popular opinion, I do regard a weak Euro for a sweet poison for Germany. And doubt the party will continue much longer.

          You could use CFDs for #1 and #3, with margin being 10% for the first 70% and 20% for the remaining 30%. Very r i s k y stuff, of course.

          Take a long look at the facts of the collapse in Cyprus. ELA way beyond the national central bank’s ability to cover the debt. => someone else must pay. The shortfall was 8.1 bn Euro, I read somewhere. ATM, the Greek central bank ran out of ammo regarding ELA as well.

          When a basically sound bank has lost >90% of its value, there might be an opportunity. And investors can make money on falling stock indices as well.

        • The most valuable thing is to keep learning. Just keep reading Prof. Pettis’ blog, read more of his books, and read as much as possible (including topics that may not seem related to finance like politics). Listen to different perspectives. Watch YouTube lectures and videos (I’ve been trying to nudge Prof. Pettis to post some of his lectures/class material on his website to no avail). The most important thing that you can have is the ability to think for yourself. If at first you don’t understand something, re-read it. If you still don’t understand it or understand the terminology, look it up.

          I’m a math guy so this part is very easy for me, but highly difficult for others: always understand the assumptions you’re making and each logical step you take. Understand that in every way we look at the world is, effectively a model. Understand the assumptions embedded in that model. If the assumptions aren’t satisfied, the model won’t apply. Remember: garbage in, garbage out.

          Don’t take anyone else’s word for anything. Do your own analysis and your own understand. Read books and follow your curiosity about these topics. If you do not understand something, keep trying to understand. Whatever you do: DO NOT GIVE UP! The first time you read something, if you’re like “what the hell is going on” or “I don’t get this or that”, that’s a GOOD thing, not a bad thing.

          Why do I say all those things? It’s because this is how I learned about these same topics. My goals are very similar to yours, but my guess is that I’m just a bit younger (I could be wrong).

          With regards to financial “language”, this is the most important thing to understand:
          Y–income, C–consumption, S–Savings, I–investment, NX–net exports (measured by current account balance)
          Y=C+S=C+I+NX which implies S-I=NX

        • One more thing: be aware of what you do not understand. Start with what you do not understand. The first thing you should think about anything (IMO) is what do I not know and what do others know.

          I highly recommend reading all of Nassim Taleb’s books in order if you have not done so. They’re extremely valuable in demonstrating/thinking soundly about things.

      • You mention that financial crises…” are often, perhaps usually, the consequence of distorted transfers between different economic groups”. I agree in Europe that is typical example, even in a very complex way : Asymmetric class and generational transfers distort economy behavior. It is becoming more and more acute withe the jobless problem affecting young generation. Germany is a global “free rider” in Europe again now. It captures youth generation from elsewhere without paying the bill for health, education and so on….Greece wants its people back from the obliged working system regime, installed by the german landlords of Europe. Germany has a lot of debt to Europe and europeans people for ages. Being aggressive is their trick not to pay debt! A new round in Europe now that Greece experiments.

  2. Bravo Michael. Enlightening post indeed.

    Latest data show that current account surpluses in Germany and The Netherlands are hitting new highs. Do you think that debt negotiations could include clausules that bind debt repayment with eurozone-wide current account rebalancing?

    • I doubt it, Ignacio. Every one in Europe benefits by the overall exporting of deficient demand abroad. It is the rest of the world that should oppose European strategies, and I suppose by the end of this year we will see a lot of nastiness and name-calling.

    • It’s interesting to consider it now but the first country to get a wrap on it’s knuckles from the European Institutions for going outside the terms of the single currency guidelines for current accounts was I believe Ireland for having too high a surplus. Evidently the rules were changed when it came to other large countries doing the same and again when it came to operating deficits outside the 3% range as France and Italy have been doing for many years even before the Crisis started.

  3. While this post really is a reconciliation of the themes that you always discuss, your ability of explaining the dynamics in differing settings is truly appreciated. Bravo!

    Yanis Varoufakis should heed the advice of Machiavelli

    Hence it is to be remarked that, in seizing a state, the usurper ought to examine closely into all those injuries which it is necessary for him to inflict, and to do them all at one stroke so as not to have to repeat them daily; and thus by not unsettling men he will be able to reassure them, and win them to himself by benefits. He who does otherwise, either from timidity or evil advice, is always compelled to keep the knife in his hand; neither can he rely on his subjects, nor can they attach themselves to him, owing to their continued and repeated wrongs. For injuries ought to be done all at one time, so that, being tasted less, they offend less; benefits ought to be given little by little, so that the flavour of them may last longer.

    • Thanks, Glen. You (and big Mach) are probably right.

    • Yea, I think Machiavelli was actually Machiavellian. I’m pretty sure that in The Discourses, Machiavelli says that he favors republics over principalities because you don’t have to worry about the biggest problems–the consent of the governed. He actually says that if republics hand too much power to the people, that’s when dictators come into power, which should be blatantly obvious to nonsuckers.

      That brings me to my next point: the idea and power of “social democracy” as you see in Europe is dangerous and will lead to dictators and probably war (again). We’re probably gonna see war, dictators, and fascism retake Europe.

      • *Machiavelli wasn’t Machiavellian.

      • Funny, when someone from the US tells a story about a war-hungry Europe. Can’t remember of any war on foreign territory in the last decades from Europe’s side, but… u know what I mean. 😉

        Funny fact 2: The numbers in so many civilicatory factors like education, healthcare, income per capity, GDP, research and well-being are often best in – some would call them social-democratic – states, like Sweden, Norway, Switzerland, Finnland, Canada, Denmark and so on. Dont want to miss out many Central and South-American states, but they mostly suffer in economic measures.

        But anyway, this (national) identity card is played for so long time with so much devestating results, I’m exhausted of it. Let’s break out of the cycle and fix some problems, because we all make them! (and don’t underestimate the beauty of solving things together)

        • “Can’t remember of any war on foreign territory in the last decades from Europe’s side”

          Maybe it’s because Europeans destroyed themselves? The Americans basically removed European defense capabilities, which made Europeans incapable of war. Eventually, Europe will end up in war again.

          BTW, the Scandinavian countries are quite capitalist. It’s a misnomer to say they’re only run by social democrats, because they’re highly capitalist with high levels of redistribution. Switzerland is a worldwide financial center, so I think that’s a bad example. The only countries in Europe that have a higher income per capita than the US are Switzerland, Luxembourg, San Marino, and Norway. Two of those countries are financial centers with San Marino, Switzerland, and Luxembourg being very, very tiny. Also note Norway has only 5 million people while the US has 320 million. In the case of Switzerland, Social Democracy is the fourth or fifth largest party there.

          In terms of education? Who cares? Having people study BS fields in the name of “education” and being proud of it while suppressing risk-takers and entrepreneurs is a damn shame and a disgrace. If you don’t have structures that encourage risk-taking (most of Europe), it creates problems.

    • I’d like to add one more thing. If you actually read and understand Machiavelli, you’ll understand that the kind of political system he asks for is currently not present in Europe, but only present in the US. A healthy republic requires checks and balances across the political system and must be able to handle retards in charge. The countries in Europe aren’t like that. When idiots get in charge there, everything blows up. The real issues in Europe involve its political structure. Until this is fixed, nothing else will be fixed.

      Actually, the Americans recognized the problem in Europe and this is why the political system was changed so radically after the Second World War. Relying on ideas like “social democracy”, “power to the people”, and “trust” is a sucker’s bet. The crazy part is that every time I interact with Europeans (mainly the people who’re my age and care about this stuff), I get these ridiculous ideas. If I bring up the stuff I’m saying to them, they look at me like I’m crazy and claim what I’m saying is morally wrong. A healthy republic consists of different factions each fighting and struggling for power that must have a decentralized structure with a self-organizing hierarchy that originates from the bottom-up.

      Sorry for the rant, but I’ve actually been reading quite a bit of Machiavelli. He was a wonderful thinker (he wasn’t this evil power-hungry guy that he’s always made out to be). It’s a major problem when a guy like Karl Marx (probably one of the dumbest people IMO) is hailed above a great thinker like Machiavelli. Marx was just a idiot/sucker filled with wishful thinking. I can go on a rant about how stupid Marx actually was, but that’s a different issue for a different day. A society can never get wealthy by listening to Marx and will see all of its liberty and wealth destroyed if it takes up his ideas.

      On a side note, I usually hear Marxists say that Communism isn’t Marxism and that Marx was taken out of context. This is complete nonsense. Marx was a nutcase and I don’t see how anyone with half a decent brain on their shoulders could say otherwise (many American thinkers like Henry George pointed this out), but many people (lots of Europeans and socialists) that I interact with talk about him like he was this great man who had no flaws. Then, I read what he said and it makes me wanna punch a hole in the wall.

      • The American system of government is deeply flawed and, having been tried on numerous occasions by other countries, almost always fails miserably. Study a little history any you, too, would know this.

        And, as far as Marx goes, I know that when a lot of obviously otherwise smart people start saying that I am not seeing the value of something, I tend to think, ‘perhaps my own intrinsic biases are making me blind to something.’ Whereas you obviously respond with ‘I must just be smarter than everyone else.’ I’m not going to say that one of these approaches is superior to the other, but… okay, yes I am.

        • I also know plenty of smart (and great) people who think Marx was a moron (Keynes certainly did). Just look at what he said.

          The reason the American system hasn’t worked in many places is because the factions simply don’t exist. BTW, the US governmental structure has been in place for 225+ years. That’s the longest in the world. The countries in Europe seem to go back and forth between fascism and socialism. How can that possibly be healthier?

      • Suvy, glad to meet you. I’m a convinced Machiavellian an also, BTW, a Hobbesian. I’m completely, 100% In accordance with what you say here.

        • Yea, Machiavelli has been very influential in the way I think about things. He was a brilliant thinker. He’s most well-known for The Prince, but I wonder how many people actually read The Discourses on the First Decade of Titus Livy. He’s very pragmatic with a very interesting way of looking at the world.

      • Marx was actually a decent economist as far as I’m concerned(for his time, obviously). He should’ve stick to what he knew instead of trying to “solve” the problems and invent an ideology.

        And he’s about to be proved right, me thinks. Was he wrong or was he early? 🙂 Employment figures like in the last 100 years are a thing of the past; sure, will take some generations for this to be accepted and even longer to fix the system, but that’s another story. Mind you, not that I have a clue about how it can be done or that I think communist ideology has any practical value.

        as far as the American system… well, it seems to be dying, so who cares? The factions you’re talking about become more and more one big pizza and it’s pretty sad if you’re outside said pizza.

        • Vlad, you seem to be trying to making a point without sticking your neck out and showing conviction.

          I don’t think you understand the “American system” as you and others seem to criticize directly or opaquely. I guarantee you that anything you see with the so called “American system” today will not look like anything you could imagine thirty years from now. Because the “American system” is constantly evolving and being shaped by popular forces. That is the pure beauty of democracy. It’s not perfect, but if enough people don’t buy-in the society is forced to adapt and change. And change it does. Over and over again.

          • “Because the “American system” is constantly evolving and being shaped by popular forces. ” – I find this totally contradicting any reality, no offense.

            It seems to me that it’s a plutocracy; something which God knows it’s anything but original. Ok, it has a better PR than most plutocracies through history, but…

            It’s perfectly predictable how it’d look like in 30 years unless an expected event happens(basically a system change). It’ll look the same…

          • A healthy republic needs an elite. You cannot place all the power in the hands of the people (or anyone for that matter).

            The fact that the system will look relatively similar to its current state 30 years from now is a sign of health. Why would you want large, gigantic changes all the time? One small error blows you up. The key is to have small changes that happen often (via state/local governments) to localize the impact while preventing large changes from happening. What matters isn’t just the change, but the scale of the change (something you’re not considering).

            The best system is the one that gains and adapts to failure whereby failure is often-occurring, localized, and small. The American government has done this very well in the past 225+ years.

      • “It’s a major problem when a guy like Karl Marx (probably one of the dumbest people IMO)”

        “Marx was just a idiot/sucker filled with wishful thinking. I can go on a rant about how stupid Marx actually was, but that’s a different issue for a different day.”

        “Marx was a nutcase and I don’t see how anyone with half a decent brain on their shoulders could say otherwise”

        These quotes adequately explain this one:

        “If I bring up the stuff I’m saying to them, they look at me like I’m crazy”

        But do go on a rant on how Marx was this unbelievable imbecile and how you successfully managed to intellectually dismiss him.

        • Oh boy. Where do I begin? Let’s start with the fact that he doesn’t ever take into account class mobility into his analysis. How does the analysis change if the child of a “proletariat” could be an elite in the next generation and vice-versa?

          Secondly, class conflicts are as old as the hills. In a time of war, it helps to have wealth concentrated in relatively few hands. In a society of no productivity increases (most of human history), it’s better to keep your public poor and your treasury rich than vice-versa.

          Let’s look at Marx’s basic idea of class conflict. He says that a dictator would come up to take the side of the proletariat, overthrow the bourgeoisie, and then we would live in a classless society. So he’s expecting a benevolent leader to come in and take the side of the people to overthrow the guys in charge and create this utopia where the working class has everything. Does he ever consider the idea that the person who actually takes charge uses the people to confiscate power, abolish the only ones with the capability to fight against this dictator, and then start oppressing the people and taking out people who disagree with the #1 guy.

          Let me put it this way, we all have different skill sets and different capabilities. There is nothing wrong with that. What we need is a society that provides each person the optionality to do what they do best. That means some will rule, some will raise regular families, some will work in trade, some will be generals, some will be financiers, and so on.

          Most people think good ruling is about how to tell people to live their lives. This is complete nonsense. Good ruling is about providing an environment where everyone can do what they do best. It’s more about what’s not to be done than it is about what is to be done.

          I don’t need to intellectually dismiss him. All you have to do is look at the constraints we have in the world we live in to realize this guy was filled with utter crap. He doesn’t seem to think about each step and figure out why his ideas make sense. On the contrary, it seems like a bit of logic is all that’s needed to debunk Marx. He makes so many assumptions (most implicit) doesn’t realize he’s making them, and never seems to consider the possibility that he’s wrong.

          Most people say that Russian Communism is an extreme version of what Marx said. This is nonsense; it’s exactly what he said. Use a dictator to overthrow the ruling elite and create a classless society that holds the common man as the goal.

          No successful republic can ever stand upon the ideas of Marx and every republic that takes up these ideas will lead to its self-destruction. As long as I have enough to live (food, shelter, basics), why does it matter that someone has more money than me. People should be judged on virtue and honor. Our leaders should be the most virtuous and honorable. If they’re not, we need institutions to check them and make sure they don’t blow things up. Marx doesn’t consider any of these real issues.

          I can go on for days about the absurdity of Marx, but I’ll stop here.

      • The problem with the competative american system is that the wealthy elites & corporations have found the weak spot in the political system – the news & analysis media system (aka the ‘fourth estate’) and are rapidly buying it up and turning it into a propaganda machine bent to their needs instead of the public good. First to go was cable news (aka Fox News and their ilk) then talk radio (do you need examples) and now it’s reaching fruition with Charles Koch on the board of PBS slowly bending NPR to his will and sidelining players like Fontline that unfortunately aren’t willing to knuckle under and tell us how great our privileged elite are and how things like coal ash & fracking chemicals are actually good for us.

        • To be fair, no one below the age of 30 (I’m willing to push this to 35 and maybe even 40) watches the nonsense you’re talking about. Also, what’s wrong about displaying propaganda? That’s a part of the freedom of speech. The real problem is that we have state subsidized news outlets that should never exist in the first place. It should all be private.

          BTW, have you seen news/newspapers from US history. I guarantee you current news is better. And plus, it doesn’t matter what the masses think. It’s not the bottom 90% that matter; it’s only the top 10%.

          With regards to inequality, I think the US is actually relatively healthy in terms of the kind of inequality we have here. There’s a lot of mobility at the top and the bottom in terms of inequality (just look at who was rich 20-40 years ago and look at mobility at the top). It’s much less healthy in Europe where you have a class of people at the rich that’re unable to go poor.

          There’s nothing wrong with having an elite and on the opposite side of the Koch brothers, you’ve got guys like George Soros using similar strategies. We need such contention between people; it’s a good thing.

          Coal ash is being removed from the system. In 20 years, the entire energy structure of the US will probably be completely off coal. This is very different from Europe which is actually increasing coal usage in spite of all of their efforts to “go green”. Hell, the most green energy place in the world is probably Texas.

          There’s absolutely nothing morally wrong with a few people having way more than everyone else or with them buying influence as long as there’s mobility at the top. The far more dangerous idea is this idea of equality or the idea that everyone is the same; they are no such thing. You need a pecking order/hierarchy.

          The fracking chemicals have actually gotten a lot better with almost all of the fluid being straight water. Every case of water contamination from fracking has come from surface water contamination (basically surface dumping which was legal in many states). On the good news, offshore production has basically been completely shut off.

          • Suvy,

            One necessary condition for inequality to be “healthy” is badly missing in the US and almost everywhere: that money is neutral, ie. that it grows at the same pace as real economic activity. Only under that condition, the resulting distribution of income and wealth can be deemed to reflect only or mostly differences in competence, merit, risk-taking, perseverance, creativity, hard work and good luck. Only under that condition, inequality is “healthy”.

            If this necessary condition is not satisfied – and it has been very far from being satisfied in the last 40 years – income and wealth distribution is distorted by price inflation either in goods and / or in asset markets. For instance, what exactly was the merit of a baby boomer who has become rich by buying a home in the late 1960’s by borrowing fixed rate, only to see the value of his / her debt almost evaporated by subsequent inflation, while his / her salary was indexed, and the value of his / her home inflated by non stop money printing after he / she had fully paid his / her mortgage? In this real life example, substantial wealth has accrued to this baby boomer that is completely coincidental. You can find endless examples of that kind. The cumulative effect of 40 years of accumulated distortions are tremendous. Speaking of meritocracy in a situation where money has been growing twice as fast as overall wage & salaries for decades is utterly meaningless. This meritocracy thing has become a myth. Indeed, it is bizarre, to say the least, that most defenders of meritocracy rigidly refuse to compete on the basis of neutral money. As if they were afraid of something…

          • The idea that inequality is only beneficial if “money is neutral” is nonsense. Everything in the natural world is winner-take-all, including wealth creation. We talk about wealth creation as something that’s predetermined, but it’s not. It comes from trial and error. You need the trials for the successes and as the probability of success drops for each trial, the gains from the success of that trial increase disproportionately.

            I come to very different conclusions. I come to the conclusion that we need these cycles. You’re right, it does allow asset speculators to get access to easy financing, but it allows some kid trying to start something in his basement to get easy financing too. We cannot let the prospect of failure deter us from taking risks. Out of 1,000 kids that start something, 999 may fail, but that’s okay because that 1/1000 chance of being correct will outweigh every loss put together.

            In the situation you described, it’s not about the probability of success, but its payoff that matters. If you can’t control the dose, then control the response. If you do control the response to set up a convex response, the more you increase volatility, the more the benefit (direct consequence of Jensen’s Inequality).

          • “Responding to Suvy”

            I am afraid I cannot agree with you “destroy the whole forest with an off chance of finding a diamond” type of economic. Further, there is a more important point – an innovation that is only viable at 0 or near 0% financing is probably one that is not very useful anyway.

          • I think you’re making a lot of assumptions (mostly implicit) about what we know about the future and how things will end up, when we really have no clue. The way the winner-take-all systems work vs the way most people’s minds naturally think about things are usually very different. In a winner-take-all type of system (anything in nature, including economies), the dynamics are very different.

            Remember how Prof. Pettis mentions the importance of reckless banking and how helpful it can be in development, even though you do have negative consequences. As long as you can keep the losses localized, you’re fine.

          • KP2011,

            I’m not arguing for destroying an entire forest; it’s exactly what I’m arguing against. Why do you think I said the most important thing is to keep the costs localized? Such institutions provide convexity by placing an absorbing barrier on the total loss.

            Please reread what I said and at least try to understand the argument I’m making before placing words into my mouth and filling it with things I didn’t say.

            What if there’s a 1% chance of success where your payoff for being right is 1000:1? Why would you not take that bet? In a winner-take-all world (fat-tailed probability distributions), that’s the way the world works. Do you really wanna be the guy betting against something because of a 1% chance of success even though the possible payoff in that result is much higher? You can take that bet; I’ll take the opposite every time. Over time, I’ll be taking your money like taking candy from a baby.

            The innovations that’re the most important are usually the ones with a near 0% shot of working. If there was a higher chance of success, it’d have already been done.

          • Hi Suvy,

            I am sorry if I misunderstood you.

            I was referring to this:
            “I come to the conclusion that we need these cycles. You’re right, it does allow asset speculators to get access to easy financing, but it allows some kid trying to start something in his basement to get easy financing too. We cannot let the prospect of failure deter us from taking risks. Out of 1,000 kids that start something, 999 may fail, but that’s okay because that 1/1000 chance of being correct will outweigh every loss put together.”

            I interpret your ‘easy financing’ using the contemporary situation which means near zero. The damages of the speculation may well outweight the off chance of a 1000 to 1 payoff (the last round nearly destroy the entire world economic system).

            However, more important – something which you did not respond to: A 1000 to 1 pay off innovation does not require sub 1% financing to work. Such innovation would do just fine in a 3-4% interest rate environment. Things that are only viable with 1% financing is likely to be not very useful stuffs at all.

            The 1 in a 1000 succes may well outweight the 999 failures, but that is not very likely to outweight the 1,000,000 damages easy financing cause elsewhere – an externalities that you ignore when you looked at the 1:1000 payoff scenario.

            So, I am afraid I have to disgree with you that easy financing will lead to some off chance 1000 to 1 payoff that outweight the damages done by easy financing.

          • Suvy,

            Thank you for explaining how it’s done in the natural world. Sounds wonderful. Here on planet Earth, things are not as beautiful but we struggle along. The money system is entirely man-made, can you believe that? There is even a central authority (they call it a central bank) which creates and directs wealth all by itself (they call it the “wealth effect”). As if wealth creation was this predetermined or centrally-planned thing. Can you believe such nonsense? I mean, not to complain too much, there are also great advantages: kids love it. It keeps them in their garage where they invent all kinds of cool stuff. You know, the kind of stuff that could never have been invented under deflationary gold standard, way better than this telegraph crap that 27 year old Edison invented back in 1874, you can’t even compare. There are a few side effects, of course, like it amplifies fluctuations of the economy into roller-coaster booms and busts while weakening the long term trend but it’s really nothing compared to this wonderful convexity stuff that makes things so awesome. Like for instance, we had a big crisis a few years back after banks behaved recklessly. They were morons who couldn’t grasp how good it was for economic development. Suckers. Losses spread everywhere, you know, trillions of dollars all over the world (Americans had sold this junk to the socialists and the fascists in Europe… well done boys!). Clueless guys were worried. These poor souls didn’t know we would be fine if we kept the losses localized. That was a piece of cake, really: we localized everything straight onto the central balance sheet. That was so beneficial, you know, there are even more kids now in their parents garage. Isn’t that great? And wealth is really unequally distributed, you should really see this. Ok, it’s for different reasons but that evokes such great memories of how things were back in the natural world, you know when things were so beautifully convex and stuff.

            Please, continue to send news from the natural world. It’s so fresh, we just love it down here.

            Best regards from planet Earth,


          • DvD,

            An economy is like an ecosystem. Whether or not it’s “man-made” is really completely pointless. It’s not something that’s engineered, that’s for sure. It’s something that grows and adapts to whatever is going on. It’s not something that some set of engineers come up with and dictate when, where, and how everything happens. If that’s not blatantly obvious, I don’t know what to tell you.

            You’re talking about how the kind of system I’m advocating for creates booms and busts. I’m saying you need booms and busts. It’s the same way you get stronger too. You destroy and tear your muscle fibers, but why would you do that? It’s because your body is able to recover given that it has the nutrients to recover and repair itself. It’s the same thing for an economy.

            BTW, the most leveraged systems aren’t demand driven economies built on entrepreneurial, decentralized markets. They’re the centralized investment/export driven growth models. Suppressing volatility is like pushing on a spring.

            FP 2011,

            “I interpret your ‘easy financing’ using the contemporary situation which means near zero.”

            No, it’s certainly not. What I’m saying is that you need incentives for people to take risks and an economic/financial system that’s opportunistic enough for these people to allow them to take risks.

            If you’re talking about massive liquidity having the potential to seriously dislocate asset markets, misallocate capital, and throw off information signals, I agree with you. However, I don’t think we need full-reserve banking as a solution.

          • Hi Suvy,

            In this case, please accept my apology for the misunderstanding.

            I agree with you that full reserve banking is not needed (although a combination of higher T1/2 + raw leverage ratio is in order)

            Original quote:
            ” it’s certainly not. What I’m saying is that you need incentives for people to take risks and an economic/financial system that’s opportunistic enough for these people to allow them to take risks.

            If you’re talking about massive liquidity having the potential to seriously dislocate asset markets, misallocate capital, and throw off information signals, I agree with you. However, I don’t think we need full-reserve banking as a solution.”

          • Suvy,

            There is so much confusion coming out of your various comments that we need to take it step by step in clear fashion:

            1. Yes, the modern economy is a man-made ecosystem. As such, if reflects a human organisation, not the “natural world”. Glad this is now clear for you.

            2. What is the main goal of this human organisation of the economic system? Different people can have different answers. My answer would be that the main goal is to achieve sustainable prosperity, ie. sustainably rising living standards.

            3. In view of the objective set in 2., are there forms of economic organisations that are better than others? We know from history that the answer is yes. The capitalist organisation based on decentralised free markets and private property in general has delivered much better than the communist organisation based on central planning and public ownership. In that sense, the fact that the economy is man-made is not at all pointless. How it is man-made is crucially important. Differences of principles on which the economic system has been organised have had tremendous impact on the lives of hundreds of millions people in the last century alone. It is anything but pointless. I hope this is also clarified for you now. Capitalism itself is not at all a “natural” state of affairs. It is organised. It does not belong to nature. You need property rights, you need rule of law, you need some public goods, ie. you need a political organisation, you need a monetary organisation.

            4. Which brings us to the question we are debating: is there a monetary organisation of the decentralised free market economy that is better than others in fulfilling the objective set in 2.?

            – If i understood you correctly, your answer is: the sustainable wealth creation objective is best served by easy and flexible money, ie. money growing faster than production and income as allowed by a fractional reserve credit system, as it increases the number of trials and errors and hence the cumulative value of successes. You say that there is a need to keep the losses localised (without saying how) to stay fine.

            – My answer is that the sustainable wealth creation objective is best served by neutral money backed by real savings, ie. money growing at a steady pace in line with sustainable production growth within a full reserve credit system.

            Why do i think the type of monetary organisation i suggest is better than the one you suggest? Mostly for two reasons:

            a) There is no evidence that the amount of successful innovation is higher in the first system so as to compensate the waste of more failures. The fact that economic growth has slowed under such system since 1971 shows that this is in fact not the case. Your argument about higher net cumulative gains from successes is not proven empirically, rather the opposite since growth as slowed. Said differently, i don’t know of any worthwhile innovation that would not have seen the light under “neutral” money. “Easy” money is not a necessary condition for wealth creation. The incremental economic gains you associate to it simply don’t exist.

            b) If production and income growth is not faster (as per a) above), the inevitable result of the first system is an unsustainable debt build-up as the system is now longer self-financed (fractional reserve can expand the amount of credit without a corresponding expansion in the pool of available savings by simply increasing the multiplier). When this unsustainable debt pyramid collapses, financial distress has a huge economic cost: borrowers cut spending, sending the economy into recession. In a fractional reserve credit system, banks are forced to cut lending to protect their liquidity and solvency, exacerbating the recession. The result is you introduce negative compounding in the path of economic development. In a fractional reserve banking system, it is by design impossible to keep the losses localised. The leverage embedded in the system ensures that losses will be magnified and spread. In the end, losses have to be absorbed by the central government, which undermines the exact principles on which the decentralised free market economic organisation rest. This is what we have seen so clearly in 1933 and recently: the more normal fluctuations in the economy have been unnecessarily amplified by an inadequate monetary organisation, the more central authorities have had to interfere with the economic system to stabilise it and regulate it. It is totally incompatible with your desire to “decentralise everything”.

            In summary, the empirical evidence is that your favored system results in no extra gain but extra cost compared to a neutral money system.

          • DvD,

            I don’t think you either read or try to understand what I’m saying. Is the economy something that interacts with other systems (like with political, social, geopolitical systems) and codevelops with them? Or is it something that needs to be micromanaged every step of the way with no interactions or developments with those other systems?

            “What is the main goal of this human organisation of the economic system?”

            What if we don’t know (and can’t know) the answer to it?! Did you ever consider that option? Because that option is the real answer. It’s arrogant to think we can know the purpose of these things.

            “Capitalism itself is not at all a “natural” state of affairs. It is organised. It does not belong to nature. You need property rights, you need rule of law, you need some public goods, ie. you need a political organisation, you need a monetary organisation.”

            THAT IS A NATURAL STATE OF AFFAIRS! Economic systems interact with political, social, geopolitical, religious, ecological, and a whole hose of other systems, which makes it very different in operation from something like a car. In each area and region, the economic systems are adapting differently.

            “Evidence” doesn’t favor what I’m saying. So let’s take a complex system wherein rare events dominate and then resort to “evidence”. Rare events and risk never lie in previous evidence! It’s not about what’s happened before; it’s about designing a system that can adapt to what’s going to happen. Using previous data and claiming “evidence” is a naive and stupid way to go about doing things.

            “There is no evidence that the amount of successful innovation is higher in the first system so as to compensate the waste of more failures. The fact that economic growth has slowed under such system since 1971 shows that this is in fact not the case.”

            This is horrendous methodology. If you create a convex payoff (limiting the downside by localizing it and not limiting the upside), it benefits from uncertainty. You’re so damn concerned about finding “evidence” when none exists. You’re trying to use methodologies that can never work in complex systems and claiming what I’m saying has no “evidence”. The point isn’t about “evidence” because “evidence” will never show you, or be able to detect, rare events or tail effects (by definition of rare event).

            “In a fractional reserve banking system, it is by design impossible to keep the losses localised.”

            Not if you decentralize currency issuance. The monopolization of currency issuance was (I think) designed for war, not to increase economic well-being. You’re talking about economic systems constantly having to adapt to constraints in other systems, but ignore the consequences of what you’re saying.

            “the empirical evidence is that your favored system results in no extra gain but extra cost compared to a neutral money system.”

            What if we have an absence of evidence that you’re confusing to seem to be “evidence”? When you have these massive data sets that contain “evidence”, you really don’t have very much. Trying to take a very data-based approach by resorting to “evidence” because it seems scientific is inherently unscientific.

            Instead, we need a way of thinking that’s more robust in the face of what we don’t understand (which is virtually everything in economic systems) instead of relying on “evidence” which obviously can’t account for risk in any meaningful way. We must think about things probabilistically.

          • BTW, this is what I mean by natural. By the “natural world”, I mean self-organizing systems.

            It’s naive to think self-organizing systems have the same behavior as engineered ones (like you clearly seem to think). You may wanna read that link so that you can think about these systems more soundly.

          • By natural, I mean self-organizing. You may wanna check this out and understand this concept a bit better. Command and control, or any variation, leads to (extremely) violent blow-ups in these kinds of systems.

            By “natural systems”, it means any self-organized, hierarchical system. An economy is obviously in that category.


          • The fundamental contradiction in all you say is that you talk about self-organizing systems that are robust in the face of unknown risks while at the same time saying that the booms and busts arising from a weakly designed centralised money system that amplifies the normal fluctuations of the economy by accumulating risks for a long time before releasing it all at once in the crudest form of feedback-suppresing organization are necessary. This contradiction is obvious when you say the losses have to be localized but you also say it was great for America that it spread the losses by selling its junk securities to Europe. The booms and busts you think are necessary are precisely the kind of violent blow-ups arising from command and control systems that you condemn. You are contradicting yourself. The lack of practical value in your approach is obvious when you say we have to decentralize the currency but when asked how you don’t know and you say we just have to wait. Once you have reconciled this fundamental contradiction and reach a stage of coherent thinking, it will be easier to understand you. Once there is operational value in what you say, we can go beyond the big but largely empty words you use and discuss seriously. You have a lot of work to do.

          • “The fundamental contradiction in all you say is that you talk about self-organizing systems that are robust in the face of unknown risks while at the same time saying that the booms and busts arising from a weakly designed centralised money system that amplifies the normal fluctuations of the economy by accumulating risks for a long time before releasing it all at once in the crudest form of feedback-suppresing organization are necessary.”

            That’s not what I’m saying. I’m saying the feedback-suppressing nature of our economy comes from its centralization of the currency issuance. Localization of the currency issuance allows for each city/region/province/state its own feedback mechanisms for input and output generation. It’s very robust.

            By the way, decentralizing currency issuance is very simple. The first thing you have to do is prevent anyone from issuing currency or money. From there, it’ll automatically develop. I actually think you can use Varoufakis’ suggested solutions for Europe as a way to restructure the monetary system here (through decentralized state organization). I actually think the places that might be most likely to take up Varoufakis’ solutions might be the United States and it might come from the American Right (not current establishment Republicans).

            I see you don’t understand what I’m saying. Self-organizing systems don’t respond well to command and control.

          • Suvy,

            Let’s recap.

            This exchange started with a discussion about what sort of income and wealth inequality is healthy.

            My position is that inequality coming from unequal economic value added under neutral monetary conditions is healthy but not inequality coming from unequal exposure to money expansion systematically in excess of economic expansion, as is the case for several decades under the current system. I provided a real life example of “unearned” wealth to illustrate what i meant.

            Your position is that inequality is beneficial even if reflecting monetary expansion systematically in excess of economic expansion. You provided no example to illustrate what you meant and simply justified your position on the basis that, in the natural world (which you later defined as self-organised systems), winner takes it all anyway (are you sure about that? is that an affirmation or a scientific conclusion? is it the way algorithms are programmed or is it the actual way nature operates always and everywhere?) and that the financial boom-and-bust cycles are a necessary condition to the trial and error process that drives wealth creation.

            I pointed out that, while we agree on the trial and error process as the engine of wealth creation which results in healthy inequality, this engine works just fine if not better with neutral money and that in any case the current fractional reserve money system is not “natural” or “self-organized” but reflects an organisation engineered by bankers as a fait accompli and that, as such, your “natural order” argument doesn’t apply. Or is it that the argument is relevant in a perverse kind of way if the current fractional reserve banking system is in fact a winner-takes-all outcome with the bankers as winners?

            Anyway, at this point of the discussion, you bring up “decentralized” currency issuance which shifts the discussion about inequality within the current money system to an hypothetical different system. I’m quite open to changes to the current money system which i view as sub-optimal but this hypothetical new money system is very vague to me and you have remained completely vague yourself. If i understand you well, we prevent anyone to issue currency or money and we just see what will spontaneously emerge? Even if you could convince everybody to make such a big step into the unknown (you might want to work on your language for better marketing impact), we have no clue what will emerge. You assume whatever new system that emerges would be perfect. May be. May be not. Your decentralized currency system is so unknown that there is no point speculating what type of inequality may or may not be beneficial under such system.

            So, as far as the initial question, I can only reiterate that “unearned” wealth inequality is not healthy under the current money system in that it distorts the incentives embedded in the decentralized free market economy and results in capital misallocation, which is to say wealth destruction.

            As far as an alternative money system, you have a lot more work to do on making the case for the decentralized currency system. Say currency issuance has been decentralized last week and banks are now prevented to issue currency. This week, i need a mortgage to finally buy the house i have been negotiating for weeks. To whom do i go and how does it work?

          • Let me make sure I make my point clear: private sources should be able to issue currency. I may have had a typo or two in the past,

            I use no example of monetary expansions leading to economic benefits or innovations? How come most innovations and business expansions (both productive and unproductive) come during periods of liquidity expansion?

            My primary qualms with inequality are shifts in the savings rate. As long as you have mobility (up and down) with lots of hostility at the top, I don’t see why inequality is an issue.

            To me, it seems pretty clear the world is winner-take-all. It’s Pareto’s distribution and the effect of scaling. It’s pretty well known in economics. The effect is even more extreme for wealth and the accumulation of wealth than it is for income. A simple example is wealth where you have 1 million people and then add in Bill Gates. That addition of one person, regardless of the sample size, completely changes the mean and variance.

            The reason I prefer decentralizing currency issuance is because it allows each region and city to have its own feedback mechanism that gives each region/area new information on how to shift inputs/outputs. The same thing can be done with tariffs, but I prefer decentralized currency issuance because tariffs can go horribly wrong.

          • The problem with stretched inequality is the one described by Michael Pettis in “Economic Consequences of Income Inequality”: weak demand, over-investment, rising debt burden.

            First, let’s look at the US numbers from end 1971 (the year the current money system was born) to end 2014. Over this 43 year period:

            – Real GDP grew at a compound annual growth rate of +2.8%, made of employment growth of +1.4% p.a. and productivity gains of +1.4% p.a.

            – As an important contributor to real GDP growth, real consumption grew at +3% p.a.

            – But, real income of the bottom 90% grew by +1.2% p.a. only, made of +1.4% growth in number of employed people and -0.2% p.a. of real income growth per people, far below productivity gains of +1.4% p.a.

            – If real GDP grows +2.8% but real income of the bottom 90% grows only +1.2% p.a., it means there is a transfer of value from the bottom 90% to the top 10% to the tune of +1.6% p.a. or a cumulative transfer of 98% over the 43 year period. Inequality is soaring. The share of real income of the top 5% grew from 20.5% in 1971 to 34.3% in 2013. If things continue like this for another 42 years, the top 5% will earn 57.5% of total income by 2055.

            – Let’s not make it an ethical or social argument. On the contrary, let’s take it for granted that this kind of inequality is fully deserved and let’s just look at the implications from the point of view of the efficiency of the economy (by that we mean the ability of the economic system to generate sustainable wealth).

            – At the aggregate level of the economy, all production generates either labor (wage) or capital (interest + profit) income and all income is either spent or saved, ie. either consumed or invested. If the share of those with the highest propension to consume (the bottom 90%) goes down and the share of those with the highest propension to save (the top 5%) goes up, it means consumption share of production goes down and investment share goes up, meaning production capacity goes up. But if final demand keeps lagging, overcapacity eventually builds up and expected return on investment fail to materialize. Capital owners have misallocated and eventually wasted capital. If consumption share doesn’t go down but labor income share goes down, debt goes up, providing an outlet for the savings of capital owners. From 1971 to 2014, total debt has grown at over +8% p.a. vs. +6.5% for nominal GDP. The transfer of value of 1.6% p.a. mentioned above has been exactly offset by debt. But if debt keeps growing faster than income, insolvency risk of the borrowers eventually builds up. Capital owners have misallocated and eventually wasted capital.

            – It is not a coincidence that inequality reached the same level in the US prior to the 2008-2009 crisis than prior to the 1929-1933 great depression. Income distribution is in itself a function along which the economy self-organizes. If you have a trade and monetary system which distorts this self-organization of the income distribution within an economy and / or between different economies, you generate artificial imbalances that degenerate into economic crisis. Hence the need to have trade and monetary institutions that don’t artificially interfere with the self-organization of the economies, either within a given economy or between different economies trading with each other.

            – In international trade, it means having a system which keeps cross current account balances at or close to equilibrium, which is far from being the case under the current WTO system. We have already discussed in comments to “How much longer can the global trading system last?” and “How to link Australian iron with Marine le Pen” how the current WTO framework rests on a complete misunderstanding of the conditions under which Ricardo’s comparative advantages are mutually beneficial.

            – On the monetary side, it means matching borrowing needs with available savings via the interest rate market (neutral money), not a banking system like we have now which creates (and then destroys) credit ex-nihilo and suppress the interest rate function by financial repression (easy money) so as to postpone the adjustments only to make them more painful later on. We have already discussed in a comment to “How to link Australian iron with Marine le Pen” how the current monetary system completely blurs the price signal which guides capital allocation. It is fair to say that the current monetary system rests on a misunderstanding of the monetary organisation compatible with free decentralized markets.

            Free decentralised markets need a certain set of institutions to operate efficiently and work their wealth creation wonders. The institutions we have now – and the policymakers running them – are mostly inappropriate. Socialists or moralists with a social or ethical perspective would say the current system and policymakers are working against the interests of labor and for the interests of capital owners and bankers. But we have left all social or ethical considerations out of the argument here. And so it is with a purely capitalist mindset that we say that the current trade and monetary system and policymakers running it are attacking capitalism at its core, by interfering in a detrimental way in the capital allocation engine room. This is the part that is misunderstood by many self-proclaimed capitalists (though many CEOs of global companies have by practical experience developed a perfect understanding of the system, at least the trade aspect, may be less so the monetary aspect ; their conclusion is that they are paid to run their company, not to design a better system).

            This is perhaps where we disagree in the end. You seem to believe that the decentralized free markets economic system is best served by a laissez faire approach while i think that institutions are not only more realistic in practise but also necessary.

          • “Free decentralised markets need a certain set of institutions to operate efficiently and work their wealth creation wonders. The institutions we have now – and the policymakers running them – are mostly inappropriate.”

            I’m in virtual agreement with your entire comment. This is why I think we need to localize currency issuance. It’s a fundamental shift in the monetary system that would allow issues to be dealt with locally. I come to extremely similar conclusions as Prof. Pettis on his income inequality post. The logic there is very fundamentally sound. It’s rigorous.

  4. Mike,

    Been following your blog for a little while now. I was hoping you would address the recent events in Europe. This is perhaps one of the more interesting developments in the world of sovereign finance I’ve seen in quite a while. I’m curious if you have ever met Yanis in academic circles and whether you have shared your views with him? Keep up the insightful commentary.

    • I haven’t, Andy, but yesterday someone sent me a link to his blog where he refers very kindly, and very briefly, to my book:

      • Dr. Pettis, do you deliberately go out of your way to piss off our German friends?

        Having said that jokingly, I’m still amazed (as you said) that this has become a national conflict. I can’t understand this dogma of the Euro. A multinational currency with limited political union and absolutely no fiscal union. How did these Euro countries inadvertently give up a big piece of their sovereignty to this far too abstract economic and political concept? Does anyone in Europe think this is democracy? Once again, I will reference Maggie Thatcher much to the dismay of our liberal British friends. When her fellow Conservatives broke with her on joining the European Monetary System, she basically said are you crazy you want to hand British monetary policy over to Berlin or Brussels.

        Monday morning standing next to Barack Obama in Washington, Angela Merkel appeared to be doubling down when she said that several of the PIIGS have begun to grow because of structural reform when answering questions about Greece. This was an indirect criticism of Greece that they have not instituted the advised reforms and austerity. Is this small growth in some of the PIIGS large enough to stem the growth of debt and start paying ot down? Is the growth sustainable? Shifting trade surpluses around to other regions seems a bit like a game of musical chairs with Germany guaranteed a chair.

        I look at these persistent German (and Northern European surpluses) like stepping on balloon. First, the Germans stepped on the right side of the balloon and the air (surplus) all pushed into Southern Europe. Then, the Germans realized the balloon would pop if they kept stepping on the right side so they stepped on the left side instead and pushed the air (surplus) to the U.S. and the rest of the world.

        Do the Germans really think their large trade surplus is sustainable indefinitely?

        • Since the Marshall Plan Europeans have been trained to be followers, that another continent is looking out for their interests, and that nice long vacations followed by an early retirement is a good thing. Which would be true if it weren’t for the rest of the world, where dog-eat-dog economics continues to rule.
          What’s sad is that in the coming era of stratospheric productivity, European socialism is the right answer. Let robots & computers work for me while I’m laying on the beach, what can be bad about that??

  5. Have you read Yanis Varoufakis’s book The Global Minotaur, it pinpoints the collapse of Bretton woods and the international monetary system based on the USD as world reserve currency to be the root of today’s global finanacial crisis

  6. Creditors always fail to realize moral hazard is double edged.

    The relatively more successful recyclers recently have been oil exporters with sovereign wealth funds investing in larger markets like Norway.

  7. Mike,

    Great material! I’ve now read most of your books, and I’ve enjoyed following your blog. I’m still trying to wrap my head around some of the balance sheet/current account examples your have presented, but it certainly comes across as a more sensible approach than the “spendthrift” vs “thrifty” country paradigm that seems to be in vogue right now.

    I’m curious….. Have you ever met Yanis through your academic circles? If so, what’s your assessment? Is he up to the task? And have you shared any of your thoughts on the EU situation with him? The Greek/EU story is one of the more fascinating events in the area of sovereign finance that I have seen in some time.

    Keep up the great work!

  8. Luis Gonzalez MacDowell

    This post is impressive.

    I try to make the point constantly in Podemos that the economic problem in Spain and Europe is incorrectly described as a German against Southern countries issue, rather than as a creditors against workers issue. Such that creditors and owners from Spain or Germany benefit alike from the situation, and German and Spanish workers share the burden alike. Only there are many more creditors and owners in Germany than in Spain.

    Unfortunately, the prevailing speech in Podemos is very much nationalistic and often germanophobic.

    Yet, it is the only party arguing closely along the lines of this post.

    Is there a chance to appoint you as spanish finance minister with a Podemos government?

    • Thanks, Luis. Ha ha, I would love to advise Spain on debt restructuring and would enjoy confronting bankers from the other side of the table, some of whom might even be old friends, but I don’t think my American passport would endear me to either side.

    • What an excellent idea! You should somehow push this idea through! I voted for SYRIZA in Greece, while Y. Varoufakis was one the only Greek Economist I admired because of his clarity and simplicity of ideas and the fact that he didn’t seem to lose sight of the real economy (what an insulting term that is!).

      I would be refreshing having two competent, knowledgeable, trained and acclaimed economists in two EU countries. Not just to deal with the debt issue, but to steer economic policies in the right direction and help growth throughout Europe and their respective countries.

    • Yes Luis,

      It is the parasitic lenders, and there is no other true cure but their complete removal.
      People or entities that represent others (Goverments, councils, etc) should not have the power to borrow money, end of the problem.
      I they borrow and I have to repay, they will borrow forever.

  9. I find it quite impressive how Pettis is able to consistently wade through mountains of economic and political dogma to give clear, concise and nuanced analysis on a regular basis. Is this something that you developed working in investment teams? I wonder if the incentive structure of ‘make money’ as opposed to ‘come up with something persuasive’ (ie academia) in your early career is responsible.

    • Thnaks, Flint, but I think I am revealing no secrets when I say that bankers think much more sharply than academics. I am not suggesting that one group is any less prone to bullshit than the other, but I will suggest that when you disagree with an academic or an economist, it is often tough to point out where the disagreement lies. Notice the debate over China’s rebalancing? Somehow China has done everything the bears said it would and the bulls said it wouldn’t — growth has slowed dramatically, debt has surged, there is a major political confrontation about assigning the adjustment costs within the elite, the growth model is being reversed — but the bulls are still able to begin every article with the question: “When will the bears finally admit they were wrong?”

    • It’s interesting what you say about ‘making money’ vs academia. I worked for a few years on that interface, trying to help academic researchers turn their science discoveries into profitable businesses/patent licensing opportunities.

      One of the things I noticed was that they focussed on ‘why is this the case?’ and I was always asking ‘what does this mean? What products and services could emerge from this? Who can benefit from this?’

      For me it was quite easy as I’d been a science researcher before my MBA. Many others find it more difficult.

      Actually, I think each of us actually has a default mindset and it’s through enabling those of different default mindsets to interact successfully that most successful life outcomes emerge……

  10. I think it’s important to acknowledge the idea of Europe as a supra-ethnic project, with membership as a means to distinguish their nationality from a rivalrous other or rivalrous history. This has tended to lend support to the Euro idea from the lower classes (in the peripheral states) when they would otherwise reject membership in the project.

    • It goes deeper than this. I’m willing to bet you the US is far more ethnically diverse than virtually all of Europe, but we don’t have the same problems here. The real problem is the geopolitical structure of Europe, which is designed for war; not for trade.

      • Really, Suvy, gotta jettison this old economics and war non-sense popular among some anarcho-libertarian free marketeers (there are far too many stupid people purveying that junk without you wasting your time, or finding more clever rationales for supporting such trash). Obviously, if anyone has ever spent any amount of time, during different era’s with Euro’s, that the Euro, has had the effect the other poster was recommending, although not merely a class based issue.

        • Just look at the natural trade networks. The entire North European Plain is a natural trade network with the Mediterranean being the other natural trade network. Northern France, Germany, and Most of Poland should be on the same trade network, but aren’t. North Africa, Italy, Spain, Southern France, and probably Greece should also be on the same trade network, but they’re not.

          If the political structures were designed for trade, you’d see a recreation of the Roman Republic AND a united economic alliance on the NEP up until (and maybe beyond) Poland.

          What I’m saying isn’t anarcho-libertarian nonsense. It’s rooted in my model about transport costs and infrastructure construction. Trade by water is about 2% of the cost of trade by land in terms of transport costs, so the most natural trade network is the Mediterranean. Similarly, the North European Plain is very easy to trade across with lots of navigable waterways. It’s flatland, it’s easy to build infrastructure, and there’s navigable rivers that empty into the north.

          Check out my two most recent posts on my framework for thinking about this.

          • Trade networks

            Comparative advantage, complementarity…tomatoes grow well in Spain, Italy, Greece and parts of North Africa, so do pine trees.

            Apples, cherries, hardwoods and much more freshwater to the north water.

            Why would trade networks evolve as you say?

            Geography, Cultural, Religious similarity…can be as much a reason for diversification of network as consolidation to take care of advantages and complementarities that are harder fought locally.

            Pakistan, Bangladesh, Indian and Sri Lankan would be natural trade partners with similar cultural nuances, but all share an abundance of labor.

            But notions of regionalization are interesting, with some talking of very long term futures as governance along these lines (bio-regionalism)

          • Okay, let’s take a look at the cultural similarities then. Is Italian closer to Spanish or to German? Was Islam more influential in Spain or in the UK?

            Pakistan is located on the Indus River Valley, which is kinda isolated from the Ganges Basin that comprises India’s core.

            Either way, it seems obvious to me that the political structure of Europe is designed for war. If we wanna truly fix the problems of Europe, this is the problem you must address.

          • Suvy

            Northern Italy, industrial heartland of Italy, can be said to be very much similar to Germanic countries (Swiss, Austria (Tirolians). etc). Will even find many blondes with blue eyes. But this is unimportant, because then I believe you are not referring to geography at all, but mixing it with cultural aspects (romance languages, Italy and Spain).

            Can you tell me how Bratislava, in Sovlakia, which has one of the top 10 per capita GDP’s in Europe, due to its importance in European trade networks, is part of a European system designed for war. Makes no sense whatsoever to me. Sounds like a stretch of some academic who has hoped to apply an environmental review, which includes geography, to the topic. I think Kaplan is great, love to {read(listen)} to him, but need to take such notions with very large grains (silo’s) pf salt.

          • Slovakia is a country on the Carpathians. The Carpathians should border off another empire/republic (the recreation of the Austro-Hungarian empire). Places like Slovakia would be one of the key pivots in the world in this new structure.

            Earlier, I said that the North European Plain should be under one trade alliance and it would include most of Poland. I think I’ll backtrack on that. It should include the UK, France, the Netherlands, Belgium and Germany with Poland being another battle ground. Denmark/Poland would be another point of contest between the Scandinavians and the North Europeans. The structure I’m laying out is, to some extent, a return to the past. You don’t even have to form or design the structures that way. If you radically decentralize everything, they’ll naturally form that way. It’s the most natural and most economically beneficial structure.

            I’m not one to think we can eliminate war completely, but what we can do is change the structures of the wars so that we can prevent World Wars. The US, throughout its history, has constantly been at war, but the wars have been localized (for the most part). From a risk standpoint, it’s much better to have decentralized multiethnic republics or empires fighting for smaller regions that happens more frequently than it is to have these centralized nation-states that get caught in weird systemic alliances.

            Actually, a radical decentralization of the entire Eurasian landmass would naturally yield the kind of structure I’m talking about. When I talk about a radical decentralization of the entire world, it’s because we need the political and geopolitical structures of the world reset (and they will be reset, the question is when and how).

            Basically, the natural trade networks assuming my framework of transport costs, trade networks, infrastructure development, and security costs are the ones displayed below.
            Trade Network 1: Mediterranean Sea
            Trade Network 2: North European Plain
            Trade Network 3: Baltic Sea
            Trade Network 4: Region held in by Carpathian Mountains
            Trade Network 5: Black Sea

            From here, I’ll start with the assumption that one governmental structure would minimize the security costs/network effects/transport costs and maximize economic activity. So now I’ll come up with names to describe the governments that control these things.
            Trade Network 1: Roman Republic
            Trade Network 2: The Barbarians
            Trade Network 3: The Swedish Republic
            Trade Network 4: The Austro-Hungarian Empire
            Trade Network 5: Roman Republic (Bosphorus Strait connects Mediterranean Sea to the Black Sea

            With regards to Robert Kaplan, I’ve never read any of his stuff. I’ve tried to listen to a few of his videos, but I can’t listen to him because:
            (a) He’s boring to listen to
            (b) He doesn’t understand economics very well
            (c) He needs to be taken with too many silos of salt for me to tolerate (a) and (b)

          • You mention Zeihan, and belittle Kaplan, his stuff becomes cliche, his delivery is practiced, but his points are generally great for the group, easy to fall asleep in the background to as one is lulled off to sleep. I watch everyone he speaks on, and have read most of his recent geographically focused books. Personally, I have always thought Zeihan to be a poorer imitation.

          • Suvy

            You might like this book…

            Cohen, Saul Bernard.
            Geopolitics : the geography of international relations / Saul Bernard Cohen. — Third edition.
            pages cm
            Includes bibliographical references and index.
            ISBN 978-1-4422-2349-3 (cloth : alk. paper) — ISBN 978-1-4422-2350-9 (pbk. : alk. paper) —
            ISBN 978-1-4422-2351-6 (electronic)

          • Word. I’ll check it out.

        • Think about how wealth is accumulated, right? I’m gonna start with the assumption that wealth can only be accumulated in cities (or city-like regions) because that’s the only way you can create ever-evolving input-output substitution/diversification networks. An economy is just how you pay for shit. In other words, an economy has inputs and outputs with the outputs paying for your inputs. In order to accumulate real wealth, you need to have a way to substitute inputs and outputs constantly in an ever-evolving fashion. The only place that can happen are city-like regions.

          On top of this, city-states need to be linked with other city-states so that you can have this constant evolution of economic activity. So you either need infrastructure like roads or canals or navigable rivers/seas. The central government is at the top of the hierarchy, but it’s power (in an environment designed for trade) comes from bottom parts of the system. It’s just like an ecosystem, right? In Europe, you do not have that structure. Paris and Berlin should be on the same trading network, but they’re not. It’s because the system was designed so that one power couldn’t unite the North European Plain by design.

          Do you read the stuff I actually write? I’m not really all that libertarian; I’d say I’m more conservative (in the Hamiltonian sense) than I am libertarian. I don’t think you’d see many anarcho-capitalists praise Nicolo Machiavelli and Alexander Hamilton while showing a hatred for Ayn Rand and many libertarian thinkers.

          The current political and geopolitical structure in Europe came about because they realized they needed to maintain the balance of power in Europe in a time when the European powers ruled the world. You may have realized that the European powers no longer rule the world and some of them (IMO) are entering a decline for the next few generations.

          BTW, the Americans in the post-WWII era recognized this problem in Europe. The design of Bretton Woods was designed to curb the European nationalist sentiment because they understood it was designed for war. Actually, even the Founding Fathers understood this at a very crude level (that Europe was designed for war). What was built in the US was something rooted in ancient thought.

          • Yes, I read what you say.
            Your tone and tenor and statements,if inferred assumptions, often place you as I describe by my understanding. It is difficult because many things mix in the current era.
            Pop-culture is a mix of these and more.
            Some of the ” why I oughta….I woulda….I could just…..” might mix sentiments, and drive y perspective a bit.

          • I write exactly like I speak. I care for sugar-coating things or making it seem more “formal”.

          • Sugar coating….say what I think, etc….

            This is a current pop-cultural meme, that is exhibited of some levels of disgust that people have, while we may feel, think and bliieve that we do this that or something else, we are, in many ways influenced by our environments, spirits of the times, and worldviews. In the current era there is quite a mix of these. For example, currently I have been reading a lot of this, thus acknowledging that you are integrating the notions, your responses, your understanding, and misunderstanding, your extensions, and revisions into your worldview, of necessity, no different than if you labored in a coal mine you would bring coal dust into your lungs (my only thought is for limiting potentials for black lung, in these circumstances.

            I have read, and meditated on Spinoza a lot, and even smiled at how I can see his thought in my beliefs.

          • If you’re saying that we’re a product of our environments as much as we are ourselves as individuals and I’m no different, I agree.

          • If such is the case, the product, then what is the use of assuming we have a no-nonsense, I says them as I sees them, when we are very much influenced and influence-able. The says them as one sees them, assumes an assured no non-sense, lets just get rid of all the hooey fallooey, when that might be all that we have, as a mere product. If such is the case, it might be less of a dura-cell, go head, knock it off my shoulders ethos, a la Natalie Woods husband, and Charles Bronson, might actually be much better (and certainly more real, insofar as being around truth rather than merely purveying our own. And, all the better that we provide ours, and listen to others (to dispel the post-Modern prediliction to see all as merely subjective)

        • Csteven,
          Having read Dr. Pettis’ blog for several years, this is not the first time someone has found this blog and has basically piggy-backed on to persistently promote other issues, theories and blogs.

          • Phil

            I have been participating since before this blog (FTM), and from the very beginning of this blog, and this is exactly what I am discussing, your criticism I suppose, and am not persistently promoting any idea, other than those as I have taken them, and then, to dispel the occasional gold-bug and similar that descends. Very much in the same vein. One need be caeful as to what we see “this blog” and what that portends and our understandings and what they see “this blog” as.

            But am generally in line with that ethos,especially insofar as for those who have ideological positioning within this matters, that all truth is found in the middle. (aura medicritas, golden mean). So no promotion here. When others have blogs and blog postings i tend to enjoy reading those as well, when their knowledge is useful.

          • Csteven, my apologies. I wasn’t referring to you. I was being a little tough on Suvy who actually does make some good comments beyond his political and economic theories.

            I love a lively debate, but some of the bloggers over the years have sprayed a constant barrage of whatever occupies their blog. A few years back, I remember a guy who seemed to be constantly discussing the Filipino economy, 3D printing’s impact on manufacturing, the accelerating devaluation of limited skill labor and futuristic views of the global economy. As they say, time flies when you are having fun.

          • I fill this place with, not what occupies my blog, but with what occupies my mind.


            I do not agree with the idea of the middle way. In real-time decision making, I think it’s very dangerous to make decisions based on the middle way. The best course of action is to take an action on an extreme. If you don’t know which extreme offers the best course of action, then try to wait as long as possible. However, it is not wise to make decisions (particularly important ones) by taking the middle way.

            Taleb talks about the barbell strategy as being more robust to uncertainty. However, Taleb wasn’t anywhere close to the first one to come up with the idea. Machiavelli mentions the same idea. I tend to agree. Most times, the middle way is the most dangerous as it provides you little to no benefit of either extreme but makes you vulnerable to both extremes.

          • Suvy

            Middle Way….uhmmmm, where different people have to be involved in a discussion, necessarily more than one, where different people have different beliefs, values interests, where there are more than a few people and where there is a great admixture of interests, necessarily, middle ways are always followed. Even Simon’s, Bounded Rationality, essentially brings one to a way that is not purely rational, insofar as what a decision-maker, with perfect knowledge (as perfect as the have), would have, and the individual satisfices, or makes a decision on what is boundedly rationale.

            I tend to choose what I choose, but in the discussion, there is no hearing without, finding all truth to be in the middle, because rare is the case where someone, miraculously alters from the things they know, they find the reasons for integrating new ways of knowing, in the midst of their existent beliefs, thus necessary to move from the center. Further, often times, they already sit there, but emotional responses and anxiety move them in a fringe direction, which leads to the matter of fact, pretend a tough stance notions that have relegated discussions on serious policy matters to dustbins for decades, while some remain emotionally satisfied that other tough talkers feel as they do. Wasting time.

          • Actually, rationality is a great assumption. You don’t have to do bounded rationality. Rationality can lead to bubbles and all sorts of crazy behavior that’s very representative of the chaos we see in the real world. The incorrect assumption is that the errors are uncorrelated. Once you change the correlation of the errors, you can get cascades and all sorts of stuff. There’s been plenty of work done by people like Benoit Mandelbrot about this.

            In chaotic systems, it’s always better to be on the extremes. Think about it from a risk perspective. In a winner take all system, it’s more important to prevent the large tail events (prevent them from happening at all) than it is to increase the probability of a positive event. It’s about impact.

            Keep in mind one thing: I don’t need to know your hand just to call your bluff.

  11. Have you spoken with our minister about your ideas?I think it would be a good thing to do…

    • Thanks, SM, but the only contribution I could make is to help figure out what an optimal balance sheet should look like.

      • Either way, this article needs more dissemination. Granted you have to be superbusy but put some energy into finding more widely read venues. PLEASE!

  12. But what about Baltic countries? The economic consequences there were the same as for Greece. Rapid GDP decline 10-20% a year for 2 years, debt-to-gdp ratio skyrocketed. But they didn’t devalue there currencies.
    They chose aggressive austerity. Real ( not make-believe ) spending cuts in budget. including abrupt cuts in wages( like 20% and more), pensions, welfare; and laying-off anyone who could be made redundant in state sector.
    And these policies were successful. Latvia and Lithuania joined the Euro.
    So, German taxpayers probably think: why Greece should be different? Because when eastern EU countries have the same problem they don’t want to devalue but cut budget spending instead. So why can’t Greece just do what Bulgaria does? Or Slovenia? Greek wages are uncompetitive to Bulgarian and Romanian ones, and Greek economy cannot compete with Northern Europe in high-value sectors. So do the structural reforms or cut wages.
    Countries that devalued( like Hungary ) got big problem with debt defaults because many borrowed not in local currency. Creditors prefer to give credit in euro or dollars. And when you borrow in local currency you also pay the cost of possible devaluation. Greeks didn’t pay any risk premium and borrowed at rates as if they were productive/efficient/high-tech northern European economy that can generate real wealth( bringing to the market new technology & services that are always in high demand ) when in reality they were a Balkan economy, more like Romania. And there austerity measures were nowhere near what Romanian government did since 2009.

  13. Rookie question.

    You mention that German savings flowed from ‘Germany’ to ‘Spain’ because Spain had lower interest rates than Germany. I thought capital flows to wherever interest rates are highest. Perhaps you (or somebody else) can help me understand this link in the chain of your argument?

    • That’s actually a good question, Makee, and I should have been clearer. Spain actually had higher nominal rates but lower real rates.

      • nd you might want to continue, along the logic of your model, and since it had lower real rates, if higher rates than Germany, where the lower real rates where a shock, in way to borrowers of funds, which would, rationally encourage people to act (perhaps, irrationally)……

        such would have been supported by…

        all the rich Northerners are gonna want to retire here
        Houses cheaper, bigger, better
        Better Climate
        globally regarded Cuisine
        Natural Scenery
        their Health System is honored here

        The Eu and Euro is a new force acknowledged globally
        Look what it has done to the mighty dollar
        Fortress Europe, low fiscal deficits, stability in the currency on entry (thus after)
        The comparative advantages in lifestyle services (restaurants through entertainment)
        etc and so forth…

        Under such circumstances one would be stupid to not avail oneself f the cheap money

    • What happened was due to the nature of the common currency zone. The rates that borrowers in Spain were faced with fell considerably when Spain joined the Euro. Banks regarded loans to Spain as without any currency risk and so lent huge amounts of money to borrowers who suddenly had access to cheap money.

      The huge current account deficit was accommodated by the ECB, and so the credit binge lasted for several years.
      It is important to understand that this situation could never have developed if Spain had it’s own currency, which would have fallen sharply due to the country’s current account deficit.

  14. In answer to number one I would say that we generally make a virtue of persistence and bravery when it comes to building a businesses. There are no end to start up guys talking about maxed-out credit cards, endless pitch turndowns and being the last person on earth to believe in themselves before they hit it big. If those are traits we ought to admire (and I think they generally are, even though most of the time that story ends with moving into your parents’ basement rather than growing AirBnB), then I’d say those kinds of people would be first in line when the cheap money start flowing- though this time with a beachfront condo development that’s 2x bigger than the other guys’. They’d also have the general admiration of society and the business press for their efforts as well.

    The key of course is having a properly functioning funding marketplace, where the capital for pie in the sky projects comes from sources that understand the risks and can afford to lose it like VC funds, while banks stick to boring likely-to-be-paid-back loans. Banks in general have a incentive to want to separate the default risk from the origination risk, which is exactly the point of regulation. (and off topic why some of these very clever ‘find a loan’ type start up companies out there sound like really risky ideas) As long as defaults are low any arguments banks make about how much better it is to spread risk around will start to look very wise and reasonable. I wish I was bright enough to figure out how to create a more ideal system, but I don’t have any concrete suggestions of how to fix it.

    And to bring it back to China, anybody who lives here has at least gotten a taste of how these investment manias work. Things start quietly with a few mentions here and then and then before you know it everybody is talking about the money they’re making from stocks, investment funds, real estate or whatever. The gains seem so ubiquitous and arguing against the seemingly endless good news so futile that eventually many do give in and join the party. It almost feels dumb and stubborn not to.

  15. If you want another example of large destabilizing capital inflows, study the Neutrals during and especially after World War I. All the neutrals experienced banking crisis after the war ended, when the world economy entered deflation in the summer of 1920. It all ended in tears. I studied banking history in the Netherlands in the aftermath of the war. There are countless of fun anecdotes of extreme speculation by bankers because of abundant liquidity, which evaporated in 1920. It took until 1927 (well into the next boom) to clean up the Dutch banking system, which among other things resulted in the Dutch central bank shouldering losses and operating with negative equity for years.

    • Please write more about this Arne. It is not something of which I was aware or thought much.

    • By the way people often will solemnly tell you, when discussing the future of the US dollar as the dominant reserve currency, that “history proves that when a creditor country with the dominant reserve currency becomes a debtor country, it loses its reserve currency status,” by which they mean the UK during WW1. History of course proves no such thing, and a single data point can never carry the verdict of history.

      Especially when there are competing explanations. I mention this because of your reference to the Netherlands during the war. My understanding as to why London lost its centrality to international finance after WW1 and had to share it with NY until WW2 was because of the neutrality of Amsterdam and NY (until 1917) during the war. Most international finance was trade finance back then, and when the war started, there was for obvious reasons, wholesale emigration of trade finance out of London to Amsterdam and NY. Liquidity begets liquidity, and after the war London was never quite able to recapture its centrality in trade finance.

      So the claim that because the UK went from creditor to debtor (and the US vice versa) during WW1, and because sterling lost its dominant role during WW1 and became just one of two major reserve currencies during the subsequent two decades (although I think it edged out the dollar for primacy), history somehow proves that the former caused the latter is an example of what I think I am allowed pompously to call the post hoc ergo propter hoc fallacy. Just because A follows B does not mean B caused A. There were many plausible reasons for the change in the reserve currency system.

      • Please share what you can about banking and the neutrals, I’m sure others are curious too. And, have you written anything on the transition of international finance from mostly trade finance to an intermediation type model? I’m not a historian, and I guess I was surprised to read that the transition had not occurred by start of WW1.

  16. Fascinating synthesis, thank you. There is one very important element that you might not even know existed/exists in explaining the transfers from Germany to the Euro-periphery: German asset capital weightings for their banks. By allowing their banks to apply lower capital requirements for loans to state and semi-sovereign entities around Europe, the German authorities created a perverse race amongst German Landesbanken and others to make loans to uncreditworthy entities suh as Greek, Italian and Spanish towns, regions and quasi-sovereigns. If you were to dig into the composition of the specifically-German constructs of Schuldscheine and Pfandbriefe, you would be flabbergast by the volumes of loans made directly by German banks to these debtors who now struggle to find the means to repay. This doesn’t even touch on the direct arbitrage loan portfolios of the Landesbanken and entities such as IKB (forgotten that disaster already?). Where was the BaFin and the Bundesbank back then? Delve into KfW’s purchases over the last 10 years and you’ll find even more shockers. Go one step further and understand how all of these flows were multiplied when funds flowed back via the bond market to Europe’s largest borrower, the European Investment Bank, who in turn made uneconomic and never-to-be-repaid infrastructure loans to….you guessed it: Greece, Italy, Portugal, Ireland and Spain. Even after the first Greek rip-off, oops, write-off, the German banks INCREASED their exposure to Greek government debt. Why? Perverse German/Basel capital ratios and, of ourse, that other “G” word not often used in your synopsis, greed.

    • Thanks, Roy. Good points.

    • Very interesting Roy. German banks, and landesbanken, were also exposed to subprime-CDOs and to iceland. In the case of Spain german banks not only massively bougth “cedulas hipotecarias” (spanish name for mortgage backed securities originated by the now infamous cajas de ahorros) during the boom. They were involved directly in the process of securitization and had a leading role in the creation and managment of the entities that packaged those “cédulas”. By the way, the spanish Cajas de Ahorros (similar to landesbanken?) increased their assets similarly thanks to the same perverse basel II capital ratio and greed you mention.

      If basel stablished a loose regulatory framework that facilitated the transfers of capital, I wonder if absent such a loose framework capital transfers would had been reduced, or if the capital would had just found other ways to move between countries.

  17. Thank you for your great article.

    As I understand you argument goes from individual debtors as a group “Spain” and same for the creditors called “Germany”. But the case of Greece sounds a little bit different from “Spain”. Here it was mostly the government who did the borrowing and free giving to its people that did result in the problems. Not like in Spain, where the government had come to rescue. Do you think that does not make a difference in solving the debt issue for Greece? Now, sorry if I am wrong – German eyes – it looks, like the Greece state – again not “Spain” – after living for decades over its means, after getting its books sober, now decide to enhance the problem again, flirting with the Russian card, I mean, if they like, they could ask Turkey for help. But they play the nationalistic tunes a lot. Even with a debt forgiveness, I see no big growth possible for Greece. A lot of its brightest people already in the rest of Europe, everything difficult there, no one paying taxes but expecting a free ride by the government…

    For “Spain” I would be completely with you, but Greece, I do not see enough potential for sustainable growth there.

    • Perhaps, Tim, and of course a major issue is the country’s institutional flexibility, of which I have little sense, but if Greece had a more or less functioning economy before the euro, I suppose they can recreate it after. The other important question, I think, is your attitude (I think I read you to say you are German) about the EU project.

      A breakup of the euro could mean the end of the EU or not. Europe is not synonymous with the euro, and I have always thought that by insisting that they are inseparable the EU supporters may actually condemn the EU to failure. It took the US 70 years or so, depending on how you measure it, for political union to include currency union. China has been a unified empire with a multiplicity of currencies many times. Most European countries managed with multiple currencies until the 17th and 18th centuries.

      The EU can introduce some currency flexibility, including perhaps national currencies coexisting with a European currency, as it works out the necessary institutions. If I were a dedicated EU proponent, I would at least be thinking about how to keep the EU experiment going under different plausible “disaster” scenarios, including the break up of the euro, one or more sovereign defaults, temporary or permanent withdrawals from the union, etc. Perhaps a group of wealthy Europhiles can fund a think tank whose only purpose is to design different possible Europes. In that case we can start thinking about Greece’s future more usefully.

      • Yes, I have never understood why the Greek government doesn’t establish a local legal currency to service its internal economy. So, for instance, the teachers and other workers Syriza wants to re-employ could be paid by the government in a drachma scrip that could be accepted as money by other Greeks businesses as they choose. Why is this idea impossible? (Category: rookie question.)

        • Of course a Drachma script with Varoufakis’s NEVER to run deficit ever will work. The script probably will need to be peg to Euro and that may require capital control depending on the confidence of the holder of the script. The script will just work like an IOU coupon/bill of exchange/cheque in place of Euro.

          Germay 3rd Reich did that :

      • Thank you for your response.

        My “problem” with your article is, that if the imbalances that created the debt bubbles are still there, like the “German” export machine and the “Spain” import machine or the “Greece” social welfare by state employment, tax evasion and oligarch enrichment machine, what does it help?

        So if you forgive debt, does that change the imbalance drivers? The dynamics? Does giving the problem kids a clean slate will be enough? I assume not. Or is it necessary to break up the Euro?

        In Germany we have also in-nation imbalances, and the better off Länder have to pay part of their surplus to the not so well off Länder. Also with sometimes crazy feeling results of when to invest or safe and when better not to for each Land. Also the Bund is giving money differently to its Länder, depending “necessary” investments. With the target that living is nearly same, where ever you might live. Of course, that target will never be hit, but I think something in this lines is, what we need for Europe.

        Only you cannot adopt such a big transfer system, if there are so totally institutionally different. Level of law enforcement, level of corruption, “business” practice are all very heterogen throughout the EU. And so you will never find the public support you need. Also the EU has no independent right of taxation. It has no central real power, like a EU military or even police force. It is not coherent. It is a cacophonie.

        And then the lending. I thought with the introduction of the Euro the lenders would not loose their mind and think that debt from Italy, Germany and Greece would suddenly be nearly same good or bad. But that happened. It shouldn’t. But I understand now why, because of the excess money flowing generated in “German” places.

        The big mistake in my eyes was, that the first Greece default was not really felt by London and the other private banks. No pain for their deeds. No banker in jail. No bank went bust. No public regulator lost his/her job. No counselor liable. Stock holders not liable. No learning here to see, I guess.

        Now it is the second time, and so for me it is questionable if the best first round solution will bring a good outcome the second time. Because now there are different lenders. Not the ones making the mess. But the ones, who stepped in. And where will it end now? With Greece, then Spain, Portugal, Italy, France, then finally Germany? Who is the guy who can pocket all the debt and eat it up? Who can create enough growth (demographics a pain in Europe, specially Germany too…) to lessen the debt…

        Well then, let Greece out of the Euro. Then make some fiscal expansion and growth plan for Spain, Portugal, Italy and France, while reforming their inefficiencies. Give the German workers more money to spend. Give the EURO EU more central powers, with institutions in every country, like taxing, federal policing and maybe even higher education. Something in that lines. Then a EU induced transfers to different regions budgets, that hopefully will find worthy investments in infrastructure and people to enable growth. Something like this, then make a forgiveness plan for the debt, growing with the ability of a central EU to eat it up. And depending how good the countries grows. Every dime they grow, double it. Depending also how the EU as a whole is growing.

  18. Here’s what I find depressing about Michael’s penetrating analysis: how many bankers or policy makers might read and understand the arguments? how many workers?

  19. Excelente síntesis Profesor Pettis. No se preocupe por los Shedlock que insisten con las estupideces “neo conservadoras” y no tienen remedio. Prepárese para encontrar unos cuantos de estos especímenes en la Conferencia de Mauldin.

  20. Hi Professor Pettis,

    A well thought out article that looks at the imbalances from a fresh perspective.

    However, what you describe is not much different from the “winning lottery ruin my life” problem. While what is done is done and a solution needs to be found, the bad behaviours should not have been watered down as ‘that happend to everyone’. Blaming Germany (and France c1871) here is similar to blaming the lottery company for sending the cheque.

    Sensible countries, as the baltics – mentioned above, and then Singapore especially have been able to managed large capital inflow in a prudent and responsible manner.

    Spain has plenty of opportunity to regulated its bank and developments but choose not to (oh well, that when the music is playing everyone must dance excuse). The capital flow could have been used to buy out Germany’s industrial base, for example.

    The faint hope here is that some lesson has been learnt from all these and we do not see anything like this again for another century. However, given the dotcom boom in the US right now, I resign to the usual short memory financial markets have and also resign to the fact that as tax payers, I will be on the hook for another bailout in the future.

    • It certainly could have been better managed, but remember that Germany in 1871 had an opportunity that Spain did not. The full transfer occurred through Berlin. Madrid was not legally allowed under EU rules to prevent banks from recycling the inflows in a piecemeal fashion. If Berlin couldn’t mange the flows well, it isn’t reasonable to insist that Madrid could. Singapore is not a model either for what could have happened because among other things Singapore was not forced to conform to EU rules, and Madrid was.

      As for using the money to buy Germany’s industrial base, I don’t think this could have even been contemplated even if Madrid could have demanded full control of the inflows. Europe talks a lot about the internal capital mobility, but any time a foreigner, and that includes from within the EU, makes large purchases of strategic assets, political opposition almost immediately scuttles it (and I dimly remember Paris having designated yoghurt as a strategic asset in order to prevent foreign acquisition, so nearly everything becomes “strategic” in Europe).

      • Thank you for your reply Professor Pettis.

        I remain unconvinced that if the government wanted to banks to behave, it could not have done so either via Bank Of Spain regulatory regime or through a game of golf or a dinner. The said finance minister who did this will of course be unpopular, but I am not convinced that nothing could be done.

        If they could not buy German’s (again not convince, but I am with you regarding French assets), they could have bought the British’s strategic assets which were sold of left right and centre during the boom.

        • Actually KP2011 they did. Ferrovial bought Heathrow Airport for example.

          But I think Professor Pettis is right, there was simply not enough supply of high-quality assets (or construction projects) across Europe to absorb the surplus cash. Second, the flow of money across national boundaries in Europe is easier than the flow of deals. Even if you take an open economy like the UK there is currency risk, language barriers, the right assets may not be for sale… and no other European economy is open in the same way, so far as I know. It’s not necessarily protectionism, in Germany the assets are simply not for sale, at any price.

          • ” Francis Evans February 7, 2015 at 7:35 pm ”

            I agree that it is harder to buy German companies due to the shareholding structures, but there are certainly things to buy such as recent Telefonica 8.6bn takeover of German EPlus (a few years late of course).

            Yes, I am aware of the Ferrovia BAA deal. But the questions is why they built millions of empty apartments rather than buying good stuffs up. On the other hand, it is not that much money really, the flow seems to be in the 1 Trillion euro or thereabout, and that is about 50 good PLCs.

            Then the Chinese use the inflows to buy hard commodity assets abroad.

            Anyway, those are all just distractions. The key point is that Spain allowed the misallocation to occured albeit under rather tempting circumstances. I also agree with Professors Pettis statements on Berlin had far more control of the flow in 1871/3 than Madrid but to say there was little they could do was just not very convincing.

            The Law of Karma would dictate that those who did the misallocation pay but most of them are no where to be seen. Only the poor and middle class who did not very much of the spending who get stucked with the debt.

            Anyway, what is done is done and seeing how things developed world wide post 2008, I am resigned to having to chip in for another bailout as a taxpayer someday.

        • Let me weigth in as a spanish participant in the questions you rise. I have witnessed with horror the spanish real-estate boom and from the beginning I used to blame the government for not doing enough to stop it. Reading Pettis’ ChFM has somehow changed my views and I find two explanations for your question:

          1) Money flows through the line of least resistance: this explains why much of the capital flows were invested in housing in Spain (as well as other countries like Ireland or the US). The regulatory framework facilitated such transfer (see Roy’s reply) as well as “financial innovation” in the form mortgage-backed securities that were massively used to finance the housing boom. Of course, there were other investment opportunities but those would had been rapidly saturated by the vast capital flows (credit for corporations, consumer credit etc.).

          2) Money flows by itself create perverse incentives. Yes, a wise president should have done its best to prevent further flows to housing or somehow hedge Spain against those. This is politically quite difficult. The monetary authorities in Spain (Bank of Spain) were just a branch of the ECB. Theoretically the ECB was the institution responsible for monetary stability in the eurozone. They should have done better. I think that the Bank of Spain should have, at least, made the alarms sound loudly and they didn’t. This was a failure. But this failure was shared by central bankers all around the world, not only Spain. Regarding the Goverment I think they did not have incentives to row against the tide. On the contrary, those benefiting from the tide were pushing hard to go on with the festival. The inflows created an illusion of wealth that was shared by much of the society making it difficult any resistance by a wise government. Moreover, those perverse incentives led to an escalation of corruption within the ruling elites.

          These arguments make the point that it is better to prevent such massive flows occuring rather than putting our trust in superior wise governments able to handle them.

    • Singapore has not been able to manage large capital flows in a prudent and responsible manner – look at the massive house price increase and consequent social unrest in what traditionally has been a very mild city state.

      • The social unrest is mild by any global standard – there are discontent of course. In respond to that, the SG government moves to cool the property market as opposed to launch.

        Also, when the tide is out, it is unlikely that we will be seeing mass banking bailouts in Singapore.

        • It’s true that the Singapore government has moved to coll the property market. They are in a unique position to do so as they control 95% of the country’s housing stock. This would be very difficult in other countries. A lot of of the capital inflows into Singapore has been absorbed by GIC and Temasek and reinvested overseas, of which investment efficiency has been extremely dubious (and unaudited, unlike Norway).

          I agree with you that mass banking bailouts in Singapore are extremely unlikely but , to use a point that Prof. Pettis has elaborated upon, that’s probably because of a massive transfer of household wealth to the state (which own the banks through Temasek) in the form of CPF savings.

          • There are many tools to cold the housing market, government does not t need to control the stock to do that at all. Lending restrictions, taxes, expanding buildings etc will all work.

            The financial repression bit is also practised in the west and yet the banks needed to be bailout (and probably to be bailed out again). There are some sensible policies that can be picked up from the way Singapore does thing.

            As for recycling through Temasek, indeed so but they are not so dumb as to allow the hot money ruin their own economy like the PIIGS or UK (the massive housing bubble…). Of course not everyone can be recycler, but till then I would rather my government be the recycler rather than the victim of large capital inflows that are seriously misallocated.

          • @Kurtz – Further I do not think your CPF claim is true anymore either as SIBOR and bank saving accounts are now sub 1% and CPF pays 4% interest.

    • This doesn’t seem to be quite accurate, at a time when Qatar is buying everything left right and centre – as the jet flies in to Findel Airport, Luxembourg, the chorus goes up “here come the shareholders!”

      • I see that my comment is totally meaningless without the section from Michael Pettis it’s aimed at;
        “Europe talks a lot about the internal capital mobility, but any time a foreigner, and that includes from within the EU, makes large purchases of strategic assets, political opposition almost immediately scuttles it”
        This doesn’t seem to be quite accurate, at a time when Qatar is buying everything left right and centre – as the jet flies in to Findel Airport, Luxembourg, the chorus goes up “here come the shareholders!”

        • ” PercyPavilion February 9, 2015 at 12:58 pm ”

          I agree. If the PIIGS wanted to recycle, there were enough asset for them to recycle. They (atually only a proportion of maybe 20-30% of the people, the lower middle and poor are unlikely to get much fun) went on a consuming binge instead.

          • Sibor rate that you quoted is at best a 1 year rate. CPF money is effectively a 30 year bond and 4% is when you put you money in a ‘special’ CPF account. Normal rate is something like 2%. Most people however use their CPF money to pay for housing, so the CPF has morphed from a system used by the Singapore government to pay for infrastructure in the 70’s to something that I’m not quite sure what’s it for.
            The point I’m trying to make is that although Singapore’s policies look and sound good and seem to be effective, there’s actually a lot more that happens under the hood, especially in terms of social cost. I’m not sure if other countries can and want to replicatethe conditions that allow for policy success in Singapore.

            Generally, everyone wants a taste of the party when faced with capital inflows. The result is what you see in Greece and Spain. That’s human nature. Simgapore only avoided such a huge boom and bust cycle as it limited the party to the politically connected and the social elite. As they are such a small proportion of the population, the boom and bust cycle was by definition small and doesn’t seem to have affected it much. That seems to be a supremely efficient solution to the problem, where one has his cake and eats it. However, I’m not quite sure if it’s very fair or has the cycle played out entirely. China seems to be loosening its monetary tap, making up for the flow of Recycled American money that’s drying up with the emd of QE.

            At the end of the day, Singapore’s economic and relative geopolitical success is bought by extreme non-monetary social cost that isn’t apparent to the casual observer. I really don’t think it can be brought up as an example to the rest of the world.

  21. A striking point from Prof. Adam Tooze’s remarkable book about the economic history of the 1920’s:

    According to his account, the US authorities long resisted debt relief for the UK, France, Germany, et al., because they believed that much of that debt was held by ordinary American households.

    The authorities thought they could not ask ordinary Americans, who had sacrificed to buy bonds and support the US cause, to bear the loss. (Whether that belief was accurate or not is another question.)

    Of course, Americans ended up suffering even more in the Great Depression. So perhaps the US government should have initiated debt forgiveness much sooner.

    But it bears directly on your point that the real question is not which nation will pay, but which class.

    • Yes, Walt, and that the longer you postpone the balance sheet adjustment, the higher the costs.

      • Hi Professor Pettis,

        “Yes, Walt, and that the longer you postpone the balance sheet adjustment, the higher the costs.”

        The question is higher cost to who. Probably not the current bunch of people who cause the problem, and that is all that matters to those. Lehman bankers who pocketed millions wouldn’t have been too stress out to see the bank went down.

        • This this this this this. The individual bankers generally arrange to walk away with large bonuses and leave someone else holding the bag.

          This is actually another reason why debt cancellation should be done fast — do it before the bankers can hand it off to “muppets” (as they call them).

  22. because the cost of saving Europe is debt forgiveness, and Europe must decide if this is a cost worth paying (I think it is),[…] If the restructuring is well designed, within a year of the restructuring I think we could easily see Greek growth surprise us with its vigor.

    Could you please explain this part? If the problem was caused by repression in Germany, which has not yet ended, wouldn’t debt forgiveness and a newly vigorous Greece simply mean that Greece’s will again rack up more debt and Germany will continue its account surpluses, thereby meaning that both types of countries end up in the same position in another ten years?

    The overall impact in Germany was very negative. In fact economists have long argued that the German economy was badly affected by the indemnity payment both because of its impact on the terms of trade, which undermined German’s manufacturing industry, and its role in setting off the speculative stock market bubble of 1871-73, which among other things unleashed an unproductive investment boom and a surge in debt.

    Can I take this to imply that the US’ implementation of the Marshall Plan after WWII was, in fact, the only option it could truly pursue in order to further its interests? (I find this line of thought reallly intriguing)

    The “losers” in this system have been German and Spanish workers, until now,

    Not to beat a dead horse, but I don’t undertand why German surpluses haven’t forced up German workers’ demands for higher wages. OK, maybe it wouldn’t have for the first few years, but at some point over the last decade it should have, no? Perhaps a better question to ask is “Under what conditions will German savings transfer back to the German household sector?”

    as long as Spain suffers from its current debt burden, it does not matter how intelligently and forcefully it implements economic reforms. It will not be able to grow out of its debt burden and must choose between two paths.

    Perhaps not, but perhaps it is in Spain’s best interests use its predicament to force through as many reforms as possible before defaulting, at which point it will grow at an astonishing speed (provided, of course, that it can find somebody to absorb the surplus.)

    • Claire, have you seriously any doubt about the US motivation for the Marshall Plan? Has anyone forgotten that Communism, not Nazi fascism, was perceived to be the true enemy of America long before WW2, and that the Marshall Plan was designed to counter the post war Communist influence in Europe and to compensate US industry for the price paid in freeing Europe. It was entirely self-serving, and recognized as such in the corridors of power.The concept morphed into the World Bank and the IMF; but the operating model remains: the principal beneficiary of the loans and investments are American, and recipient governments are not trusted.

      • It was entirely self-serving, and recognized as such in the corridors of power

        Well, I don’t think that anybody who works in a plitics is a saint or anything. I was more intrgiued by the idea that the Americans’ hands were effectively tied and that they had no practical choice but to recycle the money to Europe, as doing anything else would have quickly put the US in the same position as 1870s Germany.

      • I am not sure I agree. For political reasons it seems that most of us insist on the magnificent generosity or the greedy self-interest behind the Marshall Plan. But I can easily list a dozen cases in which large grants today would have benefitted the country tomorrow, and yet those grants were not made. For example, it is in Germany’s interest to implement its own version of the Marshall Plan in Greece, but so far we aren’t seeing much action.

        Of course, there was no way the Marshall Plan was ever going to be designed to hurt US interests, but it is empty cynicism to call it entirely self-serving. Europe was so desperate for help that the US could have imposed much tighter conditions on the disbursements than it did. For example US conditionality was minimal compared to Chinese aid to Africa, and minimal compared to US treatment of war debts in the 1920s.

        • In a sense, the Marshall Plan also acted as a safeguard against speculative capital movements and a tool to address the European capital flight (before and post-war).
          I’m reading Eric Helleiner’s “States and the Reemergence of Global Finance: From Bretton Woods to the 1990s”, it’s well worth a read.

        • “knowingly” designed to hurt american interests…..
          while the current configuration of the world system is as it is, where there exists multi-lateral systems institutions, advanced levels of material advancement, of the capabilities of people and nations, and under advanced degrees of peace and stability it can be thought, this is neither merely, surely, or inevitability related to American interests, surely dependent upon how those interests are defined, and how they change through time, as all must inevitability in non-static systems….it should be stated knowingly against, or knowingly within

          The notion of perfect and absolute design and control lead far too many people into highly disastrous positions and perspectives too often inflamed by ideology, thus irreality and lessor outcomes for everyone from this confusion (see fundamentalists who will starve as the world leaves oil where Hitler ran coal in his heavy machinery 7 decades ago, and we would again, despite the conspiratorial lamentations of zealots and treehuggers .

    • Claire,

      1. If lenders are willing again to provide unlimited funding to Athens and Athens puts into place no mechanism to manage disbursements, yes. One would hope that some lessons had been learned, but what matters is whether or not they had. We have seen many cases of “deadbeat” borrowers quickly relapsing once the decks were cleared, and many cases in which they evolved into creditworthy borrowers. There is a book or two that can be written about why one or the other, but of course if lenders do not impose discipline, then the only hope is that every potential borrower is prudent, careful, and honest. I wouldn’t bet heavily that this can ever be the case.

      2. The Marshall Plan is a great case study. It is too easy, and almost certainly wrong, to say all large recycling lead to good outcomes or to bad outcomes. A better approach is to ask what the conditions might be for one or the other. In the case of the Marshall Plan, we know that WW2 had wiped out a substantial portion of Europe’s infrastructure and manufacturing capacity. There was consequently a tremendous need for savings to fund the tremendous amount of productive investment opportunities, but insufficient savings (savings are total production minus consumption, and Europe was barely able to produce enough for current consumption needs, let alone divert production into savings. In that case the Marshall Plan filled the gap.

      3. German workers should have forced up wages, but I think their unions were willing to “cooperate” a little too generously, and so what soared seems to have been corporate profits. I met a a senior leader of one of the major left-of-center parties in Germany last year and I don’t pretend to know the details but there was some anger about how workers had failed to get their share of growth. Of course now that everyone is trying to maintain competitiveness by driving down wages, it may be very hard to reverse the process.

      4. I agree, and I think Rajoy has done some things right. That is why I think that once the write-down part of the debt, we will be surprised by the spurt in Spanish growth.

      • Thank you for responding.

        I need to ask for a bit of a clarification, though:

        That is why I think that once the write-down part of the debt, we will be surprised by the spurt in Spanish growth.

        I am sure that this is probably Banking 101, but if Spain (or any country) is going to default, why would they not default on all their debt instead of just part of it? The downside to them would be roughly the same (I assume), but I guess that any country would be better off starting off with a more or less pristine balance sheet (maybe excluding internal pension obligations, etc) than one with much of the original debt intact and only part of it written off?

        Let’s just make things easy and assume that enough debt gets written down to cause the economy to recover very strongly. Doesn’t this again bring about the “unbalanced” growth that you said accompanies all countries that experience fast growth? Also, who remains to import Spain’s goods? (obviously not the remaining PIIGS countries, and not Germany unless German saving rates decline?)

        Thanks again for all of your great writing, by the way. I haven’t quite grasped everything completely, but this has been an eye-opener and an amazing education.

  23. Brilliant, thought provoking article.

    “3. What about the other side of the recycling? In most cases the recycling country also experienced bubbles and rising debt. Have there been cases that did not also end in tears and if so, how were they different?”

    If I have rightly understood, France was effectively a recycling country by virtue of the indemnity imposed on it after the Franco-Prussian war. You made the point that contrary to expectations payment of this indemnity actually damaged Germany’s economy and rejuvenated France’s. Therefore, is not 1870’s France an example of a succesful recycler ?

    • I believe France’s experience of the Long Depression was indeed less painful than that of most other countries. It would be an interesting exercise to figure out the conditions under which the transferring country is better or worse off.

      • It seems to me the 1870s reparations were financed by mobilizing idle wealth. The wealthy saw that they could take positions earning low returns and purchase these bonds and earn better returns.

        A la Piketty, the question comes to mind whether France ever thought it should use taxation of this wealth (which would also compel people to look at how to get better returns from their wealth – a good thing for economic welfare). It is an interesting question especially when you consider that the bonds were purchased to a large degree by non-French residents.

        This situation in history may reflect that France was/is a wealthy, large-population country with a somewhat diversified and stable economy, with some history as being a nation-state with a cultural identity (symptoms of stability I think). People trusted it, so they were willing to buy their bonds. Not sure that would happen for smaller countries with weaker economic fundamentals and weaker historic claims as a nation-state.

        Can you comment on wealth taxation then as a way to mobilize wealth into capital as happened in France then, and the role of the EU in helping countries like Greece to successfully collect more taxes from the wealthy?

        Thanks. Absolutely stellar article, and incredible comments (as a first-time commenter I admit to being inspired, but also intimidated).

  24. Would you consider the Marshall Plan and the whole European Reconstruction effort a large inflow?

  25. Thanks for this analysis, Michael. Very informative, and a good history lesson.

    I find the prospect grim, of who gets assigned the losses, unless a middle road is taken. I wonder how those loss scenarios would play out.


    An interview with Varoufakis.

    VERY impressive. He really gets it. I’m so much more optimistic after reading that, he might actually be able to convince the European masses to make a change. Perhaps the fall of Greece is the rise of us all!

    • Indeed. He even made the same point, more or less, more than 3 years ago!

      “Come the Crisis, the German ants were then told that they must tighten their belt again, at a time when they are falling deeper into a poverty trap. […] Why are we working harder than ever, taking home less than ever? […] Meanwhile, the Greek ants were both desperate and indignant. […] they had, in effect, threatened (through their profligate ways) to bring down civilisation-as-we-know it. They scratched their heads, thinking that there must be a mistake since they never had any good days during the supposedly good times. They had struggled then and they are struggling now, admittedly far more desperately. […] Europe’s grasshoppers found it convenient to fall back on the scoundrel’s last refuge: nationalism. Suddenly a war of words between Greeks and Germans, Northerners and Southerners, was staged that hides a terrible truth: No one was ever bailed out except for some of the grasshoppers of both the north and the south.”

  27. ” the more optimistic and irresponsible the bank, the more it profits, and the more optimistic and irresponsible the borrower, the more it receives, is it meaningful to refer to either side as behaving “irresponsibly”, and if so, which side?”

    It is pretty obvious that the “Bank” is the irresponsible party, and “Bank” here means “Bankers”. I don’t know how this can be even debatable!

    Loan application is a process that carries no obligation (other than to avoid misrepresentation, which in most countries is criminally prosecuted as “Bank fraud”, and is therefore effectively deterred). If I am a Spanish barista making 600EUR per month – which I properly disclose – and would like to take a EUR 500,000 mortgage on a beach condo, there is zero moral, social or legal obstacles for me to apply for such a loan.

    The banks on the other hand, are supposed to have systems, personnel, and other infrastructure to make the right decision, as well, as highly compensated management team to implement and supervise proper underwriting standards and policies. Blaming the borrower is absurd! What if we take this line of thinking to other areas of life, say sports? What if I show at the New England Patriots training facility, tell coach Bellichek, “I want to play quarterback”, he lets me in, with disastrous results, and then tells the media it was my fault, because I wanted to play? Absurd! While there may be millions of people who would fancy themselves as good players, the coach is there to decide who want to play and who not, and he is properly compensated for this job.

    So, of course it is the bankers’ fault, and there a very good underlying reason: when loans are being made, the banks calculate profits right away based on certain formulas and assumptions that are often widely incorrect. Profits are directly tied to bonuses, while bank losses are not tied to the corresponding negative retribution to the bankers’ net worth. Privatization of profits, socialization of losses. In the case of Spain, the State had to assume the bank burden; bank shareholders took a bath, too, but to my knowledge there haven’t been any initiatives to disgorge the financial management class from their bonuses during the boom.

    So yes, there is a morality play here: irresponsible bank lending practices, tied to an extremely dysfunctional compensation structure in the financial sector, is where the blame should lie.

    • I have always wondered why no one has ever brought a tort for fraudulent conveyance against the banks on behalf of the citizens whom insured/bailed them out.

  28. Dear Michael, thanks for your article, a most enjoyeable read and worth its length. One thing your analysis overlooks: the impact of the wall of money on the institutions of these countries, and the feedback effect of these on the financial cataclysm. This was the main focus of my Journal of Economic Perspectives piece with Jesus Fernandez Villaverde and Tano Santos Political Credit Cycles ( Essentially, our view is that you are channelling a lof of money through some really weak institutions. A Caja which, if small and with little access to internaional Capital markets, cannot create much havoc in spite of being totally in the hands of the politicians, when huge and with access to unlimited liquidity is a weapon of mass destruction. Our image is of an old, rusty oil piline with little imperfections pumped suddenly with a lot of high pressure oil. The wall of money ends accountability, ends any semblance of money being allocated with any criterion approaching efficnecy, and further weakens institutions by favoring the worst projects and the worst people, who in turn worsen misallocation. Here the “guilt” is not Spanish still, but the view is more nuanced– bad institutions alone would not have mattered so much, together with unlimited liquidity they were deadly.

    • Perhaps these small institutions, such as Cajas, Sparkasse, etc., were advised by smart bankers from Goldam Sachs, Lehman Brothers, etc…

      Or perhaps there is some other problem.

    • Very good points, Luis, and institutions most definitely matter. I prefer to think of this in Minskyite terms, so that I think of the role of institutions in dissipating or exacerbating volatility, or in concentrating debt (because financial distress costs are highly convex) or even in optional terms. This will be part of my next book.

  29. In answer to your question about capital recycling, I can only think of one that is comparable: Norway.

    They basically took their huge capital surplus and recycled it into foreign assets immediately. Spain could conceivably have done the same, by, using its artificially low interest rates available to the government to borrow and immediately buying, say, US treasuries, they could have diverted the flow into a larger economy better able to handle it.

  30. Another major long-term result of the Franco-Prussian war was the outlook of Robert Schuman, who was the client with the power to offer Monnet’s plan to Adenauer and end the cycle of western European civil wars through sharing rather than domination.
    Schulman’s father and uncle were partners in the bustling family horse farm 300 metres inside Lorraine which, a decade before Robert’s birth, became part of Germany for nearly half a century. His father had fought against annexation and moved in disgust, as a self-styled Lotharingian, to the city of Luxembourg a mere ten miles away, renting a house down in quiet Clausen and living off rents and profits from his properties.
    Robert was an only child, very academic, whose thoughtfulness sprang from the contrast between the solitude of the city and the hubbub with his cousins during the holidays at the farm. His cousin Jean Duren recalls him telling of how as a young boy he followed the plough, perhaps crossing that line between Luxembourg and ‘Germany’ 200 times in a single day. From the kitchen window in Lorraine he could look out left towards Luxembourg at the end of the field, and ahead over the Moselle and the Hunsruck towards Trier, Constantine’s first capital city.
    After three civil wars the pressure from Acheson and the U.S. on Europe to find a solution to the security problem was building up to another armed conflict in spring 1950 over the Saarland. It was a ‘happy coincidence’ (Luxembourg’s Prime Minister Pierre Werner told me) that Schuman and Adenauer, old witnesses of the Franco-Prussian catastrophes, were in a position to take decisions that represent as revolutionary a turn as 1789 (see Schuman’s own ‘Pour Europe’ for this claim). The Werner Report and the single currency stem directly from the same fount – Werner was a disciple of Schuman, the frontiersman who was called ‘Bosch’ by the communists and ‘traitor’ by the nationalists in France.
    The inheritors of the centre ground marked out by Keynes and Schuman include Delors and now Juncker – pooling has been the common answer to common problems, and the current situation is no different.
    Many thanks to Michael for bringing out the importance of the past to the present – for me the Schuman garden in Évrange and Fenner’s cricket ground in Cambridge (Keynes’s Olympus) are of more relevance in analysing the E.U. than the desiccated statistical models of Tinbergen’s heirs which have so often in recent years been shown to rest on ill-judged assumptions. A bit more intuitive thinking along the lines of Keynes and Schuman is required at present.
    The euro is here to stay – the current crisis is the natural counter-revolution of the nationalists and the old left to the Werner Report, and will end when the centre finally gathers itself to move on to the next stage of European integration.

  31. Dear Mr. Pettis, thanks for this insightful and well-documented article. My main squabble with it – and with all mainly Anglo-Saxon commentators and their ‘recipe’ for dealing with diverging competitiveness within the Eurozone, is that this was exactly what was tried in the so-called ‘periphery’ the decades before EMU.

    Instead of introducing reforms to combat declining competitiveness, southern European politicians and their politicized central bank would periodically devalue the currency – as per the standard recipe of many economists – destroying savings and pushing up the price of imports for the short-lived benefit of the export sector.

    And it was precisely because of these periodic devaluations that people in southern Europe welcomed the euro – to a far larger extent than people in the North – because they reasonably expected an independent monetary authority and strong currency would preclude the very politicized monetary decision-making that had hampered their political economies.

    From now on, the political classes would be pressured by the ECB and Eurozone partners to introduce the hard and painful – for their respective clientèles at least – reforms which they had been able to postpone indefinitely by devaluation after devaluation.

    So how bad is this much maligned ‘euro straight-jacket’? Do you even realize Spain, Greece and Portugal were third world countries a mere twenty years ago, with massive joblessness offset only by a very large grey and black sector? Do southern Europeans really want to revert to perpetual periodic devaluations? Why do Anglo-Saxon commentators insist on this remedy when it has proven at least as damaging as the current efforts at ‘internal devaluation’?

    • Why do some…..

      commentators influenced by

      Marxian and anti-Imperialist thought

      under premises of continental economic philosophers

      utilizing memes of some strain of anarchists, libertarians, goldbugs, marxists and agenda of anti-Imperialists, use terms like
      Banksters, Fraudsters, Amerika…..using K in everything, like people on RT, and on Islamic fundamentalists websites, while also criticizing Anglo-Saxon economic notions that they illiberally associate with neo-liberal policy (neo-liberal and policy are oxymoronic).

      Is it that the Command economy, really never left the bloodstream, even with, were, when it becomes more practiced, it is as beggar they neighbor as internal (European, East Asian, Other) dynamics.

    • Maybe, Bas Ben, but I am not sure which Anglo Saxon “recipe” you are referring to, and I wonder if the phrase hasn’t become simply an expression of frustration. It doesn’t seem to have much content. I don’t know your age, but for many Spaniards of my age, the euro was not a currency. It was a promise that Africa did not begin at the Pyrenees. As such it was an absurd but deeply held belief that, I am glad to say, young Spaniards as well as Anglo Saxons do not seem to share.

      At any rate you probably know as little about my background as I know about yours, but I know Spain, Spanish culture, Spanish politics and the Spanish business environment quite well, and I am not sure that it is only Anglo Saxons who would disagree with your characterisation of Spain’s performance before and after the euro. For one thing, while it might be true that Andalucia and Extremadura were almost Third World 40-50 years ago, when my family first moved to Malaga, Spain was most certainly not a third world country 20 years ago.

      But more to the point, while Spain’s experience from the 1950s to the 1990s involved many speed bumps and a great deal of uncertainty — as did that of France, the UK, Germany, the US, and many others, by the way — Spain did managed to survive a major cultural transformation, an even greater political transformation, fraught with risk and at least one attempted coup d’etat, and yet still generated much more growth, much less instability, and far less unemployment than we see in Spain today.

      Of course you are right that “people in southern Europe welcomed the euro – to a far larger extent than people in the North – because they reasonably expected an independent monetary authority and strong currency would preclude the very politicized monetary decision-making that had hampered their political economies.” I know when the euro was introduced my family was delighted, and I still have the first euro coin that my mother handed out to each of my brothers that day. But if Spain had received what even then I thought foolishly optimistic, there wouldn’t be this debate today and I am sure Podemos would be nothing more than a few academics sharing coffee in a bar in Madrid. I disagree with many of their policies, but I don’t see how you can exclude them from the list of non-Anglo Saxons who are also critical of the euro.

      Of all the many statistics that depressed me in the past few years, I think the transformation of Spain from a country of net immigration to a country of net emigration was in some ways the most depressing.

      • Was it Napoleon that said “Africa begins at the Pyrenees”? i never understood that — it would only have been a sensible thing to say (in my opinion) if the Reconquista had been defeated and Iberia had remained a Muslim land…

        • Don’t be surprised if Spain is mostly Muslim in 200-300 years.

          I can see where Napoleon is coming from. Spain is in a trade network that makes it more feasible to trade with North Africa and Italy than it does with Germany, the UK and virtually all of Central Europe.

          People keep bringing up such points and I keep saying the same thing: the current structure of Europe makes absolutely no sense. Yet every time I say that the current structure of the trade networks make no sense, everyone jumps on me and says I’m bringing up crazy “theories” that make no sense. On top of this, I’ve yet to hear a legitimate argument upon the logic of the models I’m using. Hell, I haven’t even seen theories that talk about the way I’m designing my models (although much of what I’m saying isn’t inherently new).

          For some odd reason, the facts that I find most obvious are the ones most challenged and disputed by others while the stuff I’m not at all sure about is the stuff that’s taken for granted by others.

          • Spain actually has surprisingly few Muslims given its geographical location. Perhaps the Spaniards are worried about admitting too many Muslim immigrants, especially in Andalusia which was historically Muslim in the past — they are outnumbered there by immigrants from Latin America.

            Perhaps if Andalusia had had more Muslims (and considering it is one of the poorest regions of Spain), they may well have spawned a left-wing populist (but with pronounced pro-Islamic slant) politician, similar to Britain’s George Galloway?

    • Bad analysis – 20 years ago Portugal surely was not a 3rd world country. You have no idea of what you are writing about. Even by then the country exported as many pharmaceuticals as good Porto wine – now pharmaceuticals being in higher numbers. Just to give you a quick example – many more could be given. Surely it was not as developed as Germany, but having ~ 70% of the average income of the EU is not exactly being 3rd world, 20 years ago, is it?….Bahh…

  32. Thank you for this highly engaging analysis.
    I absolutely agree with you that the current crisis was not brought about by any cohesive national entities such as “Spain”, “Germany” or “Greece”. I do believe, however, that the level of sophistication among policy makers is not quite as “terrifyingly low” as you would have the reader believe.
    The real reason for their strenuous efforts to attribute guilt to individual states is not an intellectual error; unsurprisingly, it is a policy tool. The question of who is to blame is just superficially important and in fact serves as a proxy answer to the most important question of all, namely who will bear the costs. And this question very much boils down to “Spain”, “German” and “Greece” because it is at the national level that pensions are cut, labor laws are relaxed, public sector employees are fired and taxes are raised.

    • You are probably right, Steven. I am usually not a big believer in explanations that require people to act stupidly or with malice, but I guess I have succumbed. We tend on average to respond to incentives, and it is far more useful to ask what the set of incentives are that would lead policymakers to accept national rather than sectoral allocations of blame and adjustment costs, even though this cannot help but strengthen the extreme nationalists. Of course that leads to interesting questions. Is it in Hollande’s interest to strengthen or to weaken the FN? I don’t know enough about French politics to answer, but I guess next month is going to be an interesting month. I always assumed that the first reaction of the French to Hebdo Charlie would be to pull together in solidarity, but I wondered whether that solidarity could last through late March. If not, I assume it is nothing but a gift for FN. To me FN and Marine Le Pen are the lynchpin.

  33. Sir,

    there are some interesting ideas but also various problems with this article.

    1) Starting with the historical data. You imply that Germany was especially badly affected by the post-1873 recession. This is not evident in the standard historical data which suggests was just as affected as other leading industrial nations.

    Comparing the years 1850-1873 with the years 1873-1890, growth rates fell from 4.3% a year to 2.9% in Germany, from 6.2% to 4.7% in the US, and from 3.0% to 1.7% in Britain.

    2) You say that there was an agreement of wage restraint imposed by the government in Berlin on trade unions and employers’ associations in the early 2000s. This is historically untrue and it is also constitutionally impossible. The German government is constitutionally barred from taking any role in setting wages for the private sector. Wage levels in the early 2000s (as before) reflected independent wage negotiations. The fact that real wages did not increase significantly reflected the high unemployment rate which made trade unions moderate demands.

    There actually was not much restraint in German wages.

    As of 2004 (around the time you suggest Germany suppressed wages), unit labour costs amounted to:

    Germany 0.701
    UK 0.684
    France 0.676
    Italy 0.660
    US 0.659
    Spain 0.636
    (Source: OECD)

    There can be no serious argument that Germany was artificially squeezing wages. There was a moderate amount of real wage constraint in order to make up for excesses in 1990s.

    Further statements require much closer scrutiny:

    “German and Spanish lenders eagerly sought out Spanish borrowers and offered them unlimited amounts of extremely cheap loans”. It is clear that the presence of German banks in the Spanish commercial banking market is minimal. You may want to imply that German banks in the wholesale markets were responsible for pushing credit on Spanish commercial banks. That is very questionable, too, since the data suggests that of all foreign banks Barclays and BNP Paribas were most exposed to credit markets in Spain during the crisis. Anyhow, inside Spain, the most damaged institutions – the Cajas – were not especially active in international wholesale markets compared to the likes of Santander and BBVA which passed through the crisis largely unscathed.

    I see how argument is meant to work in theory. I don’t how it works with specific reference to the facts.

    • 1. I confess I don’t have the data for Germany and I base my description on the accounts of other economic historians and contemporary accounts. You should know that it is very questionable to derive too much explanation from a single set of figures, however, especially when they are so broadly averaged out as yours are, but even these numbers don’t strike me as creating much or a “problem”. I guess I am not sure what your point is. Have you read Kindleberger, or the Monroe book, or any of the economic histories of that period, or are you just using these three sets of average numbers?

      2. I said “Berlin, with the agreement of businesses and labor unions, put into place agreements to restrain wage growth relative to GDP growth,” and I am not sure if you are nit-picking or not, but if you really want to check, it is quite easy to do so. It took me only a couple of hours to get quite a lot of wage data and some excellent analyses by German and French economists — the former often not welcome by Berlin by the way. The basic argument is that workers income shares declined, inequality rose, and so savings rose, but Germany actually reduced its investment share in spite of the greater savings share. By definition of course the CAD had to reverse and became among the largest CAS every recorded. I don’t have the numbers in front of me, but off the top of my head I believe wages grew in the last decade at one-third to one-half their growth rate in the previous decade, even as unemployment dropped sharply and GDP growth picked up. By the way I am not sure why you think comparing unit labor costs is at all relevant. I am pretty sure no one has made the argument that German labor costs or wages were lower than Spain’s. By the way what is the point of your disagreement here — do you think Germany in fact did not export a growing gap between savings and investment?

      3. When I took my courses in trade I was very lucky to have a professor who made sure we understood from the beginning something that he said no one seemed to understand (and he was right, I am afraid) and that is that bilateral balances are almost useless in understanding trade pressures. It was always better, he taught us, to look at the capital account. I cannot go into the reasons here, but if you really want to understand it, I think it is in Chapter 4 or 5 of my book, The Great Rebalancing. The arithmetic is quite simple. Something similar occurs with capital flows. If Germany begins to export large amounts of capital and simultaneously several European countries with low or negative real rates Spain begin to import large amounts of capital, tracking the nationality of the banks through which the flows are mediated would only confirm the underlying insight in a world of strict capital controls. If you are not convinced, perhaps instead of my tracking the flow of capital from Germany to Spain bank by bank, you can track the flows bank by bank to show that the excess of German savings over investment did not go to peripheral European countries.

  34. Sir,

    There is a still more fundamental problem with the argument when you seem to imply that the situation of Spain is somehow similar to that of Greece. Indeed, you suggest that Spain is representative of several other European countries. It clearly is not. The problem lies in this sentence:

    “Fundamental to the argument that Spain (or Greece, or anyone else) has a moral obligation to repay in full its debt to Germany are two assumptions. The first assumption is that “Spain” borrowed the money from “Germany”, and that there is a collective obligation on the part of Spain to repay the German collective.”

    I do not know anyone who suggests that Spain has borrowed from Germany. Therefore, I don’t see how the idea of debt forgiveness applies to Spain in the current situation. Can you explain?

    The question of debt forgiveness for Greece arises because through the EFSF/ESM it has borrowed from other European nations. The existence of creditor nations (in the Greek case) is a reality. However, it is quite inaccurate to suggest that this is a German/Greek question. Germany accounts for no more than about 27% of loans made available to Greece. There is no point in trying to simplify this. There are 18 creditor nations in the EFSF/ESM that Greece would need to deal with. You will have noticed that one of the most outspoken critics of Greek debt forgiveness is the Spanish government.

    I do not see the relevance of your article on the 2015 debate on Greek debt forgiveness.

    This article would have been more relevant regarding the Greek situation in 2010. But at that time not only EU officials but also most non-European economists and financial commentators were primarily worried (rightly or wrongly) about another “Lehman moment” if Greece defaults on its debts to private sector financial institutions.

    • Regardless of whom the creditor of record is, at the end of the day it is the capital surplus of Germany (and others) that was borrowed. Directly or indirectly.

    • “I do not know anyone who suggests that Spain has borrowed from Germany. Therefore, I don’t see how the idea of debt forgiveness applies to Spain in the current situation. Can you explain?”

      I really don’t know what this means and suspect that there is a great deal of confusion here. Debt forgiveness occurs (rationally) when the debtor is insolvent, or, when referring to sovereign obligations, when the debtor is unable to repay the debt except at an economic cost that exceeds the benefit of repayment. Historical precedents, however, suggest that creditor governments will choose to treat the issue as a problem of liquidity, rather than one of solvency, until their banks are sufficiently well capitalized to absorb the loss. This means creditor governments will put pressure on the debtor governments to prevent any formal discussion of solvency, and will instead provide just enough liquidity to roll over principle and interest payments. During this time the creditor banks are recapitalized, partly through financial repression (at the expense of household savers), partly by government assumption of the debt (at the expense of taxpayers), and partly by asset liquidation and equity sales (although usually only the weaker banks are forced to do either). Once banks are sufficiently recapitalized to recognize and write off the losses while still maintaining required capital ratios, creditor governments are willing formally to initiate discussions on solvency and debt write-downs. After the debt is renegotiated and written down, the debtor countries usually begin to grow, although there is a great deal or variation here.

      During this time it is acceptable for traders and investors openly to acknowledge the recapitalization and delay process. It is not acceptable however for for the lending banks or for government officials, either from the creditor or from the debtor nation, openly to acknowledge this process.

      I am not sure why you precede the statement “it is quite inaccurate to suggest that this is a German/Greek question”, with “however”. The point of my blog entry is to show that debt imbalances are driven not by national conflicts but by sectoral conflicts. The assignment of costs is almost wholly the outcome of political manoeuvring and has little to do with moral obligations. My recommendation is always for debtor countries to move quickly to recognize insolvency so as to minimize the overall damage to the economies. It isn’t a lot more complicated than that.

      • The confusion arises because you continue to say that the cases of Spain and Greece are similar. The Spanish state is obviously not insolvent. The banking system is far from needing ELA. Neither the situation in public finance nor the state of the banking system are remotely similar.

        You will have noticed that Spain and Greece sit at opposite ends of the negotiating table on the issue of debt relief. The current Spanish government is in fact one of the most intransigent on Greek debt forgiveness.

        “My recommendation is always for debtor countries to move quickly to recognize insolvency so as to minimize the overall damage to the economies.” That is a valid point but this is precisely the option that the Greek government wanted to avoid in 2010 which is why it requested the bailout.

        • “That is a valid point but this is precisely the option that the Greek government wanted to avoid in 2010 which is why it requested the bailout.”

          Ummm not really.

          Both the IMF and the Greek government (Papandreou at the time) were arguing for a haircut (i.e. partial/selective default). But reportedly Mr. Sarkozy and Mrs. Merkel were completely negative, protecting their respective banks –and, may I add, eventually sending the bill to the EU taxpayers.

        • You say: ”The Spanish state is obviously not insolvent. ”

          Obvious to whom? This is a pretty empty statement. I would suggest that you might want to consider the market reaction before and after Mario Draghi’s promise to do “whatever it takes” as suggesting that investors do not share your opinion.

          In 2011 I made a number of predictions about what would happen to Spain, based on a very long and ample history of sovereign insolvency, and even wrote some of these up for Politica Exterior in January 2012. Debt would continue to rise faster than GDP year after year until there was substantial debt forgiveness. No matter how aggressively reforms were identified and implemented, the only time we would ever see GDP growth numbers high enough to imply that the crisis is not getting worse would be in government projections for next year’s growth. Until they were forced by the electorate to do otherwise, government officials would insist year after year that Spain was suffering from a liquidity crisis, not a solvency crisis. A party, either of the left or the right, would take an anti-debt position and its popularity would surge until either it won the vote or it forced one of the centrist parties to adopt its position.

          How did I know all this would happen? Easy — this is nearly always what happens during a sovereign insolvency crisis, and Spain was following the script assiduously. Most analysts do not understand how debt itself constrains growth and why overly-indebted countries cannot grow their way out of the debt, but in spite of overwhelming historical support for the claim, and a fairly robust explanation in finance theory, they are happy to predict, just as their predecessors always have, that they will not repeat the historical precedent. It is disappointing that those in Madrid responsible for resolving the crisis know so little about the history of sovereign insolvencies, to the point that even their denials take exactly the same form that history proposes.

          And that is why it is almost funny when you say: ”You will have noticed that Spain and Greece sit at opposite ends of the negotiating table on the issue of debt relief. The current Spanish government is in fact one of the most intransigent on Greek debt forgiveness.”

          Yes, we have all noticed, and some of us with dismay, but not with surprise. This exactly what is supposed to happen as part of the political process in a country facing insolvency. It’s informational value about Spanish solvency is nil. In fact I would have thought hat most of us understand exactly why for domestic political reasons PP cannot possibly acknowledge Syriza, especially in an election year. Isn’t it obvious?

          • It is widely accepted that the very high Spanish bond yields in 2011-12 signalled exchange rate risk (in case of euro break-up) rather than solvency risk.

            You are entitled to your pesssimism about the Spanish economy/banking system/public finance. But current data and forecasts make it look it extremely unlikely that the Spanish government will face Greece-style solvency risks at any time in the foreseeable future.

            Current IMF forecasts are that Spain will grow 2% in 2015 and 1.8% in 2016, the deficit will keep falling and Debt-GDP ratio peaking in 2016 at 102% before starting to decline. Why should we expect insolvency?

          • Well that’s pretty much resolved it then, hasn’t it? If the IMF predicts it, it must be true. I have never known them to be wrong.

          • “It is widely accepted that the very high Spanish bond yields in 2011-12 signalled exchange rate risk (in case of euro break-up) rather than solvency risk.”

            I am not sure how you can separate the risk of a euro break-up from solvency risk. If Spain did not have a debt problem, why would anyone expect it to choose the nightmare of a currency break up? And why would the guarantee by the European Central Bank cause interest rates to collapse if everyone was worried that Spain would leave the euro.

            But even if you can separate those risks, what is more puzzling to me is your certainty that no one doubted Spain’s solvency. The newspapers were filled with articles comparing Spanish debt levels with those of other highly indebted countries, investors went looking urgently for data on the Spanish banks, the description of Argentina’s “corralito” was everywhere in the Spanish press, and it is hard to explain these things if Pettis is the only one who questioned whether Spain could repay its debt. It was only the guarantee of the European Central Bank that stopped all that talk, and yet since the guarantee Spain’s debt has gotten much higher. If there were questions about solvency before the guarantee, why wouldn’t there be similar questions today? I am quite sure that if a German were able to use the courts to cancel the guarantee the Spanish bond markets would collapse overnight.

            I respectfully suggest that if you truly do not think there was widespread questioning of Spain’s solvency, whether this questioning was valid or not, it may be because you are too emotionally opposed to the idea and so you refuse to see it. But I think it is always better to prepare for the worst case scenario than to deny that it can happen.

          • Funny, in 2008 to 2009, I stated that the US economy would get back toward normal in 2014 (which seems to be what has occurred). At the time, this was merely Lehman’s and Wall Street greed, the 2003 decoupling of EM from advanced country growth was beginning to be rebuilt anew. Somehow, growth in debt in one area, was seen not to be present in another or related to heightened levels of growth more broadly, which were largely related to investment for provision of supply, or importing of demand, or exporting of unemployment, however one wants to see it, all three are useful, while all is inextricably linked in a system. A system that will need to switch toward domestic demand (US at 70% makes nothing, a story built when US was largest manufacturer in the world), but inevitably where more need to go, toward demand, has “take off”, industrialization and similar are cycled more broadly. It might be difficult for small, useful to modernization commodity producers store up FOREX, and similar, but it is quite destabilizing, when this is done more broadly, especially in areas that need to alter toward more domestically driven, demand driven economies, where siphoning off demand, and cycling up FOREX as has been recently done in East Asia, inhibits a broader term development, stable growth trajectories globally, inequality dynamics internally and externally and commitment toward some levels of globalization for development and further global stability, insofar as this is encouraged by processes of global development.

    • As of the second quarter of 2014, Spain has total non-financial debt (ie. debt of households, non-financial businesses and government entities) of 313% of GDP. Greece stands at 317% (source McKinsey Global Institute, Debt and (not much) deleveraging, February 2015). A priori, their solvency (or lack thereof) doesn’t look dissimilar.

      • Sorry, but I don’t understand how these numbers support your argument. The same report mentions 325% for the Netherlands, 302% for Denmark and 290% for Sweden respectively. I suppose the overall amount of debt is completely irrelevant – in sharp contrast to the ability of servicing debt.

        • You are right of course that one needs to go further than looking at a static average ratio of total debt / total income. That’s why i used the words “a priori”.

          The quality of GDP (its composition), its sustainable growth potential, its distribution vs. the distribution of debt, the perception of risk by interest rate markets are all important parameters in making the dynamics stable or unstable.

          Also, in the three countries that you mention (Netherlands, Denmark, Sweden), the pension system is funded and so households have pension assets against some of the high household debt / GDP ratio in an explicit way that households in countries with pay as you go pension system don’t.

          Having said that, the McKinsey report concludes that Netherlands and Sweden are among the 7 countries with potential vulnerabilities in household debt. Certainly, the Swedish banking regulator has been trying to cool down the mortgage market for several years now (with very limited success).

          Finally, always remember that things can change quickly. Sweden has a safe haven status now. But it had a severe banking crisis in the early 1990’s (discussed in the report). From the chart on page 24 of the McKinsey report, you can see that Total Debt / GDP for “unsafe” Sweden in 1990 was materially lower than for “safe” Sweden now. So, as you say, “the overall amount of debt is completely irrelevant” … until, all of a sudden, it is the only thing that matters.

  35. Thank you for that article. It is eerily accurate as it applies to Ireland, where I live.
    Interestingly while our economy here is growing it is because our exposure is far more towards the UK and the US and not the Eurozone. That has dragged us along.
    Ireland foolishly (with massive pressure from the ECB) guaranteed its bank debts, bondholders, senior and junior and left the people to carry the can. Despite pleas to our European “partners” all we ever get are lectures about prudence. Reminds me the the temperance movement in the US.
    I see in places that Ireland is being promoted as the model child for this austerity. The comments above about the prudent Germany and the profligate Spain (Ireland) ring very true to what has played out and is playing out here.The last thing we should be considered for is the poster boys (and girls) for austerity.
    The last two governments here went with the austerity programme and the people suffered, not as badly as Greece, but there was and is a lot of suffering. Traditionally Ireland has had an escape valve through emigration and this has been used again, there isn’t a single town or village outside of Dublin where the scourge of forced emigration hasn’t afflicted the population. Were it not for emigration the numbers wouldnt be nearly as rosy as the government likes to portray.

    Even here, people are beginning to rise up. European politicians in the middle seem to be sleepwalking into a nightmare where the radical left and the radical right are gaining traction because of the despair and misery inflicted by this never ending austerity. In Ireland the radical left is gaining massive ground.

    And guess what, we are more indebted now than we ever were before. How, I wonder, if we couldnt pay back our debt in 2010 when Ireland entered the bailout, can we pay back another €50 billion (or whatever the number is) several years later?

    • Thanks for the color, Michael. I don’t follow Ireland as closely as I should but from what you describe Ireland is stuck in the same trap in which the interests of the banks and the interests of producers/workers are in opposition. It is a pity that in order to choose rationality on the debt issue you have also to choose the irrationality of the extremists, but it seems to me that if the indebted nations were to agree among themselves to an optimal solution for Europe, they should be able easily to impose it.

      But as a Spanish mother of two told me yesterday, a tad wearily, the beggar with 10 euros to his name insists that he is in a different class altogether to the beggar with 5 euros to his name and refuses to socialize.

  36. The gist of this post is that Eurozone countries who goosed their savings rates then exported indigestible amounts of capital to a wide array of individual actors in recipient countries. Those recipient countries are not hobbled by the debt burdens of those individual actors. Provokes several questions in my mind:

    What of the capital transfers from ‘Germany’ to the governments of ‘Spain’ et al in the form of government bond purchases?
    Do these governmental recipients warrant the same restructuring afforded to individual actors?
    How would governmental debt restructuring benefit the individual actors in those countries? Would not this trigger a vicious cycle given the recipient governments’ proclivity to borrow?
    Had ‘Germany’ not goosed their savings rate, would not the indigestible capital transfers still have occurred through the agency of smaller actors within ‘Germany’?
    How does a ‘Germany’ safely handle large capital surpluses? More widely distribute it?

  37. The gist of this post is that Eurozone countries who goosed their savings rates then exported indigestible amounts of capital to a wide array of individual actors in recipient countries. Those recipient countries are now hobbled by the debt burdens of those individual actors. Provokes several questions in my mind:

    What of the capital transfers from ‘Germany’ to the governments of ‘Spain’ et al in the form of government bond purchases?
    Do these governmental recipients warrant the same restructuring afforded to individual actors?
    How would governmental debt restructuring benefit the individual actors in those countries? Would not this trigger a vicious cycle given the recipient governments’ proclivity to borrow anew?
    Had ‘Germany’ not goosed their savings rate, would not the indigestible capital transfers still have occurred through the cumulative agency of smaller actors within ‘Germany’?
    How does a ‘Germany’ safely handle large capital surpluses? More widely distribute it?

  38. The notion that Germany exported deficient demand is bizarre, but completely in sync with a Keynesian perspective of the world. “Deficient demand” is actually a desire to save, and to defer current consumption relative to one’s production, so that one has a future claim on production to provide for one’s retirement, one’s children or other heirs, or to give to one’s preferred charities or other causes. Such desire has almost no correlation with our modern financial systems’ capacity to create debt completely independent of anyone’s desire to save and invest for the future. Central banks and commercial banks today facilitate the creation of new debt to allow governments to spend in excess of their willingness to tax, allow speculators to gamble on assets they cannot afford through their own excess production over consumption, and allow bankers to skim off large swaths of the total production pie before the bad loans have their “emperor has no clothes” moment. The current attempts to transfer the burden of all that bad debt onto the backs of middle class citizens, many of whom had nothing to do with the creation of the bad debt, is the reason for the current political earthquakes around Europe.

    The Germans, Dutch, Austrians and Finns must do what the Swiss have realized is necessary for the long-term health of their citizens … bail on the Keynesian lunacy of unlimited money-printing and “ponies for all”, and leave the euro (in the Swiss case they broke the peg). Yes, it will require the respective governments capitalizing brand new banks to absorb both the bank liabilities they wish to protect (e.g. bank deposits of citizens and businesses) and the “good assets” held by the bad banks (those “assets” that have any prayer of being repaid in real terms). But if done right, the new banks can be privatized in short order, recouping the initial taxpayer capitalization. Let the shareholders and debtholders of the failed banks, which have brought the middle classes to their knees, rapidly descend into the abyss of insolvency. And let the nations which believe they can bring prosperity through QE, MMT, or magic beans, continue to destroy their currencies, sinking their citizens into poverty. Remaining in the “print-till-you-drop” fold only ensures your own demise.

    I’m hoping the Greeks intend to ultimately follow exactly that path.

    • Just to clarify, when I stated “I’m hoping the Greeks intend to ultimately follow exactly that path”, I meant the path I was advocating for the Germans, Dutch, Austrians and Finns. Not the “print-till-you-drop” path of nations which believe they can bring prosperity through QE, MMT, or magic beans.

    • I think you may be confusing household savings with national savings. When either income inequality rises or when the household share of GDP drops, the national savings rate rises more or less automatically, and not because of any change in the preferences of individual households.

      As for the export of deficient demand, this really isn’t bizarre at all, it is just another way of saying the export of excess production. There is nothing especially Keynesian about it at all. Since at least the 17th century, and probably much earlier in Italy, thinkers like Thomas Mun have explained how to force up savings and export the resulting gap between demand and supply. There have bee different reasons for doing so, from accumulating the gold and silver needed to wage war, to lowering the domestic cost of capital, to generating central bank reserves, and even to undermining the economy of a potential threat.

      • When I spoke of savings I did frame it from the perspective of an individual. However, national savings is accurately described in a similar way … it is the excess of production over consumption, enabling the accumulation of capital and or financial claims on the future production of others, which if deployed wisely produces a real return to the nation. This accumulation can be used at a future date when the nation “needs” to consume resources in excess of what the nation produces. As their economies flounder watch China and Japan consume their U.S. dollar reserves over the next few years. The idea that a nation, which exports more than it imports, has deficient demand, is in fact bizarre. Bizarre in my world which realizes nothing can be consumed before it is produced, and a world which values excess production over consumption, enabling claims on future production of others when circumstances may develop requiring deployment of that prior savings .

        The Keynesian focus on demand is the error. Humans have limitless demand, as is evidenced by the white-hot demand for $20 million apartments in New York City and elsewhere. It is the ability to produce them that is the difficult part (otherwise we’d all live in them). Gather ten of your Keynesian friends around a dinner table and ask them to raise their hand if they are willing to spend more than they currently do if you give one million dollars or euros of newly printed money to each participant . All 10 hands would be raised, as most humans have a propensity to consume far in excess of that which their effort in life permits. Then ask all ten how many are willing to produce more … you know, work longer hours, learn how to work more productively, perhaps by gaining access to better capital goods. Likely no hands will be raised, as most people believe they already work too hard and have too little leisure time.

        There is no such thing as deficient demand … there is such a thing as deficient demand at the current price. Our refusal to allow prices to correct to equilibrium levels (that price level determined by the pool of real savings in the world … not determined by incremental accumulation of unpayable debt … is the reason for the current financial chaos we see everywhere.

  39. Brilliant article professor. I was wondering if you could briefly share your thoughts on how the current dynamics in Europe (export of savings) could impact the rest of the world, and specially the US, in the face of very low 10y/30y treasury rates and rising US dollar?

  40. Your comment regarding who is more irresponsible, the lender, or the borrower: I think you can make a parallel to the internet stock bubble – who was more irresponsible: the investor paying 100x sales for a company with only .com in their name, or the company who IPOd knowing full well that they weren’t likely going to be able to make that kind of money. At the end of the day, unless there was fraud involved, ie. the company misrepresented themselves, the responsibility lies with the buyer: buyer beware. They made the decision where they thought the risks were justified and at the time 100x sales seemed like a good idea.
    Now back to our case of the banks lending irresponsibility: they are purchasing loans – these are assets on their balance sheets – if they think that loan is too risky, no one is forcing them to make it. The borrower can only takes the loan when the bank accepts the terms. Buyer beware.

    Great article – as a French national I found your discussion of the early Third Republic enlightening and educational, and an interesting parallel to the current situation.

  41. Prof. Pettis, I think I can follow the argument about the flow of funds from Germany to Spain but I’m having trouble following the calculations, which I think is important to the argument since it is the relative magnitudes that make the difference (right?).

    For Spain, over the period 2000-’04, the flow of funds was roughly equal to 20% of average GDP (of that period), while during the next period (2005-‘09) the flow of funds effectively doubled in magnitude (as a percentage of the period’s average GDP)

    (The magnitudes of cumulative ca deficits over average GDP are around 21-22% and 39-40% for each successive 5 year period, respectively).

    On the other hand, if one looks at the whole decade of 2000-’09, it is obvious that the flow of funds was equal to 65% of average GDP.

    So, if we compare the ‘performance’ of flows in the second 5 year period (2005-‘09) with respect to what happened during the first period (i.e. 2000-‘04) we see that cumulative flows increase faster than average GDP, which makes the flows increase as a percentage of average GDP.

    If we compare that to what happened during the whole decade, we observe that the average GDP (over the decade) is less than the figure of the 2005-’09 period, while, obviously, the cumulative ca deficit is higher (by definition, since we are talking about cumulative deficits).

    Therefore, we end up with the observation that funds flowed faster in Spain during the 2005-’09 period (at a rate of 8% per year) when compared to the previous one (4% per year), while at the same time, they flowed faster than when compared to the whole decade (6.5% per year).

    Now, if the norm for Spain to borrow is equal to its decade long figure (i.e. if it were supposed to borrow 6.5% of its GDP each year) then, if not anything else, Spain has been borrowing less than its fundamentals would allow and not more (notice how it has been borrowing at +1.5% x 5 years = 7.5% above its threshold in 2005-’09 and 2.5% x 5 years = 12.5% below its threshold in 2000-’04; those figures imply that over the whole decade Spain could have borrowed an additional 0.5% per year)
    On the other hand, if its threshold for borrowing is the 4% of 2000-’04, then it has actually been borrowing an extra of 4% per year (+4% x 5 years = 20%) than it should have been borrowing.

    Therefore either Spain was actually borrowing more or less at the level it was supposed to or it was borrowing at 4% per year more than it should have been.
    Can 4% per year more do so much damage? I mean, it certainly is not comparable to the 6% (~= 20% / 3 years) per year transfer in the case of the French indemnity to Germany.

    *Data: AMECO

    cumulative sum of CA
    over 5 year periods,
    2000-’04 = -165.165 billion euros,
    2005-’09 = -415.095 billion euros

    over 10 years,
    2000-’09 = -580.26 billion euros

    average GDP (current prices) over 5 year periods
    2000-’04 = 751.992 billion euros
    2005-’09 = 1042.918 billion euros

    over 10 years,
    2000-’09 = 897.455 billion euros

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  43. This is a very interesting post. The effort to pierce the national/institutional structures to reach the real sources and causes of the capital flows is quite valuable. The whole analysis of the Spanish real estate boom (my shorthand, the author is more circumspect) in relation to the export of Germany’s savings raised questions for concerning the oil and real estate booms and busts that have been characteristic of Texas since I was a student in the 1970s. I would love to see Mr. Pettis or someone who shares his approach and insight into regional and international economics compare and contrast Texas’s recurring crises and recoveries with the current crisis of the European periphery.

    Texas chauvinism aside, does the fact that these booms and busts occurred within the more integrated markets and monetary system of the US make the analysis or conclusions any different? Is the story that the Texas bust in the 80s and Spain now are pretty much the same with the similarities obscured by the political and economic complexity of the EU and nation states compared with the simpler market and political structures of the USA, or do the institutional differences of Spain within the EU versus Texas within the USA have any impact on the real economics? I suspect the answer is that the nation state structure and EU complexity slows the adjustment and prolongs the agony.

    One key financial consequence of the Texas oil and real estate bust of the 1980s, particularly, was the absorption of Texas’s homegrown banks by the big national banks. Before the 80s, for good or ill, the leading Texas bankers influenced politics and investment inside Texas in a way that seems a lot like the influence the big Wall Street banks and hedge funds exert in Washington, DC nowadays. Is Texas better or worse off as a result? The falling price of oil this year is cooling off an apartment building boom in my hometown of Houston, and word is that the hot national money that has fueled it has dried up in a matter of months. Will this leave Houston and the other booming areas blighted, or is it a needed correction that will prevent capital overshoot? Again, it would be great if someone of Mr. Pettis’s knowledge and ability were to make a real time comparison of how the booms and busts are worked out in the EU and the USA.

    • Its late at night so I will only make one comment, but we would find it strange if there were a major debate in the US about whether the 2007-08 crisis were the fault of Texas, the fault of New York, or the fault of any other state. The US debate is over deadbeat borrowers versus foolish lenders. This might throw some light on why I think it is mistaken to apportion blame for the European crisis on one country or another.

      • Is that the debate? It was quickly realized that both lenders and borrowers behaved predictably. The crisis resulted from rediculous measures by the investment banks to monetize the associated loans, and concommitant secret pacts to be insured the associated risk, which may suggest that global liquidity needs should never again be left to huge banks without oversight. But what governments have the effective power to provide that oversight? Not the USA, as we have seen with Dodd et al.

    • I’m looking out of my window in Uptown Houston and I can count eight cranes currently building commercial office and luxury residential high-rises in my sight lines. This of course says nothing of about the state of the Houston economy and its future, but rather the residual effect of the oil boom that appears to have ended definitively late last year. As far as I can tell, there was no way to avoid a “capital overshoot” because the price signals have been stubbornly incentivising overinvestment in the Oil industry for the last several years while other industrial commodities had already significantly retraced their gains during the last global boom.

      I don’t think the Texas Oil Boom-Bust cycle is solely a U.S. economic story, but rather natural economic responses to global events. I wouldn’t draw many conclusions or comparisons from the fact that most large Texas banks were consumed previously in the last oil bust in the 1980s. Continental Illinois Bank was the seventh largest U.S. bank when it taken over by the U.S. government in 1984. It was overexposed to the Oil Patch when prices collapsed. Any bank overexposed to the oil patch whether it was Texas, Oklahoma or Illinois failed. (Separately, I must say what a refreshing concept for a financially collapsed bank to be taken over by the U.S. government.) The same fate will again await any banks overexposed to the Oil industry.

      The two oil booms of recent memory were driven by global investment booms. The 1970s oil boom can be attributed to the global investment boom triggered by loose U.S. monetary policy which led to recycling Petrodollars throughout the world and developing economies. This recent boom seems to have got its genesis from the rapid growth of China, its investment boom and its impact on most commodity prices. Beyond that, I would hesitate to take this into a deeper dive into regional U.S. political and economic policies. I would just say Texas is the benefactor and casualty of global oil booms and busts.

      Some have surmised that Saudi Arabia engineered a collapse of oil prices in the 80s (with U.S. concurrence) to deal an economic blow to the Soviet Union. Now that same reason has been surmised for the Saudis to send an political/economic message to Iran today and perhaps Russian aggression as well. Regardless of the truth in these geopolitical matters today, it’s clear the supply of oil is clearly exceeding the demand for oil. While the growth in oil demand has decelerated, the production of oil has accelerated. The economic axiom in commodity markets that high prices are the cure for high prices could never be more true.

      • Even now, it seems like oil is hitting record levels of oversupply even with crude oil trading at $50. If I’m correct, inventories are still piling up. I’d like to add that much of this production has come from developments in fracking that allow us to extract oil from shale. Whether this is good or bad in the long run or from an environmental perspective, I do not know. It seems like there’re both benefits and costs to it. That being said, what is your take on fracking?

        Either way, the US is now the world’s largest producer of oil and natural gas with a massive drop in oil usage dropping simply because we don’t have to ship it halfway across the world. The Saudis didn’t engineer a damn thing. On the contrary, I think their regime is very vulnerable and fragile (there are way too many red flags).

        Also note that any slowdown in global trade places downward pressure on crude oil prices assuming transport costs don’t go up simply because less stuff is being shipped. Add in a technological breakthrough in fracking and a collapse in the world’s excess capacity and it shouldn’t be surprising to see a drop in oil prices.

        • Exactly, back at time of stimulus, great talk of Em driving growth, globally, on tail of global super-cycle in commodities discussion, while discussion had moved to American over-consumption (rather than too high a level of global growth) being the culprit and prime victim of the GFC, after an immediate slump, and deflation in markets globally, prices spiked, from already too high a level, across a number of commodities, to ridiculously high levels……iron ore, oil, gold, etc…all broke a long term relationship to movements in the dollar, and each other, that had been traditionally been seen (interest rates, bonds, stocks, commodities influencing dollar and links to other currencies, which are essentially, along with commodities, and prices of a slew of other assets, regardless, and despite local, merely derivatives of the dollar, in the linked world that we have).

          So, no the Saud’s did nothing, and the high prices enjoyed by commodity producers, which have exacerbatted asset dynamics in those who have investment driving growth, have yet to be worked out, ….the Saud’s realize this, although the Anti-Imperialists, MArxists, Islamic Fundamentalists, Socialists, Libertarians, Free-MArketeers, and any number of other ideologues, rather than than system reviewers, have grave difficulty in such.

  44. Let me sum it up: Someone talks endlessly about history and bankers against workers, and then warns about not to turn it into class war and nationalism. Well, I do hope to see the end of the “grand” European experiment!

  45. Interesting view. Here are a few questions:
    1. Do you see any difference between private and state borrowing? Why did Spain and Ireland bail out the banks when they could have changed the bankruptcy laws (see US existing laws and Hungary Swiss Franc loan changes)? Greeks have very little private debt, but they are happy for their elected politicians to borrow and bribe the electorate. Are they not responsible?

    2. Savings push vs. borrowing pull – how come “the push” worked only on some countries? Responsible countries (Korea, etc.) apply incoming capital control to prevent destabilization (they learned their 1997 lesson).

    3. Greece and Spain still have net capital inflows – all the screaming is a “drug withdrawal” effect of the money pipeline being closed (requiring a primary surplus). Isn’t that inevitable? Else, who should lend them more money to continue an imbalanced economy?

    4. Yes, Greece is bankrupt and they will likely default, but shouldn’t this be an opportunity to reset their economic structure? Do you see any possible painless recovery that also makes their economy sustainable?

    • “Savings push vs. borrowing pull – how come “the push” worked only on some countries? Responsible countries (Korea, etc.) apply incoming capital control to prevent destabilization (they learned their 1997 lesson).”

      The article touches on that: the EMU facilitated the push through currency distortion (inability to adjust the exchange rate), and the integration of the financial system, which makes the comparison with Korea inapplicable. “Spain” could not put restrictions on the push.

      • In Spain, the money flowed to private Real Estate – they could have restricted with zoning laws, banking restrictions, property taxes, easy bankruptcy laws, etc. Austria and many others within the EU were not destabilized at all.

        In Greece, the money flowed to the government – see my question 1.

  46. Putting the Euro Yoke on countries without adaption of their economic institutions was unwise. But the finding that we should not be talking about “Spain” or “Greece” or “Germany” leads to an important understanding of how the mess was created and what needs to be done if the Eurozone is to survive. Or should it?

    • I think that if you read some of Pettis’ other columns (e.g.: ), you get the idea that the Eurozone can’t really survive in its current form.

      I think (but I could be wrong and I don’t want to put words in anybody’s mouth) that he is also saying that such a crisis was inevitably and that Greece/Spain and Germany fundamentally can not belong to the same currency due to their structural differences. Ergo, any immediate “solution” for Greece that does not involve one or the other from leaving the Eurozone is basically an exercise in kicking the can down the road.

      • Indeed Claire. Some saw this coming a long time ago :

        “If a coun­try or region has no power to devalue, and if it is not the ben­e­fi­ciary of a sys­tem of fis­cal equal­i­sa­tion, then there is noth­ing to stop it suf­fer­ing a process of cumu­la­tive and ter­mi­nal decline lead­ing, in the end, to emi­gra­tion as the only alter­na­tive to poverty or starvation.”

        Wynne Godley 1992

        • Thanks for the link.

          I also thought this excerpt might turn out to be prophetic:

          “It should be frankly recognised that if the depression really were to take a serious turn for the worse – for instance, if the unemployment rate went back permanently to the 20-25 per cent characteristic of the Thirties – individual countries would sooner or later exercise their sovereign right to declare the entire movement towards integration a disaster and resort to exchange controls and protection – a siege economy if you will. This would amount to a re-run of the inter-war period.”

  47. Michael….as I watch this chronic Greek tragedy unfold in what is becoming yet another chapter in this epic battle between north and south….sometimes I cannot help but wonder, in my own simple way, if this war is worth waging? I admit I have long been a eurosceptic…so I am biased…but it seems to prolong the agony of the broken and dysfunctional experiment which will doom the whole Euro zone. It worked when times were good…but is failing the test when times are bad…. It seems to me the ones crying the loudest about doom and gloom scenarios if the the EU/ECB fails and therefore we must keep it together at all costs… are the ones who have a vested interested in it.

    I actually think that eventually there could be a huge sigh of relief if the grand experiment failed and we could go back to buying francs, DM’s etc again…am I naive?

  48. It’s an accounting identity that a $1000.00 bond trading at 50 has the same value as $500.00 principal amount of a bond trading at par. Restructuring clearly makes sense for the troubled economies as removing the Sword of Damocles of a crushing future obligation can create conditions conducive to future investment.
    The losses have already occurred, but the current debt market, with the Spain 10 year yield @ 1.48%, papers over the problem due to the prospect of ECB quantitative easing leaving a high perma-bid for what should be junk paper. How does a market restructure rationally when government bond prices are centrally planned?
    What I don’t get is the solution to the Eurozone after such a restructuring. I perceive, as I believe you do, a continuing problem of current account deficits in “Spain” and surpluses in “Germany” after such a debt restructuring due to inherent competitiveness of these economies in the world. Debt restructuring in my view is necessary but not sufficient. It’s the common currency that makes adjustment so difficult. Spain simply needs to devalue, and it can’t.

  49. Outstanding post and comments.

    What difference does the zero lower bound make to the comparison of the current to historical crises? Also it is not quite clear to me why foreseeable asset-price bubbles must, rather than might, occur.

    • Also it is not quite clear to me why foreseeable asset-price bubbles must, rather than might, occur.

      Because so long as Germany was running massive surpluses, the money will keep flowing in until there is a bubble, I think. I believe that “Spain” would have changed its internal policies such that the bubble could have been in, say, tulips instead of property, but so long as it was unwilling to accept higher unemployment, it was stuck with a bubble of some sort.

      Actually, given Schengen, I wonder if all the Spanish-type countries could have averted a bubble by making policies that simultaneously increased unemployment, but simply encouraged those unemployed Spaniards to leave the country and settle somewhere else (say, Germany, so that Germany’s surpluses end up paying for the unemployed Spanish in Germany). Or sent them overseas on military escapades, I guess. Neither approach is really practical and would create another problem, but I guess both approaches might be possible in theory, unless I am missing something.

      • Thanks Claire. That clarifies my second query a lot, and shows how the politics and economics could interact in ‘Spain’, Ireland or Greece .

        I still wonder about the ZLB, which Michael Pettis doesn’t refer to explicitly, and which figures increasingly in macroeconomic theories.

        • OK, I am not an economist, but I guess I would ask why ZLB would make any difference? Bonds are already going negative, so zero isn’t really a “boundary” so much as it is a sign of absolute lunacy (IMO)

          • Thanks Claire. For a non-economist you’re making a point that has only fairly recently appeared in the blogosphere and hardly in the journals. But (i) the ZLB has been a hard constraint in Japan for at least twenty years: Paul Krugman deserves all the credit for identifying this in his extremely readable Brookings paper “It’s Baaa…ack…” in 1997 (ungated in Google Scholar); (ii) MP’s stocks and flows accounting de-emphasises some possible factors in the analysis, two of which are the need for LONG-term inflationary expectations to rise across the EZ (so, especially in Germany etc.) for the monetary channel to work, and lacking that the need for interventionist fiscal policy.

            Both of these points follow from macro of the nineteen thirties and ‘forties (Hicks and Modigliani). As far as I can see, MP’s analysis would not have surprised Bagehot in the previous century, but not at all the worse for that.

            You cannot step into the same river twice, but there is nothing new under the sun.

          • the ZLB has been a hard constraint in Japan for at least twenty years:

            OK, let me take a stab at this, and let me know if I am wrong.

            1) ZLB could have been a hard contraint in Japan because there was no need to lend money for below zero–there were other risk/reward propositions (eg: lending to the US at 4% or whatever the rate was) that didn’t force money into Japan at negative rates. That may not always be the case.

            In a very simple hypothetical two country world, let’s say Zimbabwe (collapsing economy where the interest rates are 100% but all the banks are de facto insolvent) and Switzerland (stable economy where interest rates are mildly negative and all the banks have huge reserves), you may be willing to dump a lot of money in Switzerland just to guarantee that you get back most of your capital.

            The knee-jerk reaction is that people will just hold the cash instead of putting it in the bank, so those additional deposits will never occur. That’s probably true for most individuals, but not a practical alternative for somebody (or a company) with millions or billions to store. Presumably they will force the stock market and housing market and commodity markets and art markets, etc, up first to bubble valuations, but after all those markets hit absurd prive levels, the only place left is to go back into the bond market and be willing to live with the annual reductoin in money.

            I guess insurers and all the other companies who are legally required by law to hold a certain amount of money in bonds would experience this before the generic billionaire/tax hoarding corporation, but the general idea holds, I think.

            2) (this one intrigues me–I haven’t read the thought process anywhere, but please let me know if you’ve been aware of the idea being forwarded or dismissed somewhere).

            Let’s say that in a wave of panic selling for fear of bank runs or whatever, invesors holding 10% of their money in Zimbabwe get their money out of the country at any cost and buy the safe Swiss bonds, dropping yields from 0% to -1%.

            This is widely heald as absurd, so speculators short the bond with the idea of guaranteeing a risk-free return. This forces Swiss yields back up to, say, -0.5%. But now another 10% of the money flees Zimbabwe into Swiss bonds, forcing the rates down to -2%. More speculators come in to get the guaranteed ~2% return, so the Swiss bond now yields -1.5%.

            Now all of the remaining money flees Zimbabwe, driving Swiss yields to -4%

            If the speculators who originally shorted the Swiss bond at -1% now need to cover, they could drive Swiss yields to -5%. This squeezes the people who shorted at -2%, forcing them to cover and driving the Swiss yields to -8%. etc…

            So I guess that this is a long-winded way of saying that the short term mechanics of the financial markets may act in a manner that makes no long-term economic sense.

            I’m sure that somebody could come up with a much better example, but this is the first scenario that came to my mind. However, in this scenario, there is no real ZBL–yields just appeared to have that limit because there was no combination of situations drastic enough to force yields below zero and to then force it to well below zero for a prolonged period of time.

            Again, I could be way, way off. I find that the idea is a fun one to map out, though…

          • the ZLB has been a hard constraint in Japan for at least twenty years:

            I just thought of a much more simple scenario. If German bonds are denominated in EUR and yield -0.5% and then Germany leaves the Eurozone to re-adopt the DM, then the value of the DM will (presumably) increase–let’s say substantially. This (presumably) means that yields on the old German EUR-denominated bonds will decline even more, and could squeeze anybody who was short those bonds, forcing the yields to become even more negative as those who were short need to buy the bonds back at any price.

            Obviously, this situation can’t last too long, because otherwise Germany itself could just arbitrage the market and issue long term zero-coupon debt at above par and use the proceeds to buy back all the debt on which it actually pays interest. But I don’t see any obvious reason which prevents the negative yield from existing for a lengthy amount of time.

          • Bm: you can’t step into the same river once.

          • Claire,

            Doesn’t that scenario basically load a gigantic spring? If an inflation breaks out (highly unlikely in the current world), none of these countries can counter the inflation by inverting their yield curve. To this, some would say, “they could just cut their deficits sharply”, or something of the sort. I respond, because relying on politicians to cut deficits and send an economy into recession for the sake of stopping inflation with a lag effect could never possibly go wrong. Keep in mind that I’m not adding the assumption that only cutting deficits while having the central bank do nothing to reduce the money market rate of interest a legitimate way of reducing inflation (an assumption that I don’t think is always valid).

            Also note that we live in a world where commodity prices are crashing down. When commodity prices bottom, I suspect we’ll see worldwide inflation bottom. If you have a money market rate of -1% with NGDP growing at 5%, good luck cuz you’ll need every bit of it.

            So we do have a condition that prevents this sub-zero rate world from continuing: NGDP growth.

          • Doesn’t that scenario basically load a gigantic spring?

            I guess so. I guess you could equally consider a short squeeze to be the gigantic spring.

            I have no idea if this can actually happen, by the way. I’m just playing with ideas. I don’t see any reason why it can’t, though–I only see some reasons why it can’t be sustainable over the long term.

            If you (or anybody) has a good reason why speculators can’t get squeezed at negative yoelds, though, I’d be interested to know it–it would remove one of the ideas I have and let me focus on other scenarios.

            If you have a money market rate of -1% with NGDP growing at 5%, good luck cuz you’ll need every bit of it.

            So we do have a condition that prevents this sub-zero rate world from continuing: NGDP growth.

            Sorry, but I’m not sure I understand what you are saying. If MM rates are -1% and GDP is contracting, so -4%, then yes, it’s a problem. But why is it impossible? I would interpret that as meaning that most people are just cut off from credit, but those who are very credible will be able to borrow on very generous terms. So the economy continues to contract (taken to an exreme, it will contract until everything is working on cash payments)…I don’t see that as impossible (?)

            In any case, I think I’m getting a little diverted from earlier. I was originally envisioning a scenario in which short-term finance creates a situation that can’t exist in a long-term economic sense.

            As a side note, I’m not sure I agree with your commodities call in the broadest sense. I believe that agricultural prices might rise significantly. Similarly, power prices may also rise before the broader commodities markets for a number of reasons.

            Again, though, I am neither an economist nor a financier, so what do I know…

          • When I say MM rates at -1% and NGDP growth at 5%, I mean the opposite. In that situation, why wouldn’t you borrow to buy real assets driving up NGDP and worsening the feedback? If inflation breaks out, I don’t see how any country would be able to stop it. Do you think a country like Japan or any country in Europe can afford to invert the yield curve? Or having negative lending rates will worsen asset bubbles and drive up the savings rate. I guess it’d depend on the supply-side structure.

            You can see the impact of negative rates in FX. It’s really screwing everything up. It seems like it’s just a different tool for a currency war. If you devalue your currency, inputs become more expensive, right? In a world of collapsing commodity prices, it has the impacts you’re seeing now. Once commodity prices bottom, you will see inflation on the supply-side in some areas.

            We haven’t seen any inflation/growth at all and probably won’t for a while. That being said, what happens once commodity prices bottom?

            There will be consequences for what’s going on now. The question is when and how.

          • In that situation, why wouldn’t you borrow to buy real assets driving up NGDP and worsening the feedback?

            1) Because you may not be able to borrow–someone may be able to, but there’s no guarantee that anybody will lend to you personally (or the general public at large).

            2) Somebody might. Positive feedback loops exist and can persist for some time before the negative feedback loops kick in. Think of a historical bubble as a typical example.

            3) But you will have to find something to do with the money. At some point, even the price of real assets (think housing) become so bloated that it’s not worth the risk of the bet (or perhaps not worth assuming the counterparty risk, or whatever).

            If inflation breaks out, I don’t see how any country would be able to stop it. Do you think a country like Japan or any country in Europe can afford to invert the yield curve?

            I agree that it will be hard to stop inflation, but that doesn’t mean it can’t happen. Similarly, lots of countries can’t afford the predicaments they end up in. That doesn’t prevent the predicament from occuring.

            This sort of reminds me of a George Burns quote. He once said something along the lines of how he simply couldn’t die before he turned 100 years old becaues he was booked until he was 105.

            Or having negative lending rates will worsen asset bubbles and drive up the savings rate.

            And the savings rate in many places (e.g. the US) needs to be driven upwards anyway. In reality, though, I’m not sure if it would really worsen asset bubbles–in this case, bonds ARE the asset bubble.

            Again, let me repeat that I am not saying that any of this will happen, or that if it happens, it will be because some country wants it. It may just come out as the inevitable result of some weird combination of circumstances.

            That being said, what happens once commodity prices bottom?

            Apres ca, le deluge.

            But now let me ask you something: what happens to yields on German Euro-denominated bonds if Germany leaves the Euro and re-adopts the Deutschmark, assuming that German-issued Deutschmark bonds yield zero percent interest?

          • What do I think would happen? The bond prices should fall, right?

            Honestly, I’ve got no clue what’s going on. To say this world has gone mad is an understatement. This world is batshit insane. Everything’s going haywire and this is not sustainable.

            The key, I think, is the bottom in commodity prices. Once those bottom (this could take a while), everything will shift. When it shifts, it’ll happen at once.

            BTW, wouldn’t NGDP growth cause a short squeeze. Long end rates should (at least in theory) track NGDP expectations.

            I completely agree that bad consequences later mean nothing about what people/countries do now. All we now is that there will be consequences. I suspect this ends up with horrible crises and eventually war.

          • Yeah, the world’s gone “nuts”. Really, I think it’s the same world, but with such massive distortions everywhere that it’s hard to tell which way is up.

            I am not sure about the idea of long bonds reflecting NIRP. Again, I have no financial or economics background, but I know that I don’t trust any government with my money for 30 years (or 10 years for that matter), especially if wars break out. Equally, I don’t trust any company over that time frame either if the entire world is unstable.

            So maybe the long bond market just disappears, as people increasingly focus on short-term returns?

            This may sound hopelessly naive to anybody who knows anything about credit–since I don’t know much about credit, it’s just another idea I’m playing with intellectually.

            I’m also wondering if NIRP basically forces copmanies to either buy back shares or pay out increased dividends, since cash on the balance sheet becomes a depreciating asset.

            As you say, it’s a mad world.

  50. Perhaps your own sense of geopolitics is limited. And geopolitics always rule over economic logic:

    • This is great. George Friedman is a genius. I’m willing to bet Prof. Pettis knows way more than he’s letting on about geopolitics and probably conciously ignores it.

      • Ok, here is where we go differently, Friedman is better than the other Friedman (ee), but Stratfor is mediocre, and Friedman interesting and very knowledgeable toward CEE/CIS/FSU/USSR/WP, but his perspectives are far too tepid to be in the arena of genius. I tend to think is analysis on non Euroland matters to be sub-par, although decent on Near East.

        • I generally tend to agree with Stratfor’s conclusions. It’s $100 for a year subscription with a free book thrown in there that’s very affordable for someone like me. It’s difficult for me to get the information that they have otherwise. Also note that the information/analysis they provide, when combined with my own analysis/information, allows me to do think/provides me with upside that I wouldn’t have otherwise had.

          His analysis on Europeans is really what I need. To me, the Middle East and Asia operate in a pretty straightforward way. It’s Europe that I have difficulty understanding. I find that Europeans think so differently from me. For example, they find it wrong that someone has more material things/money than them (at least this is how they seem to come off). Why would anyone value themselves by their material things (provided they have enough food/shelter/basics)? I find that horrifying and despicable.

          Most (virtually all, I can’t think of one to the contrary) of the Europeans I’ve interacted with tend to be much more okay with authoritarian ideas than me. The idea of someone telling me (or anyone else) how to live my life infuriates me. As long as I’m not hurting anyone else or forcing anyone else to bear risks, what’s wrong with me living in such a manner that the public votes as wrong?

          I’ve met one European that specifically said what’s wrong with the idea of nationalism. That it’s a good thing because it helps a band of people unite together under a common identity and prevents disputes in a country. Why would you want your country to make decisions whereby disputes are tossed aside? You should want people to vigorously make points for the other side, particularly good points. You should want intelligent, courageous people to bang on a table for something they strongly believe in (provided they’ve done their homework and know what they’re talking about). I certainly don’t want people who’ll lie down like cowards running the show and I sure as hell don’t want maniacs getting in charge who only crave power.

          Now think of a person who wants power and sees a people that can be united easily as soon as he has a majority of the populace under his vote. Now add in a society where capital is viewed as a national asset with everything running through the banking systems. Now add in a people who are in some trouble, financially or otherwise, with a highly democratic system. Now fill in the dots.

    • Thank you so much for that link. Fascinating and terrifying. Europe could get it together to lead the world in developing modern structure for states and transnational entities, but it would seem very unlikely to be able to get it’s act together this time around.

    • Michael, thanks for that piece.
      As another layer of the onion to peel away in the search the real actors, the capital and labour interests are representative of typical right and left political affiliations. The right (capital) is focused on the contributions of individuals to the group (and protecting their rewards), while the left focuses on the importance of the social group (and protecting society). The reality of human nature is that we social groups of individuals with specialised skill sets and therefore the truth requires both the protection of reward and social infrastructure. See Capital destruction become much easier to recognise when the basic sanctity of the society is not dependent on the preservation of capital.
      Preserving the sanctity of debt and the value of currency, as well as preserving the social infrastructure, are common across any population. Those two are no more appropriately described as competing elements than using nations as substitutes.
      Thanks for your insights. I look forward to more.

    • George Friedman is clearly an entertaining speaker, but I’m sorry I don’t view this as much more than infotainment. To a degree, I admire people like this for their success in taking current events formulating them into simple, marketable concepts and prognosis that look insightful when applying them to recent memory. However, these prognoses often fall short when you go back and look at what actually happened from that point. There are dozens and dozens of these soothsayers offering and profiting from these geopolitical predictions. Only when we look back do we see they are overly simplistic, sometimes obvious at the time and a bit bombastic. I would put this Friedman in the same category as the New York Times’ Tom Friedman.

      If you need an example of this, in the video George Friedman pats himself on the back for predicting in 2008 that “the European Union was an unsustainable entity”. I heard this prediction years prior from Dr. Pettis and others. By 2008, many, many more realized the unworkability of the current structure of the Euro and European Union to the point where conventional wisdom was building that the Euro would lead to sovereign defaults and/or a break-up of the Euro zone.

      I think everyone realizes the Ukrainian situation is very dangerous. Russia might be a gas station for the rest of the world, but it is a gas station with a First World military.

      • I don’t think the Ukrainian situation is that dangerous. I think it’s more propaganda than anything else. As of 5 years ago, Putin was fine with the situation in Ukriane. Putin’s daughters (and the rest of the Russian elite’s families) all live in the West. They have all of their assets in the West. They do not want war with the West. The Russians do not want war with the West. It’s the US that’s the aggressor here, not the Russians.

        Basically, much of what you said about Ukraine is just not true. Subjugating entire populations to your will is a very expensive procedure, particularly when you’re an economy dependent on exporting natural resources at a time of economic/financial crisis. It takes a gallon of gas to move one tank one mile.

        If you don’t believe me, look at a map of US bases, weaponry, and missiles around Russia. Then come back and tell me Russia is a real threat.

  51. What really striking me is the complete lack to seek permanent and satisfactory resolutions from the politicians in the EU (and everywhere).

    As I hear the analysis in the radio/TV I have a feeling they want to kick the can down the road,but after six years of kicking the situation is the same,without improvement.

    Seems like the Germans are quite happy with the current situation, all that they want is to block any change in the current EU order, but it would mean that the Greek/Spanish/France voter has only limited, however destructive way to break this.

    So, how the Euro (or the EU ) could survive with this “permanent” crisis on the periphery?

    I mean, at the moment I think the chances are the next for the next four years:
    a.Break up of the EU:60%
    b.Partial or full break up of the Euro zone, but the EU remain as today:20%
    c.Kick the can down the road, without any solution:10%
    d.United States of Europe:10%

    the main reason of the ratios is the painless of Germany.
    Anything that I left out as possible outcome ?

    • The key may be getting ordinary German (or all European?) workers to recognize their precarious position under the current EU institutional framework/order. It’s doubtful that the EU elites will make substantive concessions without effectively being forced to do so via the exertion of popular political pressures. Thus, fostering a sense of sectoral/class solidarity will likely be a necessary prerequisite to any successful effort in this area.

      Professor Pettis’ concerns about the potential rise of radicalism or vulgar populism are certainly valid, but Syriza’s leadership appears to be charting a reasonable course for genuine reform within the Eurozone. Having said that, I am aware of the potential pitfalls moving forward.

      • We don’t know anything about the Syriza.

        Whatever is they choose path at the moment all that they can do is data collection,and keeping Greece in the current state.

        If they want to leave the Eurozone then we will know about it on the day when it happens.

        Why they would stay in the Eurozone at the moment? There is no benefit for that.

        And if one leave, the others will follow.The worst outcome for Germany would be that if Greece will be successful after breaking out, and making precedent for others.

        • Here’s Yanis Varoufakis’ rationale for Greece remaining in the Eurozone:

          “In summary, a Greek exit from the Eurozone will trigger a week-long bank closure, the rapid loss of liquidity for the already fragile private sector, a subsequent bank run upon the banks’ re-opening, an instant exodus of cash savings, and Greece’s loss of one of the European Union’s few achievements: unimpeded movement within the EU. It will also mean that the Athens government will no longer be in a position to negotiate a write-down of its debt with the EU and the IMF (appr. €280 billion), as a de facto default on its euro-denominated debt will be unavoidable. The economic impact of these developments will be, undeniably, shattering.

          Might the political benefits outweigh the economic cost? While it is true that, presently, Greece resembles an occupied nation, and is ruled over by a Berlin-directed troika of bailiffs, it is important to recall that this state of affairs is not cast in iron and would disappear in a puff of smoke if Italy, Spain, Greece, Portugal etc. were to form an alliance to demand different policies. In sharp contrast, Scotland will always be dominated by England within the sterling zone, courtesy of a permanently demographically lopsided two-member union.”

          • I would suspect that mini-bank runs might be seen then in Spain, Portugal and elsewhere.

            It seems to me that the risk of Europe-wide economic dislocation and distortions just in the near term following a Greek-failure, adds up to more money than would be “lost” by a compromise.

            Paul Krugman has a column about a month ago making note that many of the Greek financial positions held by the Troika are accounting ledger entries. I inferred this to mean that the real world won’t be affected much at all by adjustments on the accounting ledgers. In another economist’s blog, Nick Rowe’s, a set of people noted how a central bank for a currency-issuer could simply throw these ledgers into the ocean and it would have no effect on the real world.

            Compromise makes more sense to me.

  52. Michael – thanks for the wonderful article, especially the historical perspective. One thing I would like to get your thoughts on – if it was imbalances between the sectors of Europe (manifested as trade/capital flow imbalances between countries), and the fact that monetary policy and currency regime could not absorb economic volatility, that was the chief driver for the current crisis, wouldn’t these imbalances still exist after the crisis is ‘resolved’ (debt-restructuring for Greece/Spain)? For example, there would still be a significant difference between interest rates between Germany and Spain. I may be missing something here but I suppose what I am asking is whether there is a fundamental flaw in the construct of the Euro itself?

    • Yes, Sonu, there could be and probably are serious flaws with the construction of the euro, and these flaws must be addressed if the currency union is to survive, but I am not sure why so many commenters have proposed that acknowledging flaws in the construction of the euro invalidates the argument that without debt forgiveness there cannot be growth. Bankruptcy is an economic process of restructuring the balance sheet in ways the eliminate certain constraints that prevent growth.

    • Might you be merely referring to the imposition of a common currency, a monetary union, upon a geographical area, without a requisite strengthening of the political union, under premises of greater fiscal coordination, and a certain sovereignty in a center, might be the missing element, the grave weakness that leaves such a union in the hoping, in the offing, in the waiting, as to weak to truly speak to the needs and interests of any in the union, and is detrimental. Your missing element, may be, just referring to the weakness that exists in the absence of much grater fiscal union.

  53. Questions (2) and 3). France was capital exporting to the south and east (Spain, Austria, “Italy”, Bavaria) on a very large scale (sorry can’t offer quantification) from the mid-1850s on. Credit Mobilier first, Rothschilds and Bischoffsheim et al immediately afterward. Results – for both France and the capital importing areas – were not visibly destabilizing. 1873 cannot also be ascribed to this, compared to the Bismarck indemnity, much longer process. Of course it was an earlier stage in the cycle.

    As for the piece as a whole, very nice. Continue to wince at your ascription of causal dynamism to accounting identities. As for why capital accumulating in Germany did not find its way into productive investment, whether in “Spain” or in northern europe, rather than bubbling, is not here explained. I’d suggest (as you might guess) Steindl’s Maturity and Stagnation.

  54. Not sure your first question to readers is loaded, but your lead up could be construed to be so because people want an easily identifiable target to blame and you are suggesting the two obvious ones are perhaps not. The blame game is particularly applicable to banks given recent history and how they are currently perceived. It strikes me that the actors could somehow be fit into an agency theory framework where the incentives/disincentives are inappropriately aligned by the principals. While I don’t have the expertise to provide a real framework for your ‘Germany and Spain’ problem, it seems that even replacing certain terms might help alleviate the collision of your idea with preconceived beliefs. At least in my view, we would move a long way toward understanding if we could recognize the various actors operate within a framework others, say politicians for example, established and for which they should hold responsibility. That said, here is an attempt are rephrasing.

    Let’s say a huge amount of capital, say 10-30% of a country’s annual GDP, is forcibly distributed to an enormous group of entities within that country in a short period of time. Let’s also stipulate this distribution is mainly through financial agents of which many are going to be banks. Further let’s recognize that the principals involved (shareholders, politicians, and regulators) may have not properly aligned the incentives influencing the financial agents which results in inducing the agents to employ overly optimistic return assumptions. At the same time the borrowing entities for a variety of reasons are also induced to be overly optimistic and thus borrow more than they can in retrospect hope to repay. In which case is it the actors, be they lenders or borrowers, who should be retrospectively judged irresponsible or should it be the principals who devised the incentive structures?

  55. Is the author proposing that a loan shark is the moral equivalent as the receiver of the loan? If I borrow money from a loan shark I have a pretty good idea of the consequent eventualities. So , the banks were flush with cash and needed(greed) to invest. They preyed on innocent guileless types(I can’t help but default to sarcasm – the author begs a victimization context) that wanted to buy a lot more stuff they did not need with money they needed to borrow(more greed) Now the loan is due, oh ,oh …what now ? How about some neo feudalism, say the loan sharks, and we won’t break your fingers.Yes , I agree with the author , it is a struggle between the bankers,businesses and elite affluent class and the workers who are never too big to fail.The two sides are similar in that they both are acting from greed, particular to their “lot” in life. This is the drama of greed,revealing itself and destroying itself.The paradigm of making ones life mission to gain more wealth and power is the underlying belief and the modern day mantra amongst both parties.Infinite want and infinite growth are modern day delusions – we live on a planet of finite resources.

    • Greed, finite reources, no really, we live on a world with an infinite number of elements, with an infinite number of attributes who inter-act in an infinite numbers of ways, have impacts (as an infinite number of elements, with an infinite number of attributes, inter-actions and forces) in an infinite number of ways on this mass of infinity.

      Growth, assets, debt, income and so forth are necessary to give some semblance of order to the complex array of elements, interactions and forces in the environment, they are ways to both review, encourage, discourage, incentivize and disincentivize the great mass of actors and forces in the system.

      Some elements will be driven by greed (as individuals or groups), others by a lust, a curiosity an impulsion, a revulsion, a taste, distaste, etc and so forth, to incentivise or disincentivise, to encourage or discourage, etc and so on in a process requiring growth and mediums of exchange, that benefits from the storing of wealth and the sharing or lending, and borrowing of it…..

      to build a restaurant or farm or factory,
      to make, sell or buy a violin
      to study a topic of a printed book, an electronic digital source and so forth.

      I find it curious how easily people assume so many things to exist in the absence of the forces that brought these things into existence in the first place.

    • No, Gilbert, the author is very obviously proposing that this process is predictable, fairly automatic, and occurs so regularly that it is complete idiocy to moralize and to ascribe vice or virtue to either side of the transfer process. It always happens the same way because the same of incentives Inexorably lead to the same set of outcomes. All you need, as he said three times, is for either side to contain a wide variety of agents with a wide variety of expertise and a wide variety of optimistic and pessimistic expectations. Once those conditions are in place, the system sorts itself so that capital flows through the easiest channels.

  56. If I borrow money from a loan shark I expect to either pay it back,get beaten or worse. Well golly I just needed the flat screen tv and the second house in the mountains.
    The loan shark had a surplus of capital and wanted more(greed), the receiver of the loan wanted stuff he didn’t need and could not afford without a loan (greed)
    This is the Greek comic tragedy of greed revealing itself and destroying itself. I won’t subscribe to the victimization context with all its historical precedence. Can this be worked out without breaking a few fingers? How about imposing neo-feudalism says the loan shark.
    The bigger picture is that we live on a planet of finite resources and persist with the delusional belief that happiness occurs with ever expanding material wealth.Both sides, the powerful and the weak believe this, it would not be a drama without conflict. Both will need to gain a new understanding, a paradigm shift, of what it means to be a human on this planet. Until then we can expect wars, extinctions,massive ecological changes, debt slavery and on and on.
    The solution is not some nuanced economic adjustment brought to you by the latest Phd. du jour.

  57. You make a convincing case but you still should accept that culture is a factor in how people react to inflows like this.
    Coming from Finland, we entered the euro only 10 years after a devastating downturn caused by the loosening of money markets and the subsequent speculative boom.
    However, this experience actually partially prevented a disaster that took place in Spain. After the 1990s debacle, a debt fuelled boom was simply culturally much, much more difficult to start.
    As far as I can see, you actually made the the case for such cultural issues being a factor in the eurocrisis stronger by pointing out that there was no official “Spain” to stop the irrational boom.
    To me this sounds like the culture really took over and indeed was a central reason for what went down.
    There was no “Spain” but there was a Spanish culture and it wasn’t one of caution like in Finland.

    • No. Spanish “culture” consisted of over borrowing when the economy is flooded with money offered at negative real rates. This clearly isn’t culture. It is just normal finance and totally predictable.

    • In Prof. Pettis’ terms:

      It is not ‘culture’ that coordinates productive investments and attempts to eliminate economic incentives to actors who pursue unproductive investments or debt-fuelled consumption, but institutions (these being regulatory, legal, market frameworks).

      Providing capital to a region will have predictable results based on the social capital (i.e. the institutions) of that region.

      You can blame a region for it’s institutions or lack thereof all you want, but the blame is irrelevant. The consequences of credit provision were obvious from the get-go. Now you need to deal with the bubble. There are ways to eliminate the bubble that more reliably lead to happiness and prosperity on a well-distributed basis and that will allow for future growth in global wealth, and ways which more reliably lead to regional inequality, debt distress costs hampering global wealth, and potential strife.

      Let’s focus on solutions that exhibit the former.

      One can attempt to collate culture and institutions in an attempt to create moral arguments for assigning blame (and thus, costs). This is what is being done. But this distracts from finding a solution based on its likely outcomes.

      • Well said. Your sentiment here is why I always discuss as i do, outcomes need not be distracted from to sustain our personal sentiments (morally, philosophically, ideologically, etc)

  58. Amazing depth of knowledge and thought.

    What I’m tempted to think, however, is that you understimate the ‘choice’ that Spain had to invest the German influx productively. Not in terms of Spaniards actually choosing good investments, but in terms of having good institutions and regulations. The way I see it, German money searched for the “path of least resistance” into each country, that is, the path that could generate faster and bigger returns, and consequentally a larger bubble.

    The nature and potential of that path is determined by institutions, regulations and culture. In Greece, the path was state clientelism. In Spain (and Ireland) it was the real estate bubble. My point is that the “choice” that Spain had was having better institutions and regulations before the influx of German money came. Because, with regards to the real estate bubble, Spanish institutions and culture could hardly had been worse. The real estate bubble was already the defining feature of Spanish economy:

    -There had already been a bubble, or the first phase of The Bubble, in the late 80s and early 90s.

    -When the euro was introduced, real estate had already been on fire for some years.

    -There were vast interests dependent on the bubble: just for example, the income of local councils, chronically under-financed.

    -Last but non least, the bubble-as-prosperity mentality was deeply ingrained in Spanish mentality. Francoist policies oriented to creating a society of homeowners. Parents who had bought their houses with a chronically weak peseta and 10% inflation, couldn’t see anything wrong with their sons buying houses in the midst of the bubble.

    Had these institutions and regulations been different, German money would have had it a lot harder to inflate such a bubble.

    The other point I want to pose is that I feel you overestimate the response of Rajoy’s government to the crisis. Most importantly, Rajoy has done nothing to fix real estate. On the contrary, he (as Zapatero previously) has done all he could (wasting millions in the process) to prevent the exploding of the bubble, to keep the illusion that the bubble was normality. For example, the creation of a bad bank to freeze the real estate assets of troubled banks, instead of forcing those homes into the market and driving down prices.

    It’s logical though: for the average Spanish mentality the real estate bubble still represents prosperity, and no party would stay in government after a really serious (and badly needed) correction in house prices. But Rajoy and his party are still guilty.

  59. This post made me think that you should publish a fully revised edition of “The Volatility Machine”. The book was published in 2001 but if I recall correctly you say that you started writing it in the mid-1990s. Since then the emerging economies have gone through a full boom and bust cycle …

  60. Excellent piece. Agree: this is essentially a conflict between debtors and creditors. So far, creditors won (re: US subprime crisis: banks were made whole).
    PS Most interested by your comments on the French indemnity of 1871.

  61. Seems a tad loquacious and unnecessarily complex, to be honest. That said, the basic message (or one of them) is clear and I agree; the fastest and least painful way to recovery for the Greeks is to refuse to repay at least part of their debt. As you pointed out, sovereign defaults are not new phenomena. The historical lesson that capital flows into countries with good prospects – as opposed to good track records – is well established, and this means that a default will be quite painful in the short run but will result rather quickly in economic health. Certainly such health will come much faster than it would with a slow, grinding repayment of all debt. Always better to yank the Band-Aid.

  62. Very good piece. I would add, though, that most historians of the 1873 crisis agree that it was also caused by insufficient/inefficient regulation of joint stock companies; German corporation law was overhauled as a result in 1884. You seem to be saying that national legislation/regulation is irrelevant but surely it can at the very least exacerbate the effect of capital inflows? Also, one minor detail: Strousberg’s road defaulted on interest payments in 1871, i.e. it the collapse not caused by the Depression per se but rather by the Franco-Prussian war.

  63. Thank you for yet another rich and intriguing article. It is a well deserved compliment to your blog that it generates so many high quality comments.

    A few additional aspects not covered in your article or in the comments so far are also relevant to the situation i believe:

    1) How did Greece become a Euro Area member State in the first place?

    Greece applied in 2000 and joined the Euro in 2001. The only criteria to join was to fulfil the utterly baseless criteria of the Maastricht Treaty (see 2) below), namely budget deficit of no more than 3% of GDP, government debt of no more than 60% of GDP and inflation of no more than 1.5% point above the average of the three members with the lowest inflation.

    It was business as usual for certain investment banks to structure the window-dressing transactions that allowed Greece to appear to comply with the Maastricht criteria, at least the budget deficit one since it was decided on day 1 to violate the public debt criteria with Italy and Belgium joining from the beginning with a public debt over 100%. Shortly after these window-dressing Greek transactions, the former Director of the Italian Treasury – a guy by the name of Mario Draghi – became the European Head of one of the most involved bank in these questionable Greek transactions. The same Mario Draghi was celebrated 10 years later as “Super Mario” for saving the Eurozone from the danger of Greek exit. Funny, isn’t it?

    And so Greece complied with the Maastricht criteria for a few quarters and, on that basis, was permanently allowed into the Euro.

    Greece joining the Euro in 2001 followed 20 years of so-called “structural European funds” transferred to Greece since it joined the European Union in 1981 to supposedly help the Greek economy converge towards Western European standards. As a matter of fact, these funds seems to have adjusted not much at all and it seems a legitimate question to ask where have they gone?

    The first lesson to learn here is that if heavy decisions such as a country giving up its currency to join a currency union with other countries are made on such shaky grounds, problems are bound to happen. Appointing conflicted persons to positions where they are in charge of correcting the problems arising from prior mistake involving their business associates is going to make the resolution a lot more complicated.

    The second lesson is that the costs of piling up bad decisions upon bad decisions are indeed exponential: billions of structural funds thrown at Greece have been wasted, making it necessary to resort to accounting shenanigans to join the Euro, then making necessary the subsequent throwing of more good money (well, not so good anymore) after bad in the recent bail-outs. With zero prospect of ever recouping any of these funds. So, it seems indeed that European taxpayers have been defrauded of some funds without any visible benefit to the Greek people. It seems that only the credit providers have benefited by collecting interest on the vast amounts of additional debt created as well as the European bureaucrats who fund their power at the expense of the people. Frankly, what is surprising is not that Syriza wants to stop this non-sense on behalf of the Greek people but that nobody else in the European Union wants to stop this non-sense on behalf of European tax payers (one has to recognise that Margaret Thatcher was completely right on this point).

    One might conclude that the decision making process in Europe is dysfunctional.

    2) How did the economic governance of the Euro Area allow the development of the imbalances you describe in your article?

    Everybody agreed since Robert Mundell that sharing a common currency among several countries involved a process of economic convergence. How was this envisaged and implemented by European decision makers? The Maastricht Treaty decided in 1992 that three criteria would be evidence of convergence: inflation no more than 1.5% point above the average of the three member states with the lowest inflation, a budget deficit of no more than 3% of GDP and a public debt of no more than 60% of GDP.

    Apart from the fact that these criteria have been violated since day 1 with Italy and Belgium being initial Euro Area members since January 1st 1999 with public debt above 100% of GDP and that virtually all members now violate the public debt criteria (making them de facto void of any substance), one has to wonder what static and arbitrary public finances criteria have to do with genuine convergence of economies that have become more and more heterogeneous the further Euro membership was enlarged? Especially in absence of any effective coordination of national economic policies.

    For instance, when Gerard Schroder pushed trough in 2003 the “Agenda 2010” which lowered German unit labour cost on the back of Lionel Jospin having pushed through in 2000 the 35 hours week at constant wage in France which increased French unit labor cost, it is immediately visible that such diverging national policies within a common currency area can only lead to imbalances within the union. What can then be the useful role of the European Council as the body in charge of coordinating policy within the Union? What can then be the real purpose of all these meetings if members follow diverging policies at the national level? Once imbalances develop, credit has to flow to cover them and, like rainfall finding the way of least resistance downhill, credit will flow somewhere somehow. While it is indeed important to acknowledge that some countries, banks or companies are better managed than others, it is largely futile on a systemic basis to expect governments or banking regulators or whoever to block the flow of credit resulting from current account imbalances.

    Now, the restoration of an abundant flow of credit to cover all these cracks appear so important that the ECB has just violated yet another clause of the Maastricht Treaty that prohibited it to finance member States, which it will officially do from March with the just announced QE program. As usual, legal niceties are provided to justify whatever.

    The lesson here is that, in its current set-up, the Euro suffers from congenital flaws which can only result in either (a) the Euro breaking up or (b) imbalances being resolved exclusively by internal deflation in the debtor countries at the expense of the people or (c) a move to a federal organisation with a unified economic policy, including labor market, social security and taxation policies. The latter is of course the never explicitly acknowledged goal of European leaders but because the flawed design of the Euro has already backfired with the area having twice the unemployment rate as the rest of the world and social deflation having hit several countries, all goodwill towards the federal project has been destroyed and it is no longer possible. In any case, it would be impossible in practise now that the Eurozone has been enlarged beyond reason to 19 countries with too heterogeneous economic structure. That all relevant clauses of the Maastricht Treaty have had to be violated under the pressure of events should be evidence enough of the flawed design of the Euro. It is in itself an acknowledgment so policymakers may as well stop pretending and get real.

    To say, as PercyPavilion does above, that the noble aim of the Euro is to preserve peace in Europe and to invoke the memory of Robert Schuman is all good and well. But good intentions are hollow without good design and good implementation. With bad design and bad implementation of the Euro having produced economic results ranging from mediocre to catastrophic depending on member countries, it is now suicidal to remain in denial and to keep pretending that pooling should be the common answer to common problems (what exactly is the common problem between a creditor and a debtor?) and that the Euro is here to stay in its current set-up. Redesign of the Euro Area is now urgently necessary, involving a materially reduced number of member countries more homogeneous in their economic structure, a unified economic policy and much more democratic institutions allowing people to re-engage. The status quo can only lead to an authoritarian drift of European political institutions and a further schism between the people and the governing class, both already visible. Moving to the next stage of European integration on such unsound foundations that have been proven to lead to undesirable economic outcomes can only work against the stated aim of preserving peace in Europe. The current state of denial of European leaders is not very encouraging in that respect as they are de facto leaving the initiative to extremist parties on either side.

    3) I’m told a not immaterial part of Greece national wealth is actually held by the Orthodox Church. Is anybody able to shed some light on this not often discussed aspect? Is it true and if so where does this wealth come from and what is the role and position of the Church in the current situation? If i’m not mistaken, Greek Governments are usually sworn in in a religious ceremony in front of the leader of the Orthodox Church but, in the case of the new Syriza Government, it was apparently a civil ceremony. If that is correct, it is not clear to a non-Greek what are the potential implications?

    4) A point not made explicitly in your article but alluded to in one of your comments and implicit in several other comments / questions, is that, in a world where developed countries workers are exposed to labor cost arbitrage on a worldwide basis, Germany had no choice to favour domestic employment but to follow the wage moderation policies it followed. It is the main reason why Germany has a much lower unemployment rate than the Eurozone average. In that sense, the German government has served its people better than other European government did and it is hard to blame it for that. In that sense, the dysfunctional Euro Area should be replaced in the context of the dysfunctional world trade and monetary system based on labor cost and currency arbitrage and resulting in large and persistent current account imbalances leading to duplication of credit on a global basis and to unsustainably soaring debt-to-income level globally.

    Since these global conditions continue to prevail, Berlin is only responding moderately to its European partners demand for domestic stimulation. For doing more would increase unemployment in Germany without bringing much relief to other European countries.

    In this regard, it is totally incomprehensible that European leaders – apparently committed to the idea of fixed exchange rates among themselves – have always come out in favour of the current world floating exchange rates regime and have never pushed – not since De Gaulle in 1964/1965 at least – to reform the dysfunctional world trade and monetary system. May be the Euro was their way of doing it. But now, with the Euro having been badly managed, Europeans have in practise failed to show what advantages could be gained from a cooperative system of fixed but adjustable exchange rates whose main purpose would be to prevent the appearance and development of large and persistent current account imbalances. It doesn’t help.

  64. I really enjoyed this reading and your points on debt forgiveness are well taken and a possible solution. This said, I want to mention another reason why the French/German War debt in the 1800’s created the effect that you mentioned. The French currency at that time was probably among the top 3 most used currencies in the World. Back then the Gold Standard determined the wealth of each Nation. So currency was more of a trade instrument and many Nations benefited from currency acquisition, and the franc was in high demand. Same thing happened in the US recently. The dollar the official currency of exchange. The US could have printed much more for bail outs and the effect on the US economy would have been minimal as Nations would have done lines for buying dollars (buy low, sell high).

    Your article is perfect in pointing out that the mistakes were made by Germany. They remind me of the US bail out when Republicans blamed the debacle on homeowners for buying homes that they could not afford. Everyone else blamed the lenders for taking unqualified borrowers and then hiding these risky investments in bundles. At the end of the day the real culprits, the lenders and Wall Street, received the bail out money. Germany will like to blame Spain and Greece for bad lending practices and laziness but they were the original lenders. I also wonder, how much of these German funds went to government officials with fake companies that never repaid their loans back?

    Also, I do not believe that Mr. Varoufakis’ solution of swapping outstanding debt for new growth-linked bonds is the final or Eureka solution. What guarantee is there to ensure that Greece will perform over these new bonds. And after what happened to Argentine, I would not recommend Greece to fall for American Hedge fund Investors.

    I will like to offer another solution to this issue utilizing the typical economic cycle of most Mediterranean Nations. When before the Euro came into existence, these Nations tended to practice what I call “Seesaw Scheme” Economics. In this scheme, these Nations have Irresponsible Government Cycles that destroyed their economies but once these governments were replaced, their currency naturally devalued promoting international investment and things were nice and dandy until after a few elections later when another inept government gets elected and the cycle starts all over again. The reason why this scheme worked so well is that these are European Nations and not Third World unstable countries so for sophisticated investors, this was a great investment opportunity. all they needed is to understand the economic cycles.

    What I propose is based on this principle; devaluation of the Euro in order to create the “Seesaw Scheme” and promote International investment. The Mediterranean countries will benefit from investments and sale of exports. The only problem with this solution is the high costs of energy and raw materials, since they import most of it, will raise the costs of production; but lucky for Europe, energy prices are at the lowest. Only the Northern European Nations will not experience a direct and instant benefit from devaluation. But this is when they have to become team players and take the hit. Anyways, in the long run they will benefit as it will stabilize the Euro and the Mediterranean Nations increasing exports and the inter-trade between European Nations. But here comes the question. . .for how much does it need to get devalued? This amount is the key to a successful measure. If it is too little, it will not have the needed effect on the Mediterranean Nations, but it will hurt the Northern Nations and if it is too much it can become a debacle for the whole of Europe. The answer is simple, I would not tell, but it is very simple.

  65. The biggest problem to solve is satisfy all the stakeholders while being impartial/selfless with love/compassion towards humanity.

  66. An excellent piece, but you leave out the real reason why the Spanish government is so keen to do Greece dow. This is that the governing party is under threat from Podemos, which as some similarities to Syriza. If Syriza gets a good deal by standing up to the Troika, that will convince Spanish voters that their givernment should have done the same.

  67. Mr Pettis, what introductory book to economics do you recommend?

  68. Very enlightening piece, especially in changing the level of argument from a national point of view to a pan-European sector point of view.

    A question on this statement though: “it would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time.” Is it really astonishing if you take into account the massive fall of interest rates in peripheral Europe in the time preceding the Euro? Greece, Italy et al. used to pay up to 600 bp above Bunds when still having their own currencies. Financial markets drove these premia down massively (practically to zero) in the mistaken view that risks have come into line with German risk. Given the higher inflation rates in these countries, increasing unit costs of production (wage growth above productivity growth), and the resulting lower real interest rates, it became an easy way to finance consumption or “silly” (in hindsight) investment by credit. Again, this is not about assigning blame, but an explanation of why, apart from the Schroeder reforms and “underconsumption” in Germany, there was such an “astonishing coincidence” in “overconsumption”.

    I would also be interested what you think about the aftermath of any debt write-off. A write-off as such will not change the basic reasons for the existence of the described imbalances. Germany will still be overcompetitive, and Greece or Italy will still suffer from a lack of competitiveness. Therefore, do you think that the reforms demanded by Europe still need to be implemented or not. Or how would you go about convincing the Germans to wilfully decrease their competitiveness? After all, they don’t just compete with the other Europeans, but also with China, the US etc. Does Europe as a whole win if Germany becomes less competitive? On the other side, I joke with my German friends about the “stupidity” of their economic model: first tighten the belt to be hyper-competitive, export a lot of excellent goods to other countries, finance this consumption by German credit, and then write off the credits and save the banks by taxes from the same people who had to tighten the belt before. Who’s being smart here, the Germans or the others?

  69. After following this blog for the last few days I am compelled to suggest that, while a great deal of analysis, quite complex at times, is being directed to the problem of capital flows within the EU, a macro approach might be simpler, and in the end, I believe, just as useful in prescribing policy. I live in Canada. I have studied our regional economic disparity issues at some detail in university and also worked in the federal government department directly challenged with the problem, and worked on assignment to the World Bank. After fifty years I have concluded that all capitalist economies, when analyzed in any geographic context, deliver very imbalanced growth. Moreover, it is impossible to spread the benefits of economic growth equitably across any geographic unit without imposed fiscal redirection. In my country this is now recognized in the constitution; all citizens are to enjoy similar standards of education, health and government services and the federal government moves resources between the thirteen provincial governments accordingly. Thus 40% of my province’s annual budget comprises federal subsidy, and we raise and educate generations that emigrate to find employment in other provinces, sending money back home and frequently moving back when they retire. Despite three generations of significant government attempts to spread growth more equally and reduce the need for fiscal transfers, the income and employment gap experienced in my province has not changed since WW1. Provinces are free to leave this federation by referendum. I am quite certain that, if fiscal equalization came in the form of loans with conditions, rather than grants, Canada would fragment. But Canadian values transcend provincial borders, and if we do not know who we are at times, we all at least know we do not want to become Americans; and it is the combination of these factors that induces stability despite historical transfers of capital from the rich provinces to the poor. It is also broadly accepted that provinces must have the freedom to manage labor law, wages, pensions, health care and education without interference. This is the essence of the nation building force in Canada.

    I see so little of that attitude in Europe; nor can I imagine how nations that have fought the most horrific wars could, in a few generations, share wealth and absorb major population movement across borders. If it isn’t clear by now, it soon will be, that conditional loans and brutal austerity cannot be the essence of nation building; moreover, that the European Union cannot succeed absent that vision. Consider how precarious was the economic union of East and West Germany when the wall fell, and divisive forces still persist. I see no hope for European Union beyond a mere name. I sometimes wonder if it was truly the will of European people that drove the union in the first place? Perhaps it was merely a by-product of the emergence of global corporations. Perhaps governments responded to the corporate agenda without adequate consideration to building the dream. In which case, talk about capital movement, demand deficiency, class conflict etc. may just obscure the reality: that the dream of European unity is not sufficient to justify social destruction on the scale we are seeing in Greece. And to those who say that major economic reform in Greece had to come anyway, I say it is the means that matter. Governments with full fiscal and monetary powers can, if they inspire their people, achieve major change and spread the pain broadly.

    • Steve, your comment was very well said.

      PS- I am always sensitive when Canadians compare and contrast with Americans. Although our countries are close neighbors, both culturally and economically, I think there are major differences that drive the societies, the politics and the economics. While I think we, the U.S. can learn a lot from Canada and our often to stubborn to look at other countries for answers, I always tell Canadians to consider the major differences/challenges facing the U.S.

      – An African-American underclass that has been a historic and seemingly intractable challenge.
      – Different patterns and challenges with modern immigration particularly unplanned immigration from Mexico. (Canada has kind of cherry-picked who it allowed to immigrate while certainly the U.S. has too.).
      – A U.S. population of nine times larger dispersed in all directions.
      – Canada has an incredible amount of natural resources per capita to help pay for social costs.

      Many of my Canadian friends and many liberal Americans think the answer is simply higher levels of social spending. I am not convinced that this is the unequivocal answer as I personally see diminishing returns here in the U.S. from government programs designed to address poverty. The problems we have with poverty seem to be rooted much deeper. For example, spending more on primary education yields little benefit if we don’t find a way to increase the desire for education across the lower strata of society. Some people object to the idea that cultural assimilation is key to bringing up the underclass. However, there can be no argument that the desire for education needs to be one cultural value that needs to ingrained across the populace.

    • Very nice summation, I particularly like the contrast with the Union of USA and Union of Europe. Do you have much knowledge of Australia? I would be interested to hear a comparison or contrast between the government systems in Canada and Australia. I feel there is similarility with what you describe, but I am interested in the specifics (eg I didn’t know that Canadian provinces are free to leave the federation). Someone else might be able to comment also.

  70. What a fabulous article. Once again, you have proven why you are the one financial blog i still keep reading after all these years.
    One question. You say ” I don’t think there are many, if any, cases of countries that were able to absorb productively such massive inflows. In every case I can think of, massive capital inflows were accompanied by speculative bubbles and financial crises.” – What about Switzerland? Do you have any assessment on the vast amounts of cash that have been fling into Switzerland through its banking sector since the 1930s and in quite staggering numbers recently? After all, Switzerland is an ultra high functional economy.
    I would very much appreciate if you could write a post about that.

  71. @Herbert, I think that point 1 is not necessarily relevant. Germany had a situation bubble and financial crash due to being given free money. Which did not need to be paid back. And that money was given to the government, not to speculators. And it was only 20% of gdp. One would not expect their economy to be this badly hit. The fact that it was hit shows how destabilising unnatural inflows are.

    The inflows to southern Europe were larger, not requested by the government, less well directed and now are expected be paid back in full.

    Regarding the German advantage from the Euro, there can be no doubt from looking at the direction of the trade surplus that, for whatever reason, a great deal of the trade surplus can be shown to have directly been taken from weaker Euro members who had too low interest rates and too high exchange rates. Maybe it is just a case of Germany’s economy being stronger, but the result was that because of the Euro, Germany benefited to the tune of an estimated 2.5 trillion EUR at the expense of the other members.

    Possibly Professor Pettis has some of the details wrong (I have not got the specialist knowledge to know), but, to me, his understanding of the broad market forces is a breath of fresh air. So simple and yet so beautifully explanatory.

    • Ari, exactly as you state, but not merely Southern Europe, now take this situation globally, look at the time-frames this has gone on, and consider how long it can. Remember Michael uses Germany and Spain for Surplus and Deficit countries. Now consider this on a global scale, and how the model we have has successfully delivered the advancement of material capabilities to societies and people globally, but how excess, and to much of a good thing, likely pushes back in the other direction of winnowing the larder.

  72. This analysis is very helpful, and whilst I am in agreement with your conclusion, there is one element that I am not clear on.

    Your premise is that it is not Spain (Greece, Ireland, etc) that was the careless borrower, but rather an economic sector within Spain. It is of course the case that when money was available cheaply and easily, individuals and businesses foolishly borrowed beyond their repayment means. The consequences of that however was not the indebtedness and near insolvency of the state, but the insolvency of the individual and the businesses. That in turn resulted in properties being repossessed, businesses closing, unemployment going up, banks (both those that lent and those that invested in securitisation) went under or had to be bailed out by taxpayers of the UK, Germany (and other countries whose banks had over-lent).

    Was it not also the case of the governments of Greece, Spain, etc getting heavily into debt before the crisis, investing in state-funded projects (infrastructure, social, etc) for the benefit of the country, spending well beyond its means. Is it not those debts (rather than the debts on an economic sector) which are now having to be repaid?

    I would be grateful for any clarification on this point. Best regards.

    • It was a wide range of borrowers, and as you point out this did indeed include many local government bodies. In some cases it also included central governments, but Spain in fact had among the best fiscal records and debt positions of any country in Europe, including Germany. That is why the French indemnity is so interesting. The money all went to the central government in Germany, but it sill fed a bubble and a subsequent crisis.

      By the way government borrowing is not wrong in itself. If governments borrow to fund investment in productive infrastructure, the country’s debt burden actually declines.

      If I had to summarize, I would make two points. First, it seems to be difficult, if not impossible, for a country to absorb inflows productively above some level. Many things determine that level. In some cases that level can be quite high, for example the US in the 19th Century, Europe after WW1 and WW2, and Japan after WW2, had far lower levels of infrastructure and manufacturing capacity than they were able to absorb productively. In other cases it will be much lower, for example advanced countries that have’t been destroyed by war, or backward countries whose low levels of social capital limit their abilities to absorb investment productively.

      We spend a lot of time trying to make distinctions based on which set of economic actors were at the receiving end, but there is little historical evidence that this matters much. If the inflows are excessive, regardless of how the inflows are allocated the result seems to be wasteful investment, asset prices bubbles, and ultimately a painful adjustment.

      The second point is that when we think of the process in terms of countries, and then assign morality to the process, we end up with absurd, economically irrational, and terribly unfair conclusions. German workers paid once, in order to force up business profitability and, with it, the savings rates, and will pay a second time to bail out German banks. Spanish workers are being forced indiscriminately to pay for the demand imbalance through unemployment, whether or not they benefitted from the bubble. Even worse hit are those who were forced into buying very expensive apartments with debt because they believed that they couldn’t afford to wait — with so many German, French, Swedish, English, Belgian, etc. retirees pouring into Spain to buy homes it seemed that if they didn’t take the plunge they would be forever priced out of owning their own homes.

      If we can strip this debate of moral accusations and nationalist connotations, it will be easier to arrive at a rational resolution. We had a similar crisis in the US. And as badly as the US has addressed the crisis, does anyone really think it would have been much better if the domestic debate were about the moral obligation of Florida to New York?

    • “T Barton commented on Syriza and the French indemnity of 1871-73”
      {Was it not also the case of the governments of Greece, Spain, etc getting heavily into debt before the crisis, investing in state-funded projects (infrastructure, social, etc) for the benefit of the country, }

      If it was really for the benefit of the country then there shall have been no crisis. If those “investments” had been productive, it will have no trouble generating the cash flow to service the debt. What had happened of course was that the fund was directed to consumption or into white elephant projects that enriched those who were well connected. (Also the PFI in the UK, but UK can print money, so the repayment can be made over a long time via financial repression).

    • Interesting analysis and discussion. Thank you!

      Would be grateful to have some analysis and commentary on Prof Albrecht Ritschl’s research covering the Marshall Plan and the 1953 London Agreement.

  73. Balazs Schweighoffer

    Dear Mr Pettis, this is by far the best article I ever read about the imbalances in EU trade. It is excellent because it is very balanced and it does not try to blame any country for the result. I still have some questions about this:
    1. You rightly criticise the situation as dangerous for both the receiving and providing countries but you dont seem to propose any solution to it. Do you see anything could be done or NOT done by the government to prevent such situations?
    2. I basically agree with the idea of your assessment that it is workers against bankers, not one nation against the other. However I would refine it as “workers against non-workers”, or “workers against zombies”. Zombies include polititians, bankers, criminals and any kind of rentiers of the system from the rich to the poor, who receive. I define a worker as somebody who creates value, which is VOLUNTARILY paid by somebody else. A zombie is somebody who lives by directly or indirectly FORCING others to pay. The biggest organisation which forcibly makes workers pay for zombies is obviously the government but there are others, like criminal organisations or individual criminals.
    So is it not the government, that is the source of all these distortions? Could we not reduce this to a minimum by reducing government meddling in the economy to a minimum?
    3. Thanks for your insightful description of the French indemnity, which I did not know. How could have the German government do a better job at distributing the received wealth? How could Spain have done a better job? My only idea is to reduce taxes and let people decide what to do with their money. This would be certainly better than inversting in some silly government programs. But even that could very well induce a boom, which would inevitably end when the extra money is gone.
    4. I miss something in your article, which is very obvious to me. The German government saved the banks at the cost of the German workers, which you mention. But you dont mention that the government should have left the banks to their fate. I beleive that would have saved the situation in many ways: (1) It would have taught the banks a lesson and the rates for Greece/Spain/… would never have been so low again. (2) It would have taught the borrowing countries a lesson, who would have borrowed a lot less afterwards (because they could not). (3) It would have allowed a quick turnaround for both Germany and Spain at the cost of a strong but short pain. (4) It could have saved the EUR, which is the applied solution did not do.
    5. Why is that, everybody says, a defaulting country must leave the EUR system?? I never understood that. Why could not Greece default and keep the EUR? I dont see any reason for that. They could just stop paying the interest and that’s it. At the same time they need to reduce the expenses to the level of the tax income, which they have done already. Of course every lender bank and government would be angry and everything, but this would be clearly possible. An honest default would be in my opinion clearly the best for the Greek working people. Or am I missing something?

    • Zombies….please, ideological claptrap.

      Why Greece not just default and stay within Eurozone, why not default and leave Eurozone, why stay within, why would that be better?

  74. Michael, good post, though may be a bit utopic. What if the Germans simply engineer the reverse situation by creating a current account deficit which would help to articulate a corresponding surplus in Spain? What if Germany implemented inflationary policies and salary increases that stimulated consumption and investment? Couldn’t that be part of the solution reducing as well the social costs?

  75. MP- thought-provoking article one again. Thank you. Your soapbox on the morality of frugal Germans vs. spendthrift southerners comes through loud and clear as it does in many of your earlier writings. In this article however you extend the same anti-morality crusade to idea that private actors are not better at allocating a surplus of liquidity ( recently Spanish/Greeek banks) than goverment agencies (French Indemnity). In as much, modern Germans not more fiscally responsible that Spainards and privately negotiated transactions between Spanish Banks and investors are just as foolhardy as government officers in 19th century Berlin. I take your anti-blame and anti-morality view more abstractly, and apply it to the private-public axis of idealogues.

    While I find the anti-morality crusade compelling, and a good antidote to conventional media regarding the Eurocrisis (among others). — I can’t help thinking the global imbalances is more than fight between the economic elite (creditors) and wage earners (debtors). Strong institutions and proper economic incentives do matter for economic growth.

    Germany does have better institutions for fair and anonymous trade (less corruption) and better incentives to direct private actors toward growth-producing investments, than does Spain. The cultural background of institutions cannot be swept under the rug entirely- and the Eurocrisis viewed strictly as class warfare. Your comment about Africa starting at the Pyrenees is acknowledgement of this cultural context.

    Leaving the racial/ethnic morality at the door, the historical narrative of Policitial-Economy makes clear that:
    Open Societies (Doug North et al.) are better than corrupt states
    Private voluntary transactions are better than government directed transactions

    Could the current tug-of-war between financial repression in Germany and the extreme unemployment in Spain just a be a short-term imbalance of cash-flows between elites and wage earners? Much like the short-term debt cycle promulgated by Ray Dalio? The imbalances of economic growth caused by culture, government institutions and proper incentives may happen on a longer-term cycle. I would like to hear your nuanced view on when, to what degree and at what time-scale cultural differences between nations can be ignored. thanks

  76. I do not agree with your conclusions in two points:

    1) German productivity

    Yes, German productivity growth was low in this period. But why?

    In the aftermath of unification Germany tried to prop up newly acquired former Eastern Germany and was ultimately saddled with high social cost and and increasing unemployment. Unemployment that in the eastern part reached up to 20%, and growth that was so slow that Germany earned the “sick man of Europe” reputation as quoted by the Economist. So Germany at the end of last century had a “bigger Greece” on its own hand. Generated by communist history,1 to 1 exchange of Eastern German Marks into D-Marks, generous social spending extending to former Eastern Germany etc. This made Germany and esp. Eastern Germany uncompetitive and led to explosion of social budgets. When Hartz reforms were introduced unemployment peaked at more than 12% (Germany in total) and then only slowly fell to now normal levels.

    Yes, Germany didn’t solve its problems by increasing productivity but it had no other choice than to free the labour market to bring unemployment and benefits payment down. It ultimately woke up to the fact that parts of it society were not competitive and they can’t carry on this way The beggar-thy-neighbor accusation against Germany is wrong. It simply did what other Eastern European neighbours did. Or would you accuse Poland and Slovakia of this that now have built competitive industries. As happened in former Easter Germany.

    2) Schaeuble, Greece versus Spain

    The comparison of debt in Greece and Spain is comparing apples with oranges. Greece debt problem is mainly a government and to a lesser extent a private debt problem, The extent of German borrowing to Greece has been small and is much less than in Spain were private debts are the issue. Schaeubles comment does not refer to debt problems caused by willing banks granting excess credit to a private Spanish housing bubble but ever repeated claims by ever changing Greek governments that are unable to deliver on any meaningful reform program whatsoever. Yes, Spains private debtors could have simply defaulted on their debt and creditor nations would have swallowed losses. Maybe combined with some kind of “Hungarian” private debtor bailouts with foreign banks facing the bill. But a bail-out was obviously the less costly solution for both sides. How do you understand the termination of the existing program, showing the troika the door, asking for more money from 18 other EZ members and saying we have no plan, no clue we need more time. Doesn’t this smell like blackmail.
    I do not believe a further debt relief makes any sense for Greek. Let them default on the debt and go and take their own route with an independent currency. That will deliver reform to Greece much better and quicker. The Eurozone serves only as a scapegoat for local politicians not to deliver on reforms.

    EZ is not only Germany. There are countries like the Baltics, Slovenia, Slovakia that have much lower gdp and shall pay for Greek extravagances and corruption.

    The root EZ problem has been bad timing: the combination of low interest rates at inception causing bubbles in the South and at the same time a restructuring Germany dealing with postunification issues. Wage restraint is no German passion. It was just a necessity between 2004 and 2010 to bring unemployment down. The CA surplus is a symptom of a currency that is now too weak for Germany.

  77. The argument follows very logically and convincingly from the premise that German wage moderation policy from 2003 pushed up the German savings rate, that this extra savings could not be productively invested in Germany and was therefore exported and that the resulting inflows in the recipient countries were proportionally too large to be productively invested and therefore resulted in a credit-fuelled asset bubble and consumption binge with the dramatic rise in debt-income level of countries such as Greece and others and the negative feedback loop on their future growth prospects, hence on their deleveraging prospects, leading to the conclusion that debt forgiveness might be the most desirable option.

    While the logic is very robust, the premise is worth examining a bit closer.

    Let’s assume the main priority of the German government in the early 2000’s was to maximise domestic employment. That’s a legitimate goal of any government and certainly was for Germany after the high level of unemployment in the 1990’s following the reunification.

    Let’s further assume that with China having recently joined the World Trade Organisation in 2001, German officials understood (perhaps enlightened by their experience of absorbing the cheap labor from East Germany in the prior decade) that global labor arbitrage opportunities had just been reloaded to a massive extent and that, under these prevailing international conditions, the only possible way to boost domestic employment was by reducing unit labor cost.

    Viewed in this perspective, it is not at all obvious that German workers have paid any price through lower share of production for the alternative would have been higher unemployment (which would have tended to decrease the savings rate).

    Viewed from this perspective, the imbalances didn’t originate in Germany but in China and Germany was simply able – through a combination of wage moderation policy and the Euro – to divert them to its Eurozone partners.

    The framework then could look rather different. It might not be labor vs. capital within the Eurozone. It might be developed countries labor vs. developing countries labor and global capital on each side of the global labor cost arbitrage.

    If that’s the case, as long as global labor cost arbitrage prevail, the debt relief solution envisaged in the article might simply be treating the symptoms rather than the cause. We write off the debt and then what? We start all over again? In the US, for instance, some mortgage debt has been written-off and another portion monetised. And then what? Yes, the US has had a bit of growth but (a) employment level is still where it was 10 year ago and (b) growth is still very unbalanced and deficit-fuelled as Chinese and European external surplus rise to record. Problem not fixed, just repeating the same artificial financial boom-bust pattern (now in the mature boom phase).

    There is another option, which another Syriza in some other European countries might pick up in the near future: the Euro organisation as currently set-up is not compatible with the world trade and monetary system as currently set-up, we might reform one or the other or both (and certainly both have many flaws) but, in the meantime, one conclusion might be to restore the European Union trade preference.

    If the institutional framework for globalisation is not fixed, the forces working against globalisation will only gather more strength and momentum. The problem is bigger than the Eurozone, which is simply a sub-set of the unaddressed issues raised by globalisation.

    • Good question. Looking at the temporal relationship, German current account changed trajectory prior to 2000, and the ease in which capital would flow within Europe, I would put more weight behind the notion of this issue originating in Europe.

      • German current account data are not very difficult to interpret. By the mid-1980’s, German surplus were rising to the point that the Plaza Accord of 1985 revalued the Deutsche Mark in an effort to rebalance trade. Then, German current account turned into a deficit from 1991 to 2001 as a direct consequence of the reunification. By 2002-2003, surplus were simply going back to their 1985-1990 level in absolute terms. Surplus soared from 2004 as a result of the “Agenda 2010” wage moderation policy implemented from 2003.

        What i’m saying is that with China’s vast pool of cheap labor having just entered world markets in 2001 at an undervalued exchange rate, Germany had only two choices to foster domestic employment: (a) expand credit to unleash a debt-fuelled investment and consumption spree, like was done in the US and many other countries at the time ; (b) reduce unit labor cost to improve competitiveness. As it turned out, the latter was formulated into the “Agenda 2010” policy in 2003. As it turned out, the other option was found – unsurprisingly, except to the confused Fed – unsustainable. So, what i’m saying is that Germany made the only sustainable choice it had given the constraints imposed by China recent entry into the WTO at an undervalued exchange rate.

        It is very true that German capital flowed into the Eurozone with remarkable ease, for the simple reason that there was no currency risk. It is very true that without the Euro, German capital outflows might have been less concentrated into the Eurozone and more diluted internationally (perhaps offset somewhat by a stronger Deutsche Mark). That’s why i said that Germany was able to divert pressures from China on its domestic employment level to its European partners through a combination of internal wage moderation AND the Euro.

    • DVD
      Good questions. I think you are mostly right. However, Germany could do a lot over the short term (next few years) by stimulating internal demand via a modest budget deficit (say about 2 % of GDP). This would give them some time to work on structural issues in order to increase weak internal investment and consumption.
      My big surprise is that I have found no economists of any stature who are actively promoting limiting or prohibiting (with exceptions) large persistent trade imbalances. This is what Keynes proposed at Bretton Woods in 1944 to deal with the problems you point out. I do not think his Bancor idea is a feasible way to implement, but there are other ways. The only thing I know of is the pathetic proposal to by Tim Geithner to the G20 a few years back to limit current account surpluses to 4 % of GDP. This was pathetic 1) because 4% of GDP is far too high as a long term average for large economies; and, 2) because the idea was quickly shouted down by China and Germany and Geithner retreated with his tail between his legs and nothing more has been heard of this proposal. Limiting or prohibiting large persistent surpluses substantially changes the incentives of persistent surplus countries, and therefore substantial changes to behavior are reasonable to expect. There are plenty of major economists who point out the need or benefits of current account surplus reductions by major surplus countries, but none I know of who are proposing concrete actions to make it happen.

      • 4% per year will compound quickly. I believe that the only answer to this is to adopt Warren Buffets idea of trade certificates . This approach has the added benefit of being able to be implemented without the consent of trading partners and is consistent with WTO rules.

      • Yet, but many re familiar with the Buffet plan, and many more are discussing,some of whom have coauthored with Michael.

      • Indeed, that’s the heart of the matter.

        Free trade can only be mutually wealth-enhancing under the condition that cross exchange rates are set at level that, on average, equilibrate current account balances so that countries end up exporting the products for which they have a relative comparative advantage and importing the products for which they are at a comparative disadvantage.

        As soon as exchange rates are not consistent with current account equilibrium, it means that countries actually compete based on labor cost and / or currency arbitrage at the expense of others. Free trade is no longer mutually wealth-enhancing but is beneficial to one party (which exports all the products for which it has a genuine comparative advantage + all the products for which it has a labor cost advantage at prevailing exchange rates) and detrimental to the other party (which imports all the products for which it has a comparative disadvantage + all the products for which it has a labor cost disadvantage at prevailing exchange rates). The result is the development of large and persistent current account imbalances, leading to duplication of credit on a global basis which is the engine behind the staggering increase in global debt-to-GDP level for the past 35 years, such unstable global debt pyramid threatening to collapse at any time (we came close in 2008).

        A balanced trade system is incompatible with the use of the domestic currency of a participating country as the international standard. In other words, it is incompatible with the international status of the US$, which condemns the US to permanent deficits. The fact that virtually all major central banks now openly intervene in their exchange rate finally confirms that the system of supposedly freely floating exchange rates is an illusion and should be replaced by a cooperatively managed system of fixed but adjustable exchange rates whose main purpose is the avoidance and early correction of current account imbalances. The WTO and the IMF should be merged as international trade and exchange rate are the two inseparable sides of the same coin and the IMF should become in charge of the new international standard of account by reference to which national exchange rates should be set.

        You are right, it is a shame that the G20 never came even close to a correct diagnostic of the 2008 crisis, which frankly is not so difficult. Of course, it has then be utterly unable to formulate any remedy, only to issue empty words of reassurance for the markets. That the main concrete achievement all these taxpayers-funded G20 meetings is the biggest petits fours invoice ever is beyond risible.

        Many prominent economists have insisted that the current world trade and monetary system was dysfunctional and could only lead to grave difficulties and have made practical suggestions to reform it. For instance, Maurice Allais used all the prestige of its 1988 Nobel Prize on this cause. He has been successfully ostracised and caricatured as an old mad scientist by those who control the diffusion of propaganda. Understandably, it did not encourage younger economists to risk their career on this issue. That’s why the people who come out in favour of this thesis are mostly retired people like Paul Volcker or Mervyn King who have nothing to lose anymore (may be a few lucrative conferences, at worst). Michael Pettis has his own subtle and didactic way of pointing in this direction but seems careful not to step into policy recommendations.

        Now, Syriza and other “anti-system” political parties are seeing their audience rise thanks to the deep and widespread frustration arising out the failure of current policymakers to reform the system. The stakes keep rising.

    • Such, as that which you have written here reminds me as to my confusion of why you seem to believe we are divergent in opinion for this is what I have been saying since before you made it to Michael’s blog as DvD. Again, this is what Rodrik has been saying, although playing on it in political terms (where he is at the School of Governance this political focus is not surprising) . But more than this it is systemic and structural.

      Frankly as I have been on this perspective for quite some time, one can say definitely from the early 2000’s, but likely well before, that I am actually at this point toward more, not hopeful, but suspecting, that we are actually moving on from a great mass of previous confusion. Despite many confused persepctives, I do tend to suggest that recent circumstances, and ongoing evolutions, imply that the ground is now forming for great changes in the many tenors of thought on these matters that have inhibited growth, as we move onwards in our understanding of these matters .

      It is obvious that Inequality, balanced trade, mechanisms to ensure cycling of take-off, and the importance of domestic demand in driving growth, even the frontier of paces of growth, to be more at the forefront of discussions as we move forward. Over the last decade and a half, two decades it has seemed that knowledge has become far to entertaining, and perspectives far too much like a sporting match. I should imagine we descend from Madison Avenue, K Street and Rodeo drive simultaneously (and similar named cohorts globally).

  78. In “These non-economic considerations are irrelevant”, the following sentence suggests that you meant “…are not irrelevant”.

  79. This interesting analysis provides a different view on the debt problems in Europe that I can partially agree with. The aspect of being rather a fight between different economic actors (e.g. workers on one side and bankers on the other) than between countries is the real core of the problem. Over the past decades, we all have been conditioned that on one hand slight positive inflation in the cpi as well as on the other hand the credit risk banks enter into being indirectly subsidized or the cost of the credit risk transferred to the general public (middle class) via different mechanisms are normal. This view neglects the distortions created by these incentive structures that lead to the so called “moral hazard” as money’s function has been abused to simply achieve short term economic benefits which lead to the incentive to invest in tangible assets (if possible with high leverage) creating different investment bubbles. Banks in turn benefited in that they reduced their risk capital in order to achieve a higher leverage in this Ponzi scheme and gained as a result of it political influence to achieve further deregulation and a higher degree of cost free transfers of risks via different mechanisms at central banks and via the influence on the legislation to the general public. As those bankers got away Scot-free, this business model has, over the past few years, been increasingly adopted by all large corporations with, until now, unknown consequences for the next down phase of the business cycle. Even 6 years after the crisis of 2008 the risk capital of banks has all but simply been increased marginally but never to the degree that allows them to absorb any major losses or in other words the high leverage and the resulting transfer of the costs of risk has still not been properly addressed.

    It definitely is a battle between different economic groups but a battle that is fought by applying a smoke screen by those in charge and applying a faulty economic doctrine by central banks. To use nationalism as the means to divert from the real issue is unfortunately a common behavior by governments who act in favor of the financial elite.

    • Fight between classes on one hand or countries, it is not a fight, it is a set of necessary outcomes from a set of existent observable elements. When X exists during Y it is likely that Z (to some degree) will occur.

  80. On question 3:

    3. What about the other side of the recycling? In most cases the recycling country also experienced bubbles and rising debt. Have there been cases that did not also end in tears and if so, how were they different?

    It seems that the bundesbank is worried about lowering real interest rates in Germany these days. Housing prices are seemingly escalating as well as construction permits. Could these be the first stages of a housing bubble in Germany?

  81. I read your blog with interest and would like to request you address a question about the past decade of phenomenal economic growth across Africa, replacing decades of desultory results, structural adjustment, aid dependence etc. How much of this is due to the macro financial balance factors that you so interestingly describe in your blog posts? And how much is due to structural factors such as the “demographic dividend”? Does the growth of China bode well or ill for Africa? I ask as a Kenyan entrepreneur whose business with Chinese clients has taken a knock this January as the Chinese economy slows. I look forward to reading more…

  82. Such a fascinating, well-rounded exploration of the Eurozone crisis, that there were bound to be some typos:

    German consumption was not “N”early as extreme as it was in Spain

    largely becau”S”e these instruments have not been “invented”.

    Why didn’t Germans, rather than Spaniards, take advantage of the excess savings to fund a consumption boom “?”

    igniting “the” ire of Brussels and Berlin

    • Thanks, Andrej. Corrections made, although because at least seven sites automatically repost all my blog entries, the original typos are a permanent part of the record.

  83. I find myself agreeing with the author except for a very important point. What measures do we put in place to ensure that such behavior does not re-occur? I know little about Spain politics and economy but I know a lot about Greece and as far as I can tell the SYRIZA policy is to have debt forgiven so that it can run new deficits, increase the public sector yet again, and stop any/all privatizations and entrepreneurship. If we could actually nudge things in the right direction there I ‘d be more than happy to sign up for debt forgiveness. Absent those I ‘d be disinclined to provide wiggle room for bad policies.

  84. Professor Pettis,
    thank you for taking the time to write this thoughtful post. Let me pl. ask two clarifications

    1. You pit workers/middle class vs bankers. But whose money did Germans banks lend? Wasn’t the money, at least partially, the German workers’ and the German middle class’s? In that case, wouldn’t bankers’ and workers’/middle class’s interests be aligned?

    2. You mention GDP warrant. I have heard about this idea for quite some time. Paolo Mauro, for one, has been indefatigable in working out the details of and advocating for GDP-linked debt. Yet it has not taken off. Would you have any ideas as to why?

  85. Excellent post, Professeur Pettis, thank you very much for your enlightening remarks. Although I beg to differ in some points (or would at least eagerly discuss some assertions), the overall thrust of this and many others of your articles is very important and extremely welcome in the narrow debate about the European crisis.

    Right now I would just like to give three short answers to your questions, just as food for thought and out of interest what you or other commenter might think:

    Ad 1.) Banks and borrowers should both be deemed irresponsible, with the possible distinctions, that banks should know their business so they shouldn’t complain if thez have to write off bad loans they made. However, I wonder whether very strict legal mortgage loan conditions in Spain (30-40 % down payment, restriction for the buying and selling of second houses, stricter zoning laws) might have changed the main direction of the Spanish boom. It is true, that the Spanish economy would have absorbed most of these savings anyway, but I’m not totally convinced, that Spanish policymakers couldn’t have taken steps to redirect at least big part of theses investments into more productive sectors. A real estate sector as overheating as the Spanish one should have been seen as dangerous for the whole economy. Sure, it is very difficult to spot bubbles, but at least from my view there was room for improvement also on the side of Spanish domestic policies.

    Ad 2.) It seems to easy to me to dismiss the US as not successfull in recycling their huge capital inflows (for most of the 19th and 20th century America ran account deficits. Sure, there were gigantic booms and busts, in the 19th and the 20th century, but in the long run (and often also quite quickly) the US economy came out of its hole, grew fast and increased its productivity enormously. In this way, the US could be an example where big long-term capital inflows can be absorbed very well, as long as capital markets are sufficiently developed and growth opportunities are abundant.

    Ad 3.) What about Switzerland, Norway, to some extent also the Netherlands? It seems to me, that these countries had or still have huge capital inflows (like Germany in the 1870s) and manage them relatively well.

    I’m eager to hear your views.

    Best wishes,


    • Benjamin,
      Switzerland, Norway and the Netherlands are too small and idiosyncratic to be comparable examples for large economies. More importantly, you have the capital flows reversed. All three countries run large trade surpluses which means that they have capital outflows (provide capital) to the rest of the world.

      Here is a good article that discusses the recent currency appreciation of the Swiss Franc, the Swiss trade surplus and briefly the global trade dynamic. Completely coincidental, it contains the now ubiquitous plug for Dr. Pettis’ The Great Rebalancing. To quote Bill Murray from the movie comedy Stripes (1981) “Oh, I’ve been listening to him for years, and I think he’s fabulous.”

      Lastly, in the 19th century the U.S. expanded it’s land mass and population dramatically while being a forerunner in the industrial revolution. None of these historic characteristics existed in Spain or elsewhere in Europe.

      • Professor,

        Thanks a lot for your reply. On Switzerland, Norway an the Netherlands you are obviously right, I mixed things up. Naturally I meant them to be examples for countries with large capital outflows not experiencing bubbles and rising debt (your question 3). It is true that they are small and idyosincratic, but I wonder nevertheless if there is something to be learnt from their policies. At least they are cases where large trade surpluses did not (yet) end in tears.

        Thanks for the interesting article! I find it also astonishing that almost everybody sang the song of unliateral rebalancing (often with a moralistic undertone) for years, just to now suddenly reverse direction and pretend to always have known it better (and have listened to you). Kudos to you and your real foresight in these matters!

        Lastly, you are certainly right that the U.S. is an exceptional case and in no way comparable to contemporary Spain or Europe. However, my point was rather that there are actually examples (the U.S. being the best one), where big long term capital inflows can have hugely beneficial consequences, for both sides. The U.S. is a historic case, but maybe India now or Africa at some point in the future will also offer similiar opportunities. I’m aware that it is not easy to set up the right environment for such a development, but I find it at least important to bear in mind that there actually were cases when these huge long term capital inflows did more good than harm.

        Best wishes

  86. Prof. Pettis,

    I think there is one flaw in your argument regarding the capital flow from Germany to Spain. You showed the data that from 2005-2009, Spain experienced cumulative capital inflow equivalent of roughly 21-22% of its GDP, while during the same period Germany’s current account surplus soared. But it seems to me this fact alone cannot prove their direct link. For example, Spain’s capital inflow could well be from China (another surplus country), while Germany’s capital could flow to other deficit countries that were not in the euro zone, right? Actually I agree with what you wrote, but I think you might need to add this point to further validate your conclusion.

    • He uses Germany and Spain to signify Surplus and Deficit countries, where these should balance at global level, point is, where policies can generate surpluses, these must flow somewhere, and German surpluses after institution of Euro, likely flowed in the periphery (rising asset prices, investment booms, lower interest rates, even non-euro european countries getting loans in EUR, SWISS, USD, etc…).

    • It’s a good point, but as been discussed before Spain’s trade deficit didn’t explode until the Euro was introduced and Germany took action to suppress consumption/increase exports. So there seems to be cause and effect. Without referencing data, I’m also guessing Germany and Spain are major trading partners.

      You can thank the good all U.S. of A for absorbing most of China’s excess capita/trade surplus.

  87. Has anyone seen this interview with Yanis Varoufakis?

    My thoughts are that he’s a brilliant guy who certainly grasps many of the major issues that’re involved. That being said, I don’t think he’s looking at the impact of war on his model of development. He also says that it’s capitalists who create the state. I don’t know about that. Historically, the guys with the guns often times beat the guys with the gold. If you have a productive capacity with little or no military, other guys will come in to ransack and take what you have. In this kind of environment, it’s better to keep your people poor and your public treasury rich without debt. Of course, in the post-industrial world, you can use the savings of the middle class to fund wars, but you still need some sort of domestic military. The military aspects of development were critical to the development of financial/economic institutions. Varoufakis completely exempts these factors from his models and views (like virtually all of the left).

    In some of his solutions for Europe, he advocates various funds for investment/infrastructure and green energy. State projects to develop green energy often have negative ramifications and, when combined with geopolitical risks, can cause negative side effects down the line. For example, in Europe they said they’d never use coal. Now, after the problems with Russia and the inability of many of these countries to have developed certain energy sources, they’re back to using coal.

    In Germany, they massively increased solar capacity over the past 15-20 years, but they’re not getting that much more solar power than they were before. Actually, Germany still uses more energy from biomass, and although biomass is renewable, biomass burns much less clean than using natural gas (the combustion of biomass is akin to burning wood).

    Varoufakis is a very intelligent man that I, having read some of his work and watching his interviews, I have a lot of respect for. He clearly grasps many of the underlying problems that, in my opinion, none of the other guys in charge have actually grasped anywhere close to the degree that he has. With all that being said, it seems like some of his solutions involve throwing more money at the problem without considering some other factors (primarily the fact that guns matter, a lot). Right now, it seems like Greece (along with Turkey and other states) is closer to a pivot with Russia than Germany. This has implications for the policies he’s outlining.

    From a geopolitical perspective, Greece should have closer ties to North Africa and Turkey than to Germany. At some point, this will matter and I don’t think the kind of structure that Varoufakis is trying to keep together is necessarily the best from a more longer term perspective.

    • Suvy

      War and Institutions….not sure who you are reading to get this perspective but is not terribly true
      Neither now, or historically, even during Imperialism, I think you might be confounding issues.
      Cold War Not an economic conflict, a political ideological conflict; democracy vs totalitarian socialism
      totalitarian socialism, economics subservient to political, democratic, some might argue political subservient to economics, others not, but major issue wasn’t economics, merely ideological battles fought in terms of these insofar as of ethics and morals of larger philosophical battles.

      Europe and Coal, they haven’t been building new coal power plants, in great new numbers, there would be more renewable and gas powered plants coming on line, be careful not to confuse rhetoric and criticism with reality. Reality is they have been using coal. But, gas increasing with time, and solar hoped for, with gas and slar likley taking account of most new generation, and that which replaces nuclear.

      • Not terribly true? Look at the reason central banking and government debt were created. Currency issuance was monopolized for purposes of war; not to help increase productive economic activity. Central banks were explicitly constructed to fund was and imperial expansions.

        Even Machiavelli talks about it. It’s better to keep your treasury rich and your people poor than the opposite.

        It’s the same as in real life. If I can beat the shit out of you and you don’t have weaponry, you become my bitch in a world with no rule of law and no concept of civilization. If you provide weaponry and capital to someone, you make them your bitch. This is the way the world operates. It always has and always will (for obvious reasons).

        • It is abrasive, ill mannered, ill tempered and counter-productive to express as you do where the commonness of your expression adds no gravity as truth, but only makes the bits that might be useful for integration into ones belief structures unappealing for presentation and positioning. Otherwise I tend you to confuse many things, let us assume that central banks were and are; steam engines were created to power pumps to drain coal mines, went on to power trains and produce energy (I know a veterinarian in NY who still powers his house by steam power, although is dangerous like a bomb).

          • Really? How else do you want me say something that should be blatantly obvious? Having economic systems that’re productive is insufficient; you need security, which is why governments are instituted.

            Also, I like to hear things like that. It makes it easier for me to understand. I don’t see how you’re saying it makes it more difficult for someone to see the truth. It makes it easier for me. Why? Because it is the truth. We (at least me) live in societies with a rule of law and a concept of civilization. In a world where this isn’t the case, we must understand its consequences. We need to understand survival constraints as well.

      • BTW, I’m not so sure on what you’re saying with renewables. Just look at European emissions recently. Many of the countries in Central/Eastern Europe have been turning on their coal plants, including Finland and Sweden. As of 2013, Germany boosted coal use by 13%. The UK did so by 22%. I’d also suggest you look up Germany’s total solar capacity vs the amount they actually get from solar. They get something like 4% of their total capacity every year.

        Gas has been increasing with time, but not everyone has connections with gas producers. Countries like Spain and France are in fine shape as is Italy. Once you start talking about Germany, Central, and Eastern Europe? What you’re saying is no longer the case.

        It’s funny because one of the leading innovators in renewable/clean energy in the US is actually Texas, as ironic as that may be. If Texas was a country, it’d rank 6th in wind energy production. It’s one of the leaders in solar installation, production, and investment. Actually, a lot of European countries are even investing in Texas energy production.

        • Yes, RE is low everywhere, coal back online, increased with movement away from growth in reliance on Russia, while still having reliance and pipeline Russia Germany, traditional supply lines to EE. Yes, Yes, Yes….but to talk of coal as if new capacity is being built is not likely true on a large scale, or comparably to new capacity being installed. Turned on, yes, built no, and percentages 13% growth, could turn into a 3% rise. Woodrow Wilson has a couple of recent vid’s on Energy issues just released.

          RE…issue is battery storage, which is growing more capable and cheaper daily, your kids, should you have them, will be far more opportunity to use RE; but even we will see it.

  88. Dear Prof Pettis,

    I had left this blog awhile back as your predictions on the evolvement of the Chinese economy had gone from being ridiculed in 2009 (I remember being overbearingly brushed aside at a seminar by a retried Danish civil servant from the Foreign Ministry, when I ask how the Chinese economy possibly could transition to a consumer based economy, when the consumer was forced by the economical system in place to accept a lower return on his savings and a lower wage) to being the main stream perception in 2013/2014.

    Now I spend most of my reading time on Murry N. Rothbard. He put most of your arguments into perspective even though his views on government intervention seem a little radical. He is even more radical with regards to the notion of fractional reserve banking, which he see as monopolized counterfeiting. According to Rothbard the financial sector likes fractional reserve banking, because it is the first in line to benefit. The rippling effect of fractional reserve banking tends to benefit those closes to the center the most. That why holding too many USD bonds and not being the US government is a bad idea in the long run.

    The myth of Germans being industrious and hard working was a very strong part of my childhood, and I still have to keep me self from making the Protestant fallacy of thinking of Catholics countries in that way. This was the discourse in which we were raised.

    Right now in Denmark my family can borrow a USD 150.000 and get paid USD 1500 a year for doing it ! If this will not inflate the asset and real estate market I am not sure what will. So in maybe 5 years you will have an answer to your question if a Northern European country can be “irresponsible” too. Still the Danish political establishment seems to understand the problem, and there are better ways of redistributing wealth in Denmark. This being said I am sure bad investments will be made all the same.

    Back to your article on Germany and Spain. As the European governments nationalized the debt of most banks they turned private debt into national debt, and thus making what essentially was a private issue between a bank and an individual into a problem between nations. When reading your article I kept thinking that many of these issues should have been handle by a judicial system and not politicians.

    This nationalization made the financial crisis of 2007/2008 into a political issue. If the banks had crashed as they should have been allowed too, then their assets would have been written down or liquidated. It would have been painful for some, but I firmly believe that the judicial system of Europe (South and North) would have provided a fair solution to the individual problem between the bank and the borrow. Instead the fractional reserve banking system created a situation where banks where kept artificially alive and borrowers artificially dead.

    One could argue that nationalizing debt in Europe meant nationalizing the issue of repayment. It is a correct assessment therefore, when Mr Schäuble says that Germany cannot or should not be blackmailed into debt relief by Spain, but it is because his and almost everyone else´s own fractional reserve banking system aka National Banks choose to nationalize and politicize what was basically an economical twist between an lender and a borrower.

    I agree with the fact that political reforms in Germany along with politics in China, Japan and other high export / low consumption orientated economies helped create an unbalanced economical problem, but it was the notion to save banks by the fractional reserve banking system, that made it a problem between nations.

    The war reparation between the Prussian nations and France in 1871 was per definition a political issue between two nations. The debt crisis of Southern Europe was not and should not have been allowed to turn into one.

    • You are picking up on a crucial aspect of Michael Pettis article: why is it apparently impossible for national authorities, even if they wanted to, to effectively prevent credit to grow much faster than production and income, thereby destabilising their economy?

      The elasticity of the fractional reserve banking system is to a large extent responsible for this situation.

      Historically, bankers were simply safekeeping deposits (keeping them 100% in reserve) and effecting payment transactions on behalf of clients. Over time, bankers observed that, thanks to compensation between withdrawals and new deposits, their reserves were never going below a certain minimum level. Soon, they realized that if they could lend part or all of the reserves “in excess”, they could earn interest and boost profit. If you deposit 100 on your current account at your bank, you consider it immediately and entirely available to you. But in fact, only 10 is available in reserve at the bank and 90 has been lent to someone else who has used it for another transaction and will repay it later, and same for the 90 deposit thus created by the loan, and so on so forth. There is duplication of purchasing power. The power to spend (in investment or consumption) exceeds available income. So, bankers started to operate in this way. The credit multiplier was born, making it possible for credit flows to exceed the flow of available savings in any period. Bankers didn’t inform depositors that, from now on, they would do that, they just did it. It is only over time that the system has acquired a kind of legitimacy that comes from a long established practice but which was never explicitly granted and accepted by clients. Then, later on, the banks realized they didn’t even need a deposit in the first place. They could simply credit your account with 100 by simply making you sign a loan contract for that amount. The banks could freely create money out of nothing but accounting entries. There is creation of purchasing power out of nothing. Which you might indeed call legalized counterfeiting for that’s exactly what it is. Credit either goes to real goods and services where it feeds inflation, and / or to asset markets (real estate, bonds, equities etc) where it feeds asset price inflation. In both cases, income and wealth distribution is distorted.

      Great fortunes have been built on this power to create money out of nothing and to collect interest on it.

      To be fair, some spectacular bankruptcies have also occurred as the banks have been made structurally unable to meet unexpected withdrawals. Indeed, the multiplier works both ways and can become a divisor. If some % of borrowers default and / or some % of depositors withdraw, banks are forced to raise liquidity by calling in loans, precipitating the collapse of the all edifice (for instance, the banking panic of 1931-1933 in the US). In such a system, where banks are fundamentally illiquid hence insolvent (in the sense that they are by definition unable to honor the commitment they give to all sight depositors for on-demand availability), bank loans are not a private issue between a bank and its borrower and depositor clients. Bank loans are systemic because they are deposits. Bank loans are a public issue because the structurally insolvent banking system is simply not viable without the backup of the State, ie. the taxpayer. The taxpayer has no choice but to save the banks in order to save its deposits. In such a system, banks have a double incentive to get bigger: to benefit from the law of large numbers in compensation to maximise their multiplier potential hence their upside and to get too big to fail to protect their downside. And so banks have become big, and then bigger. Head, the banks win ; tail, the taxpayer lose.

      Under such a system, monetary authorities are unable to control more than a tiny portion of the money supply, which is base money or bank reserves. The vast majority of the money supply, monetary authorities can only hope to indirectly influence via the setting of short term interest rates but they can not control it. It is the banks who control the vast majority of the money supply and their profit incentive is to expand it as much as they can during good times. And to withdraw it as fast as they can to protect themselves from illiquidity and insolvency during bad times. Here is the engine behind the boom – bust patterns that we are all very familiar with. In fact, the fractional reserve banking system makes it impossible to deleverage on an absolute basis as paying down credit means destroying deposits, ie. weakening purchasing power, hence demand.

      It is inevitable under such a system that, when offered with liquidity (either deposits or via the interbank money market) that they could profitably on-lend, Spanish banks unleashed a dramatic credit boom. To prevent this would have required a serious increase in Spanish short term interest rates, which was clearly not possible under the Euro but which would have been relatively unlikely also if Spain had kept an autonomous monetary policy as policymakers are very reluctant to hurt the economy for the uncertain purpose of curbing financial exuberance.

      We are all very familiar with the boom – bust patterns related to the way the banking system works but what we don’t realise is that they are largely unnecessary and avoidable.

      Up to 1914, under the Gold Standard, there was a practical argument in favor of the fractional reserve banking system: it was minimizing the need for actual and cumbersome metallic species. Now that this argument is gone under a purely fiat money system, there is in fact no need and no reason whatsoever to keep the fractional reserve banking system as it is.

      Reforming the design of the banking system will have two major advantages:

      First, it would make the distribution of income and wealth much more equitable and much less unduly distorted. The fractional reserve banking system is the “privatized profit / socialized loss” virus weakening from within the wealth creation engine of the market economy. In good times, the benefit of money creation accrue to the bankers and asset owners, like a modern day seignorage. In bad times, the structurally unstable design of the system makes a taxpayer funded bailout a necessity. Goods and / or asset price inflation benefits disproportionately the few while crisis and deflation cost disproportionately the many. Or, as Michael Pettis says “if you separate those who benefitted the most from European policies before the crisis from those who befitted the least, and are now expected to pay the bulk of the adjustments costs, …, it might be more accurate to posit a conflict between the business and financial elite on one side (along with EU officials) and workers and middle class savers on the other”. Obviously, this is not purely a European phenomena. As Michael Pettis has shown in “Economic consequences of income inequality”, an undistorted distribution of income and wealth (which is not the same as an egalitarian distribution) is in itself a necessary condition for the efficient functioning of the market economy. The undue distortions related to the private benefits / public costs of the current organisation of the credit system lead to an inefficient allocation of resources and need to be removed in the name of the efficiency of the market economy.

      Second, it would to a large extent dampen the devastating cycle of euphoric booms and depressive busts which results in capital misallocation and destruction as well as in long term demoralising social effects by making monetary swings much less violently pro-cyclical.

      Many economists have defended another organisation of the money system called “100% Money” or “Narrow Banking” (the Chicago School in 1933, Fisher in 1935, Rothbard, Hayek, Friedman, Allais, Minsky, Tobin and others) consisting of separating money creation under the sole responsibility of a public institution like the central bank and the distribution of credit from genuine term savings. In practise, the banks will be legally separated in two distinct types of banks: the deposit and payment banks receiving sight deposits covered 100% by reserves and effecting current payment transactions for clients ; the credit banks making loans financed by term deposits of similar duration.

      The proposal by the Chicago school and Irving Fisher in the 1930’s were formulated in the wake of the Great Depression to fundamentally improve the design of the banking system and make it much less vulnerable to deleveraging episodes. It was ignored. The 2008-2009 crisis shows that this exact same problem still remain unresolved today.

      Like Keynes’s Bancor, Fisher’s 100% money idea is well worth revisiting today. In fact, the two ideas in combination are probably the only chance to gently deflate the global debt balloon we now face in a non depressive way by gradually reducing the accumulated current account imbalances and taking the multiplier out of the banking system. The two proposals combined will fundamentally strengthen the world economy and its financial architecture, improve real growth and greatly mitigate the amplitude of cyclical fluctuations. It will reconcile finance and production.

      You wonder why, then, we never hear about it and it was not even contemplated once in the last 6 years as a plausible solution to the illusive economic growth and financial stability? Simple: the oligarchy who benefits from the exorbitant privilege of the current system and owns policymakers doesn’t like it at all. They much prefer the current system, no matter the costs. Financial repression is not simply an expression, it is to be taken literally. May be the ones being irresponsible are not those who are presented as such.

      • Why would you want governments in charge of the total money supply?

        I think the advantage of fractional-reserve is optionality. It allows more opportunities to be tried, which necessarily means more failure.

        Isn’t it just a better idea to decentralize currency issuance instead of centralizing all monetary control to a few people sitting in a room? The downsides from the latter are obviously much higher, allow a few people to centralize power even further, and encourages the incentives for a few to buy out the guys in power.

        We can’t design financial systems that won’t have errors if we want them to properly allocate capital to risky ventures. You need trials in order to have successes. The more trials, the more likely chance of a hit. Also remember that the advantage of a hit for a society is winner-take-all. So the less likely the shot, the much higher (in proportion to the likelihood of success) the payoff.

        It’s not about successes vs failures, particularly in finance. It’s about the GAIN on the successes and the cost of the failures. If you decentralize currency issuance, you keep the optionality on the upside and place an absorbing barrier on the left tail by localizing the impact possible.

        We must remember that centralization in finance usually stems from war finance (it’s the only real advantage IMO).

        • “Why would you want Governments in charge of the total money supply?”

          Governments will not be in charge of the total money supply. Like today, they will simply be in charge of base money backing sight deposits, with the difference being that base money will be bigger than today as coverage goes from fractional to 100%.

          The rest of the money supply, ie. the flow of credit to the economy in any given period, will remain determined by the supply from savers and the demand from borrowers. The only difference is that banks would become simple intermediaries of this flow of credit and will no longer be able to create credit ex-nihilo.

          In reality, this is largely a semantic issue as fractional reserve banking requires Government (ie. taxpayer) support anyway. It would just be made explicit and transparent rather than implicit and opaque, which would be a welcome clarification in my view.

          As to why, the answer is simple: global debt is now ~ 300% of world GDP, up from ~ 100% forty years ago. It is already implausible that the current level of debt can be serviced out of the future cashflows generated by productive activity. Meaning, we can’t let debt to continue growing faster than debt-servicing capacity. Yet, that is still what is happening since 2009 according to the Geneva Reports on the World Economy n. 16 and the recent McKinsey Global Institute report. Deleveraging is quasi impossible in the current system. It is so to speak designed to generate debt faster than income, which is precisely what it is doing with remarkable consistency for nearly 40 years.

          “Fractional reserve allows more opportunity to be tried, which necessarily means more failures”

          Yes, it has been the big argument in its favor all along and it has effectively happened and we now have the answer. If, out of more opportunities being financed, the gain generated by the successes vs. the cost of the failures had been an adequate ratio, income would have grown in line with debt. It has not been the case, income has lagged behind debt. Which bring us back to the previous point.

          “Decentralize currency issuance”

          What do you mean by that? Under fractional reserve banking, currency issuance is already decentralized to each bank. With the observed results that they all behave as one, all expanding together during good times and retrenching together during bad times in a highly pro-cyclical manner.

          “We can’t design financial systems that won’t have errors if we want them to properly allocate to risky ventures”.

          Fully agree. A 100% money system won’t make credit risk disappear as if by magic, it will still be a fact of economic life. The only difference will be that each default will have a 1 for 1 impact on the bank concerned instead of a 10+ to 1 impact in the current system, so the overall strength of the banking system will be greatly enhanced. And it won’t change anything as far as equity financing is concerned. Each saver will still be as free as today to decide where to invest his / her savings, so the capital allocation will remain decentralized in that sense. If anything, the choices facing each saver will be much better informed as the distinction between available liquidity (available sight deposits) and unavailable term savings financing multi-year investment projects will be a lot clearer, while it is today completely blurred within the opaque asset and liability management of the banks in a way not comprehensible to citizens and not even to most professional investment managers.

          • Why not just build systems that’re based on equity financing where people can buy and sell capital goods on open markets?

            “Under fractional reserve banking, currency issuance is already decentralized to each bank.”

            In the current one, the only entity that can issue currency (reserves) is the Federal Reserve. Notice I didn’t say money, I said currency. One of the reasons the pro-cyclicality occurs is because instead of each city/region/state having its own currency to adjust to trade flows, you have all of these places unnaturally unified under one currency structure. It doesn’t allow feedback for individual cities/states/regions to adjust their supply/demand imbalances at smaller scales. Remember that all of the financial imbalances are just real production/consumption imbalances between countries.

            The reason you have debt growing so quickly isn’t fractional reserve; it’s central governments being allowed to drive the imbalances via economic centralization. They get caught into these feedback loops whereby those in power have to continue the policies that’re destructive to maintain power and this keeps going on until the system crashes. Of course, that’s what politics is largely about.

            Relying on people in power to make smart decisions with the best interests of the country in mind at all times while requiring the highest level of prudence simply isn’t robust. We need to expect the people in charge to keep driving the imbalances, which means we need to focus on limiting the imbalances they can drive. We need to limit centralized power and decentralize everything. This is not an economic issue we’re talking about; it’s a political, geopolitical, economic/financial, and social issue.

            Another note, sometimes making things transparent and explicit isn’t always the brightest idea. There are some things that should be opaque and there are others that must always be hidden and kept in secret.

          • Suvy,

            I understand your reservations about Government policies driving imbalances in the first place (amplified by the effects of fractional reserve banking in a second step) and why it might sound unrealistic to expect people that seem to be part of the problem to come up with a solution. In this respect, i think politics is not different than sciences in that the evolution of dominant ideas and accepted wisdom follows the passage of the people in charge. Ideas change over time as generations of leading policymakers and scientists are renewed.

            The rest of your argument sounds very vague to me: how do you propose to “decentralize everything”? That sounds even more utopic than evolving towards a 100% reserve banking system.

            What exactly do you think is gained (and by whom?) by keeping the banking system opaque?

          • There is an anarcho-libertarian strain running through your writing where what seems to sound as if better, which might even find itself beautifully able to be expressed in mathematics are very able to be applied more broadly into the broader society, pretending the beauty of the math would, can and is preferable to obtain, rather to reign more broadly.

            You realize, that while taxing and spending, fiscal policy, stability, revenues and spending are the hallmark of an advanced economy. Obviously it might not want to be too high of a percentage as in Europe, where too hhg of a percentage, continuously, limits options and flexibility in downturns to ramp, ramp up, as a stimulus, and for expectational purposes, but that too low of a percetnage also has the same real, continous impact, and expectational, spirit mollifying impact. Neither too high nor too low, and only in the middle, between extremes to we find a useful tool. It is a hallmark of an advanced economy to have a fairly steady flow to revenues, if this is what you are speaking of need for decentralization. I am into decentralization of hierarchies, as much as the next guy, but these things in moderation and we shouldn’t undermine the foundations of more advanced societies merely to pander to recent intellectual fashions, nor longer term ideologies otherwise.

          • Csteven,

            I disagree on the “middle way” again. The federal government shouldn’t intervene in most cases, but when they do intervene, it should be when things get really bad. I’d use a 90/10 rule. 90% of the time, we do nothing while the other 10%, we take very strong action. Again, it’s more robust to be on the extremes than in the middle when it comes to decision making.

            When you talk about Europe, you’re talking about a place that has taken the “middle way”. They intervene in everything to the point where they gain little every time they do intervene while not being able to take strong action when they really need to. Instead, it’s better to just focus on the extreme scenarios and let everything else take care of itself.


            Why is it absurd for those who were part of the problem to come up with a solution? Maybe cuz they’re already invested on one side.

            How do we decentralize everything? We don’t have to do anything. Central governments, over the past few decades, have repeatedly shown themselves incapable of ruling well. They will blow themselves up. The question is when, how, and at what cost.

      • Dear DVD,
        Thank you for your ideas and reply. I think historically banks were storages of gold, silver and goods of high transaction value. The idea of interest was not too welcome in the Christian world until the Catholic Church was weaken during the Reformation. The introduction of more nationalized and centralized banking detached from trade in goods probably came together with the large navies that arose in the late 17th and early 18th century. The English parliament did not allow for more formalized and stable taxation until after the fall of Cromwell, when the Royal navy needed permanent maintains.
        The only psychical entities used in transaction, which people would trust were gold and silver. They live up to a good amount of basic requirements 1) Easily recognized (taste, feel, simple chemical texts) 2) Universally recognized (we all know Gold and Silver) 3) Divisible (It can be cut in pieces) 4) Transportable and durable (easy to move around and is a hard metal). 5) Limited in amount and has a functional use as jewelry (You cannot just create more gold out of thin air and there is a real demand for it). I think that this list is the basic arguments behind the hard constraint theory. All things being equal gold and silver were a clear and distinct form to use as a substitute for goods.
        Now the USD or RMB etc (fiat / value by decree) are equally as good as gold in the first 4 requirements, but fails to fulfill the 5) requirement as it holds no value in itself and can be created without constraint. The other problem with fiat in a fractional reserve banking system is that it ripples and automatically flows to fixed assets or capital-intensive investments, because banks can allocate the largest amount of fiat wealth into such entities.
        I think Prof Pettis´ argument regarding the balance of payment is a way of saying that, if a fractional reserve banking system exists in an economical structure with consumption restraints and suppressed wages you will get high fiat savings. These fiat savings can and often will be invested into capital-intensive export-orientated manufacturing complexes, fixed assets and exported outside of the economy to economies less “unbalanced” if you will. The excess liquidity in form of goods or exported fiat savings will force the receiving countries or economies to have a high consumption, high wages and asset inflation. At some point, the receiving economies will have reached a level where demand for fiat in form of goods and liquidity is fulfill and the bubble will burst.
        Now to blame a people, a religion or a culture for this is non-sense. It is kind of like blaming your children for being fat after only feeding them McDonalds for 10 years. The problem is that no one in Germany or the EU understands this. They still live in world were debt is perceived as simple IOUs between individuals that must be honored, when in fact it is debt endured between economical systems because of structural imbalances.
        I believe the only way to control a fractional-reserve system is through retribution. That means for every time the banking system creates new fiat they should be tax going to the lowest income groups in society. That means for every Federal Reserve note there should be a ripple tax collected and redistribution should be done to the lowest income groups.

    • Not just you, Anders. It is funny how the 99% of economists who disagreed with Pettis every step of the way on China have no problem telling you today that they easily saw it coming. I despise economists.

  89. Dear Professor Pettis,

    I am a big fan of your work. Inspired by your books, I have come up with a suggestion to counteract the curse of reserve currency status, which I discuss in a blog post:
    I would be really honoured if you would read it.

    Kind Regards,


    • Interesting idea, Ari, but I am not sure it would make much difference. The UK would still run a deficit equal to the net inflow. According to your plan, London would effectively monetize a portion of its debt equal to the amount of the net inflow, but this just means that there will be a transfer of wealth from those who are long monetary assets to the UK government, so it just becomes a kind of hidden tax. In the end the UK, except in the unlikely case that productive British investments could not be financed because of insufficient access to capital, would still be forced to choose between the debt and unemployment.

      In the end there has to be a more fundamental, and global, change in the rules governing the balance of payments.

      • Thank you for looking at it and giving your opinion, which I value very highly.

        I have a couple of questions about your reply:

        1) I understand that it is a tax because it reduces the value of the GBP (and most GBP assets) held by people of the country by diluting the money supply. But doesn’t this exactly cancel out the subsidy provided by the foreign buyers of GBP who are reducing the domestic money supply and pushing up the exchange rate? Then tax and subsidy are exactly equal and opposite, I would think.

        And if the subsidy was a false subsidy then removing that subsidy should help to reduce the deficit for the next year.

        2) Even if it were a tax, it still reduces the overall debt level within the UK. This must be true as it is a tax on savers (and foreign holders of GBP assets) to pay off debt.

        I do see that there is a transfer of debt from UK creditors to foreign creditors but how significant is this?

        I have worked an example.
        Current: Economy of country A has 10m of demand but spends 9m internally. Country B net saves 1m from the current account surplus. Country A has to borrow 1m to fund the deficit, effectively from Country B. Govt A borrows 1m. Exchange rate higher as 1m taken out of domestic money supply.

        Result: Increase in debt of 1m. Exchange rate higher so deficit next year could be larger.

        My way: Economy of country A has 10m of demand but spends 9m internally. Country B net saves 1m from the current account surplus. Country A has to borrow 1m to fund the deficit, effectively from Country B. Govt A borrows 1m. But Central Bank A writes off 1m of Govt borrowing. Exchange rate the same as before.

        Result: Reduction of domestic debt by 1m, increase of foreign debt by 1m. No change in exchange rate.

        Eventually the UK will need to pay back the foreign debt and clearly this is a problem but at least this policy would keep the exchange rate from going up and therefore hopefully reduce future deficits. I accept that it would not neutralise the impact of foreign money, but the alternative is simply an increase in total debt which strikes me as much worse.

  90. Very interesting analysis – effectively the Euro distorted savings and borrowing decisions across the union by increasing savings rates in “the north” and reducing real interest rates in “the south” – the savings surplus in the north was then recycled via lending in the south leading to an asset price boom (and sucking in manufactured goods from the north). This issue is thus expressed in the exposure to largely private debt (and inflated asset prices underlying them). The consequent debt burden is unsustainable (the south cannot grow its way out of the problem) so the issue is simply the timing of when the south either defaults (declares bankruptcy or whatever) which crystalizes the transfer or the north explicitly recognizes the reality and takes a “haircut”. The rest is just optics and politics. However, I don’t see in this analysis how the Euro can survive in its current form – so long as there are major differences in the labour markets you cannot manage a common currency without fiscal transfers; a German Euro can’t be worth more than a Spanish or Greek one so the surplus has to be recycled somehow!

  91. DvD: “The banks could freely create money out of nothing but accounting entries. There is creation of purchasing power out of nothing. ” Ford creates cars, banks create money; agreed. But if the sentence I quote is true, why are banks not “creating purchasing power” in every small town in America and Europe?

    “The 2008-2009 crisis shows that this exact same problem still remain unresolved today.” No. The recent crisis occurred in the unregulated SHADOW banking system. No one lost a penny in the “normal” banking system.

    • This isn’t the case. Actually, some of the countries worst affected had losses in their normal banking systems. When you create assets (loans) and those assets don’t increase productivity enough to offset the real debt servicing cost, there is a loss taken. It doesn’t matter if that loss occurs in your shadow banking system or your regular banking system. Shadow banking is, in many ways, better because you’re dealing with capital assets rather than formal loans.

      In Europe, they have the kind of system you’re talking about. The total size of their formal banking system is 3-4 times GDP because of regulatory restrictions on banking. However, their losses are actually much, much larger than ours as a portion of national income. Actually, we exported many of our losses to Europe because their banks (ex. IKB) bought our shittiest assets.

      There are several Europeans that’ve complained about it on this blog. My response is: hey numskulls, why’d ya buy them?

      This isn’t the first time in history American financiers have sold junk securities to European banks and I highly doubt it’ll be the last. It’s actually great for the US.

      • A more interesting investigation is how and why those junk securities came into being. That is the structural relations underpinning the forces that led to the creation of those assets, and similarly those that enabled, encouraged, even required, entities to purchase them. I suspect you might not find “actually, it is great for the US”, upon a more complete review of those matters.

        • Those junk securities came about as a leveraging boom starting in the 1980’s. The problem WAS NOT deregulation. The real problem was that the current monetary system became unstable which was exacerbated with poor incentive structures (ex. the government telling banks to dish out bad loans to poor people in the name of “equality”). However, it’s a great thing when our shittiest assets were transferred to foreign banks instead of being held within our banking system.

    • Dan,

      1) Quite simply because the economics of small towns in America and Europe don’t make them interesting at all for banks. Piecemeal amounts of many low income customers, hence high cost, high risk, low profit opportunity. Much better bang for the bucks to lend 1 billion $ or € in one go to, say, a private equity fund to finance a leveraged buy-out. I said that banks were creating purchasing power out of nothing but accounting entries. I didn’t say they were doing it specifically or to a disproportionate extent in every small town and village of the US and Europe. Not sure what’s your point here? You see a business opportunity? You’re thinking setting up the Dan Berg Rural Bank of America? In that case, you don’t mind me asking to see your guarantee before making a small deposit?

      2) “No one lost a penny in the normal banking system”. I assume you mean not a single depositor / senior creditor? Yes, because the banks that would have failed without intervention have been bailed out at taxpayer expense (TARP, Fannie, Freddie, etc = socialized losses) or bought out by big banks who have thus become bigger (JPMorgan – Washington Mutual, Wells Fargo – Wachovia, etc = too big to fail), which are precisely the two points i made. As for the “unregulated shadow banking system” of 2008-2009, i’m surprised it is even necessary to remind you that it included myriads of special purpose vehicles and structured investment vehicles sponsored and backstopped by regulated banks. The distinction between regulated banking and shadow banking is purely legal, it has no real economic meaning. Because these entities were not funded by retail deposits but by wholesale markets with a backstop facility from the parent bank just in case, the banks were allowed to move them off-balance sheet and to run them with much less capital (this is explicitly called “regulatory arbitrage”). But the bank, hence depositors, are still ultimately on the hook because the bank is the lender of last resort to these entities. For all practical purposes, shadow banking is an extension and an intrinsic part of the banking system. In fact, taxpayer funded bailouts were not even limited to the regulated banking sector but also had to be extended to the regulated insurance sector with AIG having sold credit puts to the entire financial system. So, no creditor lost money, and certainly not AIG counterparties, which to my knowledge were not covered by any guarantee but which for some of them had representatives in the Government deciding bailout terms. Private profits vs. socialized losses: the core of the system i described – usually hidden and insidious – was clearly visible during that time.

      If your purpose is to argue the case for the current banking system, you are most welcome and it could make for an interesting discussion. But you have to come up with slightly sharper arguments. For now, i really can’t see any bank hiring you as their lobbyist.

      • What was the difference between the response in the most recent crisis vs historical American crises (excluding 1929)? It seems like this is just ingrained into US nature. The Americans issue loans to their populace, who often times can’t afford them. Then, they package these loans into securities and sell them to whoever. You’ve created a shiftable capital asset.

        It’s very different from a normal loan because these assets can be bought by anyone. Traditional banks can’t do that and can’t function in that environment. It actually makes it easier to raise capital for different projects. In the 1870’s, this same type of behavior led to an infrastructure boom that ended in a very similar manner.

        • Makes it easier to raise capital or is a symptom of the glut ov savings, and the rise of capital, the general great and grave liquidity we find in the current era and deregulation with wide open capital accounts for some and not for others, creating sluices in which capital is forced, increases in velocity and runs rapidly, chasing yield as it is forced out of traditional positions of recognized safety to the global printing and manufacture of assets, chasing yield and pushing people further afield into positions of much greater risk. A risk mitigation tool used by some, exporting the risk onto others, as others are fine with it, for the potential to win for a few years as the bulk of traders that Taleb describes..

  92. The German lending that was directly to Spanish consumers should not have affected the Spanish Governments overall debt burden. In fact, those citizens with debt that is too large could (and should) choose bankruptcy over the continued repayment of bad loans.

    How did the Spanish Government, the entity that owes the vast sums of money, incur it’s current debt burden? The same question applies to Greece. What did those countries spend the influx of capital on? How does the Spanish Government’s debt burden relate to to capital inflow that Germany saw in 1871-1873?

    • It’s pretty obvious in the case of Spain. The Spanish government was in a stronger and more prudent fiscal and debt position than most of Europe, including Germany, but the asset bubble ignited by huge inflows and collapsing interest rates combined with the huge hole in the banks’ balance sheets caused their debt to explode. Under that tsunami of money even prudent governments were swept away.

  93. Dr. M. Pettis,

    Firstly thank you for this fascinating and balanced article.

    I have a question from a non-economist for you (and others): what is to prevent the EUR continuing to act as a unit of exchange if Greece “leaves” the EUR? I lived in Russia in the late 90s (including ’98) and live several months a year in Greece. Nobody from executive to cleaning lady dreamt of accepting anything but dollars and later Euros as payment. The shops were legally obliged to execute transactions in RUR but the prices were displayed for individual products in “conventional units” – a euphemism for USD and/or EUR and the shops would change their exchange rate from “conventional units” to RUR daily and sometimes several times a day (naturally taking a healthy margin on the exchange rate). One would convert money at the ubiquitous private exchange kiosks on a daily basis if necessary. Eventually as conditions after ’98 improved confidence in the RUR it stabilised (this has been reversed by recent events) and we all became almost indifferent to using RUR or “hard” currency.

    I believe that Montenegro uses the EUR despite not being a member of the Eurozone. Could not Greece do the same? (Naturally I understand that the structure of the Russian (or Montenegrin) economy is radically different).

    Any explanation would be welcome

    Many thanks


    • Hi JB,

      Nothing is stopping the future use of the EUR in Greece after they leave the Euro zone. I think a bank run is already under way in Greece right about now. No one wants to have their EUR savings frozen and exchanged into Drachma. Still public to private monetary transactions and anything official will be done in Drachma. There will properly be a large black market for EUR goods if they leave the EURO. A domestic market with local goods traded in Drachma will of course arise.

      Greece leave the EURO zone will most likely mean a rise in employment domestically and strong export numbers over time. Greece will still be in the EU free trade zone but with price levels below anything you see in the rest of the EU free trade zone. I guess Greece could peg the Drachma to the EUR but that would make little sense as the currency would not be worth much in the beginning.

      • Thank you for your reply Anders. Rgds Julian

        • The problem is pensions and people who have savings, because the nominal purchase power of the Drachma will be weaker than the EUR outside of Greece. You are trading in a trusted currency for a currency unknown.

          A really worrying thing about Greece leaving the Euro is that it might hurt retired old people as they will take a hit on their pensions, medical cost (medicine is almost always imported) and savings deposited in the bank.

          What I don´t know it what will happen to the Greek EUR debt. In principal they could demand that all debt obtained during the period they were in the EURO will be repaid in Drachma. If not then there will be little reason to leave the EURO as they would have a massive debt in a foreign currency.

          If they leave the EURO it should become clear to everyone that they can never repay the debts. Maybe it will then become clear for German banks and the EU nomenclatural system in Brussels that they need to negotiate a restructuring of debt.

          • Medicine, imported. Is this the case? Rare is it that countries to not domestically produce dairy, tobacco, soft drinks, and the bulk of their medicine (including all that is either legislatively un-patentable or out of patent otherwise, and even if so, the single pay negotiate lower prices but for in the US, where the sick, HMO’s and the government subsidize Swiss, French and German pharmaceuticals in the name of choice and the market. This is what is hilarious about people from the EU being surprised about TV commercials their companies run to get Americans to ask their doctors to buy their medicines)

          • I am looking forward to returning to the small Greek island where I live April-Oct this April. “Looking forward to” is the wrong turn of phrase – I am very concerned about about how my Greek friends will be faring and their bank deposits – in line with your comments. For now I am having an “interesting” time trying to get some funds out of Greece myself.

            Still with only 2,500 people and one cash point machine it is an interesting and easy microcosm to observe.

            I very much fear the backlash when Greeks have actually read the text to emerge last night and the fact that Tsipras essentially lied to the populace in his speech today. Greece is probably the most politicised nation that I know.

        • If Greece pegged to the Euro, or used the Euro, they would still be subject to the policies of the ECB, without ability to influence.

          • I believe it is the case – based on my living half of the year each year on a (very) small Greek island. The cost of medicines is astronomical. Also of some items – 7 EUR for a deoderant in Sparta (usually a cheap place) some years ago sticks in my mind

  94. I read this blog and understood about 3% of it and trust me, I’m not good with percentages, I am not exactly excited about being one of those inside the can that is getting kicked around in this financial mess. What the hell does one do to save one’s pittance from predators such as the EU elite who have made such a cock up of Europe and bankers who have proven themselves to have even less intelligence than my 3%.

    I have a little house, a little car and a little savings for old age and I pay my taxes which seem to get squandered on fine dining, meetings that resolve nothing and endless aid to ungrateful countries. In the meantime, I can’t afford the luxury of keeping a dog. Reading Machiavelli, Taleb or Pettis is very interesting but, as ever, it’s the unknowable future that counts, so I’ll wait for Taleb’s Black Swan and hope that, this time it glides past regular folk to attack those with the dirtiest, greediest hands first. Fat chance, I know but the can is getting very badly dented and has some very sharp and dangerous edges.

    • Part of the problem is pretending that it is merely greed, or that if it weren’t for some luxury dinners, jets, sex parties or whatever. The real issues are far larger, and far less exciting. Imagine that it weren’t the greed and wastefulness of a few elites but rather social democracy itself, or the ethos that would seek to return everything to a fictional state of nature where natural neo-darwinian meritocracy was able to hold, thus the most efficient use of resources at any particular moment in time would enable the best of outcomes.

      This is the real issue. Change, structures that work until other structures are needed do to altering conditions, forces, relations, inter-relations, or essentially until some emergent properties of a system lead us to a new stage, where some, i believe for want of something to wield, choose a position (if we were just to decentralize, match demand deposits to lending, eliminate greed, heave enlightened leaders, enforced equality, heightened liberty) then all would be perfect. All is, has been, and will be messy, forever in the past and into the future, complicated and messy as we for use, hope to make it simple, understandable, and able to be wielded in, and as truth.

  95. I said that banks were creating purchasing power out of nothing but accounting entries.”. . .”you don’t mind me asking to see your guarantee before making a small deposit?” I’m surprised it’s even necessary to point out that the previous two sentences present a problem. My guess is that the MNCs which “deposited” their short term funds in the shadow banking system (I refer ONLY to the US system) were at least as prudent? “Not sure what’s your point here?” My very simple point is: if “banks were creating purchasing power out of nothing” (no collateral?) why aren’t they doing it now – on a huge scale?
    My purpose is not to argue the case for the current banking system, but to point out what appear to be errors by sensible contributors to this blog

    • DvD: Sorry; I’m not being clear; the 6:22 entry also responding to DvD: Banks create a demand deposit account (liability). The borrower draws on that account and spends the cash. The liability is still on the bank’s balance sheet, which must be funded, lets say through an interbank loan. No free lunch.

    • Dan,

      The two sentences you say present a problem are perfectly consistent: it is precisely because banks issue money backed by insufficient available reserve that a deposit guarantee from the State is necessary. That’s the all point of fractional reserve banking. See the last paragraph below in response to your latest comment for a practical illustration.

      As to why commercial banks are not creating money on a huge scale now, please refer to the paragraph starting with “To be fair, some spectacular bankruptcies have also occurred…” and following paragraph in my initial comment on the topic. It explains how the credit multiplier during good times turns into a divisor during bad times when default increase and liquidity dries up. Banks create money during good times and destroy money during bad times to protect themselves from illiquidity and insolvency and this behavior embedded in the fractional reserve system amplifies normal cyclical fluctuations of the economy and turns them into artificial boom – busts episodes. This is what has happened since 2009 until recently. Commercial banks have stopped creating money and have deleveraged during the crisis. In the US for instance, total bank loans grew from $4.7Tr in Q3 2001 to $8Tr in Q3 2008 (+7.8% p.a. so faster than nominal GDP which grew +4.9% p.a. in the same period, so you see the multiplier effect), then dropped to $7.2Tr in Q1 2011 (-9.3% vs. Q3 2008 vs. nominal GDP +2.3% over the same period, so you see the divisor effect). The same happened during the 1991 recession when bank loans dropped from $3Tr in 1990 to $2.7Tr in 1993 while nominal GDP kept growing. There appear to be no errors for this is clearly explained in my initial comment. Since 2011, US bank loans are growing again at a +3.4% annual pace and have now crossed just above their 2008 level at $8.2Tr. Instead, since 2008, most money creation has had to come from central banks – at least in the US, Europe and Japan – which picked it up exactly where commercial banks left it (+$10Tr balance sheet expansion from central banks globally since 2008 and Europe QE starts next month so more to come). There is little need to further comment on where this newly created money on a huge scale has ultimately gone via the portfolio rebalancing effect on investment managers and where the multiplier effect has clearly manifested itself and why it has not arrived en masse to every small town in America in Europe. In fact, one important thing changes when money creation shifts from commercial to central banks: when commercial banks are willing to lend, they also need the active participation of willing borrowers for money to be effectively created (what they don’t need is to have an equally active participation from savers) and willing borrowers being real people and real companies, a good portion of credit usually tends to flow to the real economy (real estate for instance). When central banks create money, the newly created money ultimately flows somewhere (with multiplier effect via self-reinforcing pavlovian effects on investment managers) even if there are few willing borrowers in the economy. Thus, you create a financial boom that is disconnected from the real economy.

      Your last point that deposits arising from loans are spent, leaving the bank to fund the new loan otherwise, for instance in the interbank market, hence no free lunch. Yes, that’s true. And it doesn’t change the conclusion that the banking system taken in its entirety can create money out of nothing. Imagine for instance a small country where the banking sector consists of only 2 banks, A and B. Let’s assume bank A has an initial loan book of 100, equity of 10 and deposit of 90. Bank B is bigger with a 150 loan portfolio, 15 of equity and 135 of deposits. The total banking sector of that country therefore has loans outstanding of 250, equity of 25 (assuming no cross shareholding) and deposits of 225. Now, imagine that in the next period, despite the banking system overall having received no new deposit inflows, bank A makes a new loan to an existing client who previously had no borrowings with either bank A or bank B. This new loan amount to 10, which is credited to the client account. At that moment, bank A has 110 loans, 10 equity and 100 deposits and bank B is unchanged so that the overall banking system has 260 loans, 25 equity and 235 deposits. The next moment, the borrower spends this 100 by buying something from someone who happens to be also a client of bank A. The situation of banks A and B is unchanged compared to the moment before. Now, assume instead that the borrower spends the 100 by buying something from someone who is a client of bank B. Bank A still has 110 loans and 10 of equity but it only has 90 of deposits left and therefore must borrow 10 in the interbank market to fund the gap. Meanwhile, bank B still has 150 loans and 15 equity but now it has 145 of deposits, meaning it has 10 of excess liquidity which it immediately place in the interbank market, where bank A is borrowing it. The consolidated situation of the banking sector in that case is 260 of loans, 25 of equity capital and 235 of deposits. The 10 borrowed by A and lent by B in the interbank market is offset on a consolidated basis (in the next period, bank A will be induced to slow down the origination of new loans due to its tighter liquidity and capital situation, while the opposite will be true for bank B, thereby reversing the interbank relationship towards balance). The banking sector of that country has created 10 out of nothing but accounting entries, equivalent to a 4% loan growth (10 / 250). Say nominal GDP of that country is 100 so that initial total debt / GDP is 250%. Of course, the extra 10 of purchasing power thus created will allow GDP to grow in the next period. For instance, imagine the 10 was used to buy homes, pushing up the price of homes and hence stimulating construction of new homes, adding to GDP and also stimulating consumption via the wealth effect. But let’s say that, because part of increased domestic demand leaked away via increased imports because the country is not very competitive at current exchange rate, incremental nominal GDP is only 3, equivalent to +3% growth, lower than credit growth. Debt-to-GDP increased to 252%. Finally, let’s assume that borrowers are too overextended at this level of debt and that something happen (may be interest rates rise) so that non-performing loans rise to 26 system-wide, ie. 10% of loans. It is clear that equity is at risk of being wiped out and, in absence of deposit guarantee, the prudent thing to do for depositors would be to withdraw their funds. To avoid bankruptcy, the banks would have no choice but to raise liquidity by selling or calling in loans and not renewing any. That will only exacerbate borrowers distress and result in further NPLs. And so on so forth. Here is the inherent weakness of fractional reserve banking: it is inherently unstable and pro-cyclical and, in the end, not viable without taxpayer backup in the form of deposit guarantee. Taxpayer have to guarantee their own deposit so that banks can leverage up to benefit their private shareholders. Clever, insn’t? The good news is: absolutely nothing says the credit system should be organised in this sub-optimal way.

  96. You write: “What is more, under normal (i.e. pre-euro) conditions the Spanish peseta would have dropped and Spanish interest rates risen, but the conditions of the euro prevented both adjustment mechanisms…”

    I would have expected the opposite – Inflowing German capital would have pushed up the value of the peseta and down Spanish interest rates, making capital export to Spain less attractive.

  97. Great economic and financial balance sheet debates and I commend Prof Pettis on his Blog.

    In respect of Greece, the economics and how the current situation happened is well articulated: the problem is the solution and the missing link is not some financial engineering technique it is much more challenging. The problem is and it is articulated by the thinking middle class of Greece – we cannot change ourselves. The changes necessary in the work culture, bureaucracy and vested interests of protectionist businesses and unions becomes a cat fight. A lunch discussion with three Greek colleagues will produce five ideas and no agreement. The inter-webbing of the Greek people and their culture and the ability of the middle class to absorb the economic pressures designed to effect changes that have not happened, the protected position of government and agency employees who will never volunteer change means the status quo remains. Economic and financial theory is good at explaining the story but more thinking and effort is required to articulate a solution.

    Time lines… France 1870-73 to 1898 …. 25 years…
    Germany 1920 – 1932 … 12 years

    GREECE 2010…… 2020…2025… ? We are only in 2015. It’s a generation game.

  98. Q2 Take a look at New Zealand. A radical shift from fortress economy with imperial preference to neo liberal outlier in the 1984 has seen the economy transformed. With regard to the capital account we have been in deficit since the 70’s. With both major parties having little economic difference the electorate has proved resiliant to unemployment and low wages. We lead the world with an inflation targeting central bank, and a free floating dollar. The economy is based on dairy (baby powder to China) and service industry, as a small and flexiable country what export manufacturing there is tends to high value niche products that employ few and make little difference overall. In the 80’s a lot of our capital inflows came from Japan and now it is dominated by China. Our major banks are Australian owned and free to choose their own capital requirements, investmant approach and offer no deposit gaurentee. Approaching the GFC we had a real estate boom (& smaller consumption) across the country, as values looked to fall the govt slashed interest rates, cut tax, and refinanced the loans conditional on preventing foreclosure. Surpisingly we have come out of the crisis with the highest growth in the OECD (thanks to Chinese demand, first country with a FTA), close to surplus budget and the fewest problems. The looming crisis is that the Auckland housing market has become decoupled from the rest of the country with annual growth pushing 25%, still with the 3-4% consistant capital account deficit. Clouds are looming, but they have been for thirty years, so far with only speed wobbles.

  99. Mr. Pettis,
    I am Greek. The Greek media keeps telling us that a default will be a huge catastrophe and should be avoided at all costs. I suspect this is propaganda supported by the lenders. What’s your opinion? If you have written any articles/books about the implication of sovereign default, please let me know.

    • I hope it is OK that I also try to answer this.

      Of course the default is going to be a huge catastrophe. However, carrying on as it is has also becoming unbearable for a large number of the population (those who have access to foreign source of income/exporting) pretty much still get what they want.

      If Greece defaults, then those who currently have ‘stuffs’ (and this includes those with pension promises) will lose more and those who have no ‘stuffs’ will probably need some sort of emergency welfare measure to survive while things reset. If it doesn’t, default then those who currently have no ‘stuffs’ but are trying to earn stuffs will continue to suffer. Those who caused the problems will probably be OK as their wealth/money is already sitting somewhere in Switzerland, London, Germany etc.

  100. I really enjoyed this detailed and rational discussion of this complex matter!

    A couple of details, though: The First Spanish Republic did not occur in 1868 (when Isabella was dethroned) but in 1873-74 (after a couple of haywire monarchical experiments and another Carlist war). And Germany was highly disunited when France declared war on Prussia, though the trend was snowballing ever more fiercely, and Sedan clinched it.

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