Internal and external balance

I was recently asked by an Australian economics journal to write a review of a book I had already read, The Leaderless Economy, by Peter Temin and David Vines (published in 2013). Because the book is a great place from which to start a discussion on the links within the global economy, I decided to base this essay on the book. I had already read Peter Temin’s Lessons from the Great Depression (1991), The Roman Market Economy (2012), and Prometheus Shackled (2013), and I know his work fairly well.

There is substantial overlap between the way Temin and Vines view the global economy and the way I do. I am a regular reader of Diane Coyle’s blog, The Enlightened Economist, in which she reviews books, usually on economics-related topics but also on anything else that might catch her attention. Besides having said very nice things about my book, The Great Rebalancing, and including it in her shortlist of top books for 2013 (I am bragging a little) she has also reviewed The Leaderless Economy, and has noted the similarities in the way both books approach the balance of payments.

She is right. Both books analyze the global economy in pretty much the same way, as an economic system in which any country’s domestic economy is inextricably linked to other economies through the balance of payments mechanisms. The ability to place events within their global context is consequently crucially important in understanding any country’s economic performance, but actually doing so tends more to be the exception than the rule.

To take one example, I remember in the early 1990s I read a book about the Panic of 1873, in which during September and October of that year gold reserves in New York plummeted, banks folded, and the stock market crashed, with the New York Stock Exchange actually closing, on September 20, for ten days. It was in many ways an excellent book about the events leading up to the crisis and the various factors that “caused” it, but except for a brief mention of the impact of the crisis on the British banking system, you could have easily assumed, as I did then, that the 1873 crisis was purely an American affair, and that events in the rest of the world barely mattered.

It was only a few years later, while I was reading Charles Kindleberger’s A Financial History of Western Europe that I learned that the 1873 crisis actually “began” with a stock market crash in Vienna in May, four months before the New York markets fell, which spread to Germany, England and other countries, and the subsequent depression was perhaps the first “global” panic and depression in history. It was in Kindleberger’s book that I also first learned about the impact of the Franco-Prussian War of 1870-71 and the subsequent reparations payments on global financial markets (which I discuss extensively in a February blog entry) and in unleashing the final stage of a global liquidity bubble that ended with the various panics of 1873.

The Panic of 1873, in other words, was clearly not only, over even mostly, an American affair. It was global, and its causes could not have been limited to American causes, as the book seemed to imply. On the contrary, I would argue that it is impossible fully to understand the crisis, whether the focus is on the evolution of the crisis in the US, the UK, continental Europe, or Latin America, without understanding the full global context.

The Leaderless Economy makes the same point I try to make in The Great Rebalancing: the economic analysis of any country is largely useless if it ignores, or treats as a minor issue, links with the external sector – i.e. other countries – and this is even more true today than in the past. Even something as important, and as seemingly “domestic”, as the US savings rate (which for most people is assumed largely to reflect cultural preferences towards thrift among American households) is not determined primarily by American households but rather by its links with savings distortions abroad.

This might seem a profoundly counterintuitive statement, but in fact you only need to understand two or three accounting identities to be able to work logically through the explanation. I showed why one country’s savings rate is as likely to be determined by domestic distortions as it is by distortions abroad in a blog entry on whether a savings glut must cause global savings to rise. In another blog entry, I explained why a low savings rate in countries like Spain was a necessary outcome of policies in Germany that effectively restricted wage growth. And finally I showed how – because of the role of the dollar in reserve accumulation and, more generally, the unrestricted ability of foreigners to buy US assets – the US savings rate is determined largely as a residual needed to balance net capital flows, in a blog entry on the so-called exorbitant privilege, and in a follow-up blog entry.

Global balancing mechanisms

In their book Peter Temin and David Vines don’t discuss the US savings rate but they do a lot of the same thing by changing the focus slightly. In my book I argue that because global savings and global investment must balance, if any country’s savings exceeds its investment by some amount, investment in the rest of the world must exceed savings by exactly the same amount. Temin and Vines express the same relationship between conditions in one country with conditions abroad in a way that can be summarized in two sentences. First, the domestic imbalance in any economy – i.e. high levels of unemployment or demand, large gaps between savings and investment, and so on – must be consistent with and equal to that country’s external imbalance at all times. Second, that country’s external imbalance must be consistent with and equal to the external imbalance of the rest of the world at all times

These two ways of seeing countries within their global contexts are basically identical. Any country’s capital account of course is simply the gap between its domestic savings and its domestic investment, and because the capital account must balance the current account (the two always add to zero), to say that the gap between savings and investment in any country must be equal to an opposite gap between savings and investment abroad is simply to restate the far more intuitively familiar claim that every current account surplus in the world must be matched by a current account deficit. Until we begin trading with extra-terrestrials the total must add up to zero.

This should all be obvious, but if an imbalance in one country must be matched by an opposite and equal imbalance abroad, there are only two possible explanations. Either the imbalances in every country are set endogenously, and, by some miracle, at every point in time, they balance out perfectly, or an imbalance in one country can force imbalances onto other countries. The first explanation is obviously absurd, so the gap between the amount a country saves and the amount it invests is as likely to be determined by external conditions as by internal. This is why it is possible to argue that a country’s savings rate (or its unemployment rate, or its investment rate, etc.) is determined by policies abroad as much as by policies at home. This is what it means to live in a “globalized” world.

Most analysts tend automatically to look at the current account as the balancing mechanism, but I think this is perhaps why it is so often easy to get confused about the balancing process. By explaining the adjustment process in terms of the capital account, as I do, I think it becomes much easier to understand how the direction of net capital flows determines the balancing mechanism. It also helps analysts avoid falling into the trap of looking at bilateral trade balances as meaningful when in fact, and very counter-intuitively, they are almost totally useless when it comes to understanding how distortions in one country might cause distortions elsewhere. For example, last year Stephen Roach, one of the most knowledgeable commentators on the Chinese economy, fell into the same confusion when he wrote the following:

The US trade deficit is a multilateral imbalance with many countries – 102 in all – not a bilateral problem with China. It arises not from the alleged manipulation of the renminbi, but from the simple fact that America does not save. Lacking in domestic savings and wanting to grow, the US must import surplus savings from abroad, and run massive current-account deficits to attract the foreign capital. And that leads to America’s multilateral trade imbalance

If China runs a capital account deficit and the US a capital account surplus, and these are roughly equal to net purchases by the PBoC and other Chinese government entities of US government bonds and US assets, China will run a current account surplus exactly equal to its capital account deficit. The US will run a current account deficit exactly equal to its capital account surplus.

This may show up in the form of corresponding bilateral trade surpluses and deficits between the two countries, but it is not necessary, and in fact extremely unlikely, that it would. While we cannot say just from looking at the numbers whether low US savings relative to investment forced the Chinese into saving more than they invest, or whether high Chinese savings relative to investment forced the Americans into saving less than they invest, we can say that the savings rate in one of the countries was determined in large part by distortions in the other.

The main point is that if you want to understand the causal relationship between Chinese surpluses and US deficits, or between German surpluses before 2009 and peripheral European deficits, you have to look at the direction of net capital flows, and not at bilateral trade. I will return to this, but to get back to The Leaderless Economy, this book is underpinned by the same deep familiarity with financial history that Peter Temin brings to all his work, and perhaps this is why the book should leave everyone terribly frustrated on two counts. First, the authors show that while the 2007-08 global crisis and its aftermath were unquestionably large and complex affairs, there was nothing about the crisis that was unprecedented – we have experienced similar events before – and we understand far more about what might or might not have worked than subsequent policymaking might suggest.

The authors show for example that anyone who had a reasonable understanding of the current and capital account pressures of the 1920s whose inconsistencies doomed Germany should have been able to understand why downward pressure on German wage growth, in the several years before the global crisis was set off in 2007 by the US subprime crisis, would ultimately force huge internal imbalances onto Europe during that time. More importantly, this understanding should have been enough to convince European policymakers that unless Germany responded to the crisis by reflating domestic demand sufficiently to generate large current account deficits, it would be all but impossible to prevent a decade of anemic growth and extraordinarily high unemployment in peripheral Europe.

It’s not that Germany in the 1920s was anything like Germany in the 2000s, or even that Germany suffered in the 1920s from the kinds of pressures it forced onto peripheral Europe in the 2000s (although this is closer to the truth). The problem was that Germany in the 1920s was required to export large amounts of capital, because of extremely high reparations demands, while its ability to run current account surpluses was constrained by European post-war policies.

No country can run a capital account deficit unless it runs a current account surplus, and these enormous countervailing pressures forced Germany, among other things, into an unsustainable borrowing path. Similarly since 2008-09 peripheral Europe has been under pressure to run capital account deficits (it must repay substantial borrowings and fund flight capital, but it has trouble borrowing without implicit ECB guarantees). Its ability to run countervailing current account surpluses, however, is constrained within Europe by Berlin’s refusal to allow a reflation of domestic demand and it is constrained outside Europe by Germany’s enormous current account surplus, which prevents a currency adjustment. This forces peripheral Europe into both rising debt and high unemployment, and it is only because Europe as a whole has forced the problem of weak German demand onto the rest of the world that conditions in Europe are not even worse.

Are trade surpluses virtuous?

Before I explain the second source of great frustration that this book provides, I want to make a quick detour on the subject of current account, or trade, surpluses. Any suggestion that Germany’s trade surplus is too large and has become a source of global distortions elsewhere seems to infuriate a lot of people, for many of whom the idea that a trade surplus can be too large is the moral equivalent of castigating people for working too hard and being too prudent. A trade surplus, they believe, is the reward a country gets when its people work hard and save their money.

But would a nation of productive and hard-working people, let’s call them ants, normally run trade surpluses? The consensus seems to be that it would. Running a trade surplus means that a country sells more to foreigners than it buys from them, and there seems to be an implicit belief that exports are what a hard working country produces, and imports are the equivalent of its consumption, so that a trade surplus means that the country earns more than it spends, and the larger the surplus, the more likely the ants in that country are especially productive, thrifty, morally upright, and perhaps fond of sensible clothing.

Countries that run large and persistent trade deficits, on the other hand, buy more from foreigners than they sell, and because this seems to suggest they are living beyond their means, we usually think of these people, let’s call them grasshoppers, as lacking discipline and prudence. Grasshoppers excite our scorn, even if we sometimes envy their carefree ways and their bohemian morals.

If households that are careful to spend less than they earn, making sure to save part of their earnings, are seen as admirably thrifty, while households that are too quick to pull out their credit cards to buy things they cannot afford are seen as foolish, and will in the end implicitly require that their prudent neighbors bail them out, the same, we assume, should be true of countries. It is unfair that ants have to bail out grasshoppers, and so naturally we tend to abhor policies aimed at favoring grasshoppers over ants, and by extension we also abhor policies that seem to favor trade deficits over trade surpluses.

But countries are not at all like households and, more importantly, a country’s earnings are not equal to its exports. A country earns the total amount of goods and services that its households produce, of which exports are only a part – and usually a small part except in trading entrepots and in mercantilist countries. The richest and most productive countries are not the ones that export the most. They are the ones that produce the greatest amount of goods and services, and we usually, although not always accurately, measure this number as gross domestic product (GDP).

A country of hard working, productive ants, in other words, will not be rewarded with a high trade surplus, but rather with a high GDP, which should translate into a higher quality of life. They might export a great deal, but the reason they export is so that they exchange their exports for foreign goods that either they cannot make at home or that take more time and money to produce at home than to import from abroad. This should be obvious when we consider that while it is possible for every household to work harder, produce more, and so consume and save more, it is impossible for every country to work harder, export more, and import less.

A country of ants could run either trade surpluses or trade deficits, depending on conditions that have nothing to do with how hard working it is, but if it did run surpluses for many years, its currency would eventually rise, allowing ants to exchange their products for even more foreign products than before. This would cause the trade surplus to disappear as the ants consumed a larger amount of foreign goods that they could acquire for less work than before.

So if ants are not rewarded with trade surpluses, what explains the fact that some countries run persistent trade surpluses year after year while other countries run persistent deficits? The reasons, it turns out, has to do with the relationship between savings and investment. Countries that save more than they invest must export these excess savings to other countries, through the capital account, because the savings cannot be invested at home.

But something else must happen. The ants must either work to produce goods and services to be consumed, or they must build roads, factories, airports, and other kinds of investment that are funded by their savings – i.e. the share of their production that is not consumed. This statement is usually characterized as:

Consumption + savings = Consumption + investment

If the ants save more than they invest, then by simple arithmetic the total amount of goods and services they produce as they earn their incomes must be greater than the total amount of goods and services they produce in order to consume or to invest. Put differently, the total supply of goods and services they produce must be greater than their total demand for goods and services, and so they must export the excess by running a trade surplus.

A country’s trade surplus (more accurately its current account surplus, which includes things like royalty payments, tourism, returns on investment abroad, and other things, but we will pretend they are the same) is exactly equal to its total savings minus its total investment, which is equal to the amount of savings it exports. This is why we refer to the balance of payments. The total money that ants receive from their trade (current account) surplus is perfectly balanced by the capital account deficit, which is simply the amount of savings they send abroad.

Why save more than you invest?

Countries run trade surpluses, in other words, not because their citizens are hard working ants, but rather because they save more than they invest. Of course ants are supposed to save more than grasshoppers because they are prudently willing to make some sacrifice today in order obtain a better outcome tomorrow, but this means that they also must invest more than grasshoppers because the only way a sacrifice today results in a better outcome tomorrow is if we save part of today’s production and invest it in something that will increase our productivity tomorrow. The natural thriftiness of ants explains why they save more, but it cannot explain why countries save more than they invest, and so run trade surpluses, year after year. There are three reasons that explain most cases of large, persistent trade surpluses.

The first reason is a good one in that it results in higher growth and a better outcome for the world overall. The second two reasons, which are really variations of the same reason, result in lower growth for the world overall.

In the first case, there is a huge investment opportunity abroad, perhaps because a group of foreign ants have identified a great opportunity to increase productivity, and this opportunity persists year after year. The returns on that investment are so much higher than they are at home that ants at home are willing to save more than they naturally would to invest at home.

Because they save more than they invest, they export the excess savings abroad, where it earns an outsized return. Total growth in production for the world, consequently, is higher, and if that increase in production is shared between the ants at home and foreign ants, every one is better off. Notice however that the foreign ants will be importing savings because their investment needs exceed their savings, and so in spite of their hard work and rapidly rising productivity, they will run trade deficits for many years. In the 19th Century England and the United States played these two roles, with excess English savings pouring into the United States to fund growth in history’s most successful emerging market, and while the British ran persistent trade surpluses, and the US ran persistent trade deficits, both countries got richer.

The second reason a country might save more than it invests is because of high levels of income inequality. Rich people usually save more of their income than ordinary people, so that the more they keep of the total amount of goods and services produced by hard working ants, the higher that country’s savings rate and the lower its consumption rate. Because lower consumption discourages businesses from building new factories or otherwise expanding production, higher savings often come with lower investment, and so countries with highly unequal income distribution tend to run large trade surpluses.

The other reason has to do with the share that households receive of everything they produced. A country’s total production is divided between households, businesses, and the government. Although governments do make purchases that we can classify as consumption, almost all consumption comes from households. This matters, because in countries in which households are allowed to keep a very large share of what they produce, whether they are as thrifty as ants or as spendthrift as grasshoppers, their total consumption will be a high share of total GDP, and total savings a low share. If their high consumption encourages businesses to open new factories, low savings and high investment might even lead them to run temporary trade deficits, although only until the factories begin to produce.

But if households retain a low share of everything they produce, with governments and businesses getting the rest, then again, whether they are as thrifty as ants or as spendthrift as grasshoppers, their total consumption will be a low share of total GDP, and the country’s total savings, which is equal to GDP minus consumption, will be a high share. Once again if low consumption actually causes investment to drop, they will run large trade surpluses. Notice however, that the country has a high savings rate not because ants have saved a lot of their earnings. It has a high savings rate because businesses and governments are able to save the money that was not given to households.

This is what happened in Germany during the past decade. While Europe boomed, a number of factors allowed companies to reduce wage growth in Germany sharply, leaving German households with a declining share of what they produced and businesses with more than ever. As income inequality also rose during this time, German household consumption rates dropped and so total consumption rates dropped. Meanwhile, German companies decided to reduce their investment in Germany, perhaps because German households were not able to buy what they produced. Higher savings and lower investment caused Germany’s trade surplus to soar.

So as counterintuitive as it may at first seem, trade surpluses are not the reward for hard work or thrift. Trade surpluses can have many causes, too often just the low share of GDP that ordinary households are allowed to keep, but trade surpluses or deficits that persist for many years are always the result of significant distortions at home or abroad. Rising productivity and hard work can lead to strong export growth, but only net capital exports will lead to a trade surplus (or, more correctly, a current account surplus). If countries like Germany, whose surpluses have caused so much damage to Europe, were to arrange income more fairly, not only would Europe benefit, but Germany’s hard working and thrifty ants would finally get their rewards – a higher income, rather than a larger national trade surplus.

The value of history

I said that for me there were two great frustrations that come from reading The Leaderless Economy. The first is that we have the tools to understand much of what went wrong before the 2007-08 crisis, and to understand why distortions in the current and capital accounts can lead to a build up of debt and a subsequent disruptive adjustment. We didn’t use these tools because we failed to work through the logic of the balance of payments, to the point where in some countries we actually applaud measures that reduce the share of production allotted to hard-working households on the grounds that their real reward is a higher national trade surplus.

The second frustration is closely related. By showing us how useful history is in understanding current events, the authors also reveal, indirectly, how little value there is in the vast literature of economic theorizing that emerges from the abstract and distorted world of academia, bereft as it is of historical context.

For most economists, history is usually little more than a data sequence whose values are plugged into mathematical models – whose implicit assumptions too often these same economists fail to understand. But as Temin and Vines show, history is much more usefully seen as the evolution of often complex institutions – financial, political, legal, cultural, and so on – through which economic behavior is mediated and which affect the ways in which recurring patterns of finance, commerce and trade unfold, and that without an understanding of history we lose so much complexity in our models that we often end up making very obvious mistakes.

Charles Calomiris, a professor at Columbia University whose work on banking systems and banking system risk is among the best in the world made much the same point at a presentation at the Federal Reserve Bank of Atlanta last month: “You have to think historically to think usefully. Traditional economic models don’t incorporate historical analysis, despite its usefulness in explaining factors behind crises or finding holes.”

The 2007-08 global crisis and its aftermath are so much easier to understand if the period is placed firmly within history, which the authors do, especially focusing on events in the 1920s and 1930s, two decades that have great resonance with the past fifteen years. One of their goals is to explain the insights that John Maynard Keynes provided on the workings of the global balance of payments as they work through the development of Keynes’ thinking in real time. Not only does this flesh out the logic behind Keynes’ evolving theories, but it also makes it easier to understand the events that inspired Keynes ultimately to overcome Ralph Hawtrey’s objections in a famous 1930 debate to his intuitive sense that excess savings and unemployment were related, although the debate itself is not discussed in the book.

Why does this matter? It is impossible to overstate the usefulness of the reasoning Keynes provided that links savings, investment, unemployment, and trade. John Hobson had already shown nearly half a century earlier how institutional distortions that force savings levels higher than the level of desired investment will affect an open economy, but Keynes created a formally logical way to think about it. By using this model we are able to understand today why in a world without a near infinite amount of credible demand for investment (the role the United States played in the 19th Century), high levels of income inequality, or downward pressure on the household share of GDP, must lead almost inevitably first to rising debt and later to rising unemployment.*

These savings imbalances are often at the heart of the great imbalances in global trade and capital flows, and in The Leaderless Economy the authors clarify immensely the transmission of savings imbalances from one country to another. Domestic imbalances in any economy must be consistent at all times with that country’s external imbalances or, put differently, any gap between a country’s total savings and its total investment must result in a current account imbalance.

So if households consume a declining share of what they produce, either they must increase investment commensurately, so that savings rise and GDP remains the same, or, if investment cannot rise fast enough (in fact in most cases it is likely to fall), unemployment must rise fast enough to keep total savings from exceeding total investment. Of course if they force the demand shortfall onto the rest of the world, they can keep unemployment down by exporting their excess savings and running a current account surplus, the counterpart of which is a current account deficit somewhere else. These are just accounting identities – the internal imbalance between a country’s savings and investment is at all times consistent with and equal to its external imbalance, and a country’s external imbalances is at all times consistent with and equal to the external imbalances of the rest of the world. To understand which country will run the corresponding external imbalance depends on the nature of the institutions through which economic behavior is mediated, and this is why a deep grounding in economic and financial history is so important.

* I explain the model formally in the “Appendix” to The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton University Press, 2013)

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  1. Doc at the Radar Station

    Prof. Pettis, what do you make of these kinds of arguments posed here:

    I’m a little confused by their arguments. I hope I’ve not gotten off topic by bringing this up, but it would great if you could give us your thoughts about this, thanks!

    • There really isn’t any contradiction, Doc. The paper, by Ricardo Hausmann and Federico Sturzenegger, sought to find an explanation for why, in spite of deep global imbalances that led to repeated warnings about the unsustainability of both the imbalances and the associated debt, the world did not seem to be having trouble absorbing the imbalances.

      The authors don’t dispute any of the balance of payments arguments in the book by Temin and Vines, and I am pretty sure that they would fully agree with the need for external and internal imbalances to be consistent. These are, after all, accounting identities, which no one can dispute. The problem is that people forget them, and in forgetting them they find themselves saying things that simply do not make sense.

      The fact that the paper was published in 2005 gives some idea of why its initial impact seems to have dissipated. The warnings about unsustainability, which they tried to resolve by showing that real imbalances were less than the reported imbalances, seemed to have been validated by the crises beginning in 2007. But the paper shouldn’t be dismissed with a sarcastic “Whoops”, and I am very glad you reminded me of it. In fact I think it is a brilliant paper, and the events of 2007-09 do not make it any less insightful.

      The authors argue, like I do in my May 17 blog entry, that our accounting systems fail adequately to measure all the things they should measure, and while my entry is about the failures of GDP calculations, they focus on the failures of balance of payments calculations. They argue that countries import and export value that cannot easily be calculated or included in the B-o-P measures, which they call “dark matter”, and for this reason certain current account deficits and surpluses may be overstated while other current account deficits and surpluses may be understated.

      They identify three forms of dark matter in particular that countries like the US may be exporting. First, outward FDI may come with considerable technical and technological expertise that isn’t correctly valued in the FDI numbers (on a relative basis). Second, some countries, most obviously the USA, serve an insurance function which creates a premium foreign investors effectively pay. Third. some financial markets, again most obviously the USA, serve as liquidity providers, which also creates a premium foreign investors effectively pay.

      They calculate each of these and estimate that the US is a huge exporter of dark matter, followed by the UK, with Germany ranking fourth. Developing countries, especially Asian, are the biggest importers, although Russia is the largest importer. China is a large importer, but not in the top ten, and if that seems surprising, it may be less so when you remember that their rankings are based on 2000-05 data.

      Some parts of their rankings make intuitive sense, others less so — for example Mexico is ranked third, ahead of Germany, as an exporter of dark matter. At first I wondered if there might not be an emigration component of dark matter, but I saw that the Philippines imports a great deal of dark matter.

      It would be easy, but wrong, to dismiss their work as having been rendered obsolete by the 2007-09 crisis. Theirs is actually a very insightful point, and while they may be the first to formally explain it in the way they do, it has long been known that the US serves both as a liquidity provider and as an insurance agent, and that it almost certainly derives income from both. For example foreign exchange reserve accumulation is clearly a form of insurance buying, and the fact that during a crisis US bonds tend to rise in value and money pour into the country proves both the US insurance value and that others see it as insurance. When China exports money to the US in the form of PBoC purchases of USD bonds, and part of that money is returned to China in the form of higher yielding FDI, you can think of part of the positive carry the US receives as simply part of the insurance premium China pays.

      The crisis, by the way, doesn’t prove them wrong when they try to use “dark matter” to explain why the seemingly deep imbalances in 2005 were in fact sustainable. From their work you would have argued that the US and UK trade deficits and the Chinese trade surplus were not as deep as they seemed once adjusted for “dark matter” (in fact the adjusted US current account is flat), but that Germany’s trade surplus was deeper.

      In fact that wouldn’t be a totally wrong assessment of the implications of the crisis and post-crisis events. The market doesn’t act like it thinks either the US or the UK are in unsustainable positions because of their current account deficits, nor do investors, especially Chinese investors, act like they think China’s credit position is as strong as it’s net exports of capital might suggest. On the other hand, the long crisis in Europe suggests that whatever the underlying imbalance, it was deep.

      At any rate I do plan to re-read this and think about it a bit. If they are right it doesn’t change the balance of payments arithmetic because it just means that all current account surpluses and deficits have to be adjusted by numbers which net to zero. But I do need to think about the impact on the savings and investment imbalance. At first read I think the adjustments are pretty obvious. Take the US, for example, if their numbers suggest a current account close to zero because of “dark matter”, it means that real US exports are higher than reported, and so as a matter of necessity real GDP must also be a little higher than reported by the same amount and, with it, real savings. By increasing savings, you automatically reduce the gap between savings and investment, and so it remains exactly equal to the current account balance.

      In fact I think this article actually is more appropriately discussed as part of the discussion around May 17 entry. Ricardo Hausmann and Federico Sturzenegger are obviously saying, like I did, that reported GDP does not fully reflect the total value of goods and services produced because it understates the value of imports or exports. Notice that by adjusting for “dark matter”, they are adjusting the GDP of countries like the US upwards, and that of countries like China downwards, which is one of the reasons I use to explain why the US might command a higher “multiple” — reported GDP might understate value creation in the US and overstate it in China.

      Thanks again for reminding me of the paper, Doc, and for those readers interested in this kind of thing, I recommend you take a look at it. It is not as rigorous as it would like to be but it is imaginative.

      • Doc at the Radar Station

        Wow! Thanks a lot for the thoughtful and elaborate reply. This clarifies my thinking greatly. I was misinterpreting them to be implicitly asserting that imbalances didn’t matter or were not really harmful. I will reread your May 17 entry, thanks again!

      • “command a higher “multiple” — reported GDSP might understate value creation in the US and understate it is China”

        “overstate it in China”

      • Monsieur,

        Maybe it is time to quantity the value of American culture (ideals,music,behaviour…ect)…it might be a big part of the “dark matter” in question. Must be hard to quantified but as I am in Vietnam, one can notice the local “communist” driving a Ford, drinking a coke while the kids play on their ipad listening Cathy Perry….You could easily think the the import of “dark matter” is an important part of any economic equations.

        Anyways, amateur here but always facinated by your sound analysis Mr. Pettis. Bravo. Your analysis of China’s economy made me understand Vietnam’s economy (and why it is sick).

        Ha Van Hotel
        Nha Trang, Vietnam

  2. ‘No country can run a capital account deficit unless it runs a current account surplus, and these enormous countervailing pressures forced Germany, among other things, into an unsustainable borrowing path’

    … I mean, it’s obvious when you read it, but I hadn’t before today

    ‘and the larger the surplus, the more likely the ants in that country are especially productive, thrifty, morally upright, and perhaps fond of sensible clothing.’

    lol. not to mention the sense of humour deficit and complete absence of joie de vivre? … they are German …

    • biggestbrotherofthe mall

      Berliners have a filthy funny black sense of humor. Droll, dark and completely un PC in US. Also interesting clothes, and highly permissive morals. Combine this with a protestant (not calvinist) work ethic and a deep understanding of how to indoctrinate and marshall troops, I mean workers. And they lucked out with with an injection of clean living Turkish industriousness.

      And difference with China doesnt stop there.

      Max Weber thought it was the protestant God, present 24/7 and not just in the church as the Catholics would have it, checking though shalt not lie on every business transaction, and the result was fan forced industrialization and bureaucratization, handshake good as word etc. hardly the way to describe business dealings in China.

      And then Germany has a competitive advantage at the top end, machines that make the machines etc. And this you may (if making more gross generalizations) trace to the guilds, a restrained class system by European standards, and an educational system that streams way to young and imperfectly at age 11 into worker, craftsman, professional with the result that a whole of of smart kids get put erroneously into the middle category when they would have made great brain surgeons- and so produce amazing sound systems and cars etc. Again not yet the case with China where, its .01% winner takes all and the who cares about the rest.

      • Perhaps it is because my parents come from two different countries, I was born in a third, and grew up in another four countries on five continents, but I have always been less impressed than other people about the influence of culture on behavior. I may be digressing a bit, but basically it seems to me that we can always find a plausible cultural explanation for current behavior, and if that behavior should for any reason flip, we manage with tremendous ease to come up with another cultural explanation for the new behavior.

        Long term predictions based on culture, however, have a terrible track record. Just the experiences of immigrants to the US undermine some of Weber’s strongest claims about the Catholic and Confucian attitudes towards economic success. I think institutions and incentive structures certainly matter, and perhaps culture helps structure these institutions, but I think we overstate cultural differences perhaps because art a superficial level other cultures seem so exotic and strange.

        • biggestbrotherofthe mall

          Culture does matter when it comes to honesty. And corruption matters when it comes to pretty well everything.

          • Culture clearly matters, but there’s more variability of individuals within cultures than there is variability between cultures. I don’t think anyone is saying culture doesn’t matter.

            Clearly, placing religious limits on banking by placing limits on interest (like banning usury as in Islamic finance, which can actually be a very advanced form of finance/banking) or by writing off debts every 50 years obviously affects the development of financial or economic system. No one is denying any of this.

            As for the corruption, I think that’s more related to incentive structures and other factors far more than it is to “culture”. For example, every time I go to India, I see massive improvements taking place, but the primary problem was bullshit socialist policies the first 40 years after independence–the completely ruined the future of the land and country IMO. As the institutions and circumstances change, the people seem to be awfully similar.

            Also, I think it’s foolish to say developed countries lack corruption. There’s lots of corruption in all of these countries, developed or developing. The problem is whether the incentive structures are geared towards genuine capital/wealth creation or rent extraction and control via patronage.

          • biggestbrotherofthemall

            My fear is not the casualties of sequential purges among the elite families nor for the eventual crash of real estate prices in Vancouver, San Diego or Sydney but in addition to the silencing of the press by global press portals wanting Chinese business the nature of the next great rebalancing…

            “Don’t forget what I discovered that over ninety percent of all national deficits from 1921 to 1939 were caused by payments for past, present, and future wars.”
            Franklin D. Roosevelt

        • To me you are worng on that. Culture do matter but not in what people think in direct behavior of economic agent like saving and consumption. But more fake political debate. When you take issues like smoking bans, it use to be a lot of talk about more individual freedom and less individual freedom, masking the fact that companies are making profit killing people. Existence of such debate il clearly cultural and consequence are clearly economical. Now if you take Obamacare much of the debate is “black people and democrats are socialist”, instead of being “do Obamacare provide more good than bad”.

          • Just a note: what is good IS NOT what does more good than harm. What is good is what does no harm.

            With regards to the ACA and health care in the US, health care systems do not scale evenly. This is why I don’t understand leftists, socialists, and statists advocating single-payer here in the US across a vast empire stretching from New York to Washington to California to Florida to Texas. Different states need different health care systems and things don’t scale evenly. Comparing the US to some country like, say, Germany is completely wrong because Germany has a homogenized population of ~80 million where if most people drive 400 miles, they’re in a different country. The kind of health care systems that work in Europe won’t work here.

            With that being said, the ACA was around 900 pages. My guess is about half of that bill is straight pork-barrel spending, so I don’t count that part of the bill as the actual bill. With regards to the ACA, I thought it’d be a disaster, but health care costs have actually slowed down their rate of increase since the passage of the ACA and the ACA actually seems to be decentralizing health care. So now, I have absolutely no idea. I actually am seeing positive signs just in the way people are behaving about health care here in the US.

    • For me, Jonathan, that is high praise. I love reading something that I knew, but hadn’t thought about in that way, and realizing as soon as I read it that it is perfectly obvious and should have been, all along.

  3. Basic concept:
    Assume A+B=C+D all the time.
    Therefore, shifts in A must be inversely counterbalanced by shifts in B or obversely counterbalanced by shifts in C or D.

    It’s really that simple. From the first, one movement in one of the parameters must AXIOMATICALLY cause shifts in the others.

    I always come back to this, but most people (including economists) lack rigor in thought. What is rigor? At a very crude level, it’s the idea that if your assumptions are correct, if your logic (thus every single one of your logical leaps) is correct, then your conclusion will be correct. What does this imply? It means we need to focus on
    1. How shifts in our assumptions affect our conclusions, models, and views of the world.
    2. What the reasons for our logical steps are and the implicit assumptions we make in our each and every one of our logical steps?
    3. How shifts in our reasonings and shifts in circumstances affect everything else?

    What I’m saying should seem simple and obvious, but very few people actually have it (I still don’t have this process down pat IMO). I see these errors everywhere and it’s particularly prominent in most modern philosophy, which is a HUGE part of the problem.

    Most “rational” people or people that claim to use reason/logic try to create assumptions and use logical leaps with a certain conclusion in mind. This is inherently not rigorous, leads to incorrect conclusions, and eventually blows the system up. These process tend to be long-winded with seemingly ruthless conclusions that tend to comfort us.

    Reason (in the ancient sense, ex. Stoic) is the exact opposite. The idea is to keep our principles simple and obvious so we can recognize mistakes easily and quickly. Instead of trying to control our outcome, the idea is to shift our assumptions and logical leaps to see how our conclusions shift. Then to use these things together to come up with possible scenarios and detect risks. This approach does not lead to comforting solutions and instead forces us to broaden our minds. To quote Marcus Aurelius:
    “Nothing has such power to broaden the mind as the ability to investigate systematically and truly all that comes under thy observation in life.”

    • I agree Suvy. There is far too often a failure to think rigorously about economics, and that means among other things understanding any model you use (and all you do is “use models” when you discuss the economy at any level of abstraction) as a logical system which necessarily makes certain underlying assumptions.

      Most people think you start with assumptions (or the data) and then figure out the model, but I teach my class what I call the “arbitrage” approach. You approach every model as if it were true, which means that you assume it flows logically and inexorably from assumptions about the world. It is then often a simple matter to work out those assumptions, and they are effectively the “information” you extract from reality. If any of this information is implausible, absurd, or even simply impossible, you cannot accept the model. It is surprising how often people use models whose implicit assumptions they would quickly and easily reject as unlikely or even impossible, and yet they still use the model.

      I call it the “arbitrage” approach because in my trading seminars I teach my students two “tricks”. The first trick is to approach all prices as if markets were perfectly efficient, so that there are no pricing inconsistencies. If you then discover that the “information” you need to justify this assumption that markets are perfectly efficient is inconsistent, unlikely, or flat out wrong, and you cannot come up with a plausible justification, then you might have a trade. The second “trick” is always to look everywhere for signs of optionality or convexity.

      My students favorite example of optionality is when I explain to them why it is possible for their parents to love them deeply, to have a great deal of experience and wisdom, and yet still to give them advice about their careers that they want to reject. If you assume that a smart, ambitious student thinks of his or her career mainly in terms of the potential upside, he is effectively long a call option on his career. Mom and dad, however, are likely to be very protective and to think more about minimizing the chance of failure (“keep your options open”, “have something to fall back on”). They are effectively short put options on junior’s career.

      That’s why although they both want junior to “succeed” (they both run positive delta), their advice can often be so much in conflict. The attitudes to risk are so widely divergent, with junior being long, and mom and dad short, kappa. You can push the analysis even further, but I am sure you get the idea. If students understand this, they will better understand the reasons behind both their own and their parents’ career advice, although inevitably someone will point out that his parents don’t understand option theory, so this cannot apply in his case.

      • All that mathiness in Econ does tend to cloud thinking, or as Albert E. put it, “As far as the laws of mathematics refer to reality, they are not certain, and as far as they are certain, they do not refer to reality.”

        • Einstein wasn’t a very good mathematician by his own standard.

          BTW, there’s very little math in economics. Mathematics IS NOT fancy formulas and useless number crunching.

      • Thank you Prof, I love the example.

  4. Kristian Garthus-Niegel

    Prof. Pettis, thanks for your insightful and accessible essays. A few days back, Siemens announce to cut 4500 jobs, today BMW “thousands”. Are these in effect expressions a more long-term trend of dropping external demand on German-produced goods? How do you assess the near future prospect of German exports?

    • I don’t know the particular details, Kristian, but I would argue that for structural reasons it will be very difficult for Germany to reduce its surplus without seeing a rise in unemployment. Its surplus, in other words, reflects structurally weak domestic demand and not, as the current story has it, an especially productive export sector.

      • Kristian Garthus-Niegel

        Thanks for the reply. By the way, did you have a say in Mr. Varoufakis’ ‘future of Greece in the EU’-speech at the Macroeconomic Policy Institute in Berlin last Monday, or did he simply borrow your Aesopic fabling?

  5. biggestbrotherofthe mall

    How might Keynes amend his view today I wonder?

  6. One question – is the sentence ‘an imbalance in one country must be matched by an opposite and equal imbalance abroad’ also true if one country starts to print money? It seems to me that it would only be true if the total amount of global capital is fixed.

    • Yes. “Printing money” simply transfers wealth from those who are long monetary assets to those who are short. In some cases, depending on underlying conditions and the form in which the “printing” takes place, this can result in higher total production and in others lower, and these will of course affect internal and external balances, but they will always and at all times be perfectly matched. These are accounting identities.

      • If I = S always, why bother with having both I and S, why not just have I (or S) in the national accounts?

        I see this I = S thing in many places, and am always confused by it, and would appreciate an explanation better than “it’s an identity”. You could introduce a J for “jumberment” that is also the same as I and use J in some calculations and I in the others, but I don’t think it would help anyone understand anything, so how does having I and S both referring to the same thing help?

        My everyday understanding of investment is that it is paying for production of something that is intended to last more than a year and enhance further production (e.g a factory) and make a profit, or a purchase of such a thing from someone else who has made the original investment. My everyday understanding of saving is that it is income that is unspent. If I put some of my income under my bed and leave it there, how does that contribute to a factory being produced somehwere else in the world as I=S appears to imply?

        Am I right to think that the S and I in the national accounts aren’t the same as the everyday notions of savings and investment (if so, what are I and S in the national accounts?), or does keeping money under my bed help a factory appear somewhere, or help ownership of the factory transfer?

        • see eg the Wikipedia article ‘circular flow of income’, ‘five sector model’. savings and investment should be equal bcz it’s the same quantity of money/income, made available by households but spent by firms

          • Thanks.

            The five sector diagram in that article seems to imply that investment comes from financial sector to firms, but in practice 2/3rds of financial sector lending is direct to households, mostly for house purchases. A dodgy diagram doesn’t mean that the equations are wrong, but not encouraging for the quality of the article as a whole.

            The article also states that the equations only hold in equilibrium, but equilibrium is rare.

        • S=I for a CLOSED economy. Y=C+S=C+I+NX implies S=I+NX. A closed economy, by definition, means NX=0.

          The point of the identity is just that. If one thing moves, everything else must move by something else and the movement of all of these must net to the movement of the underlying variable. You seem to be making fun of it for it’s simplicity, but that’s exactly what makes it useful, robust, and not error-prone. Why would you wanna make things more complex than what they are? It makes no sense.

          • Thanks.

            It seemed to me to be more complex than needed, due to S=I, rather than too simple. The ridiculous example of storing money under a bed making a factory appear somewhere was just to try to understand what S actually is.

            I think you forgot taxes and government expenditure in your equations.

          • I didn’t forget taxes and government expenditure. The way I’ve defined it makes more sense. Government expenditure is either consumed or invested. All taxes do is shift C_p, S_p, or I_p to C_g, S_g, or I_g. This why the other definition makes no sense, is less simple, and leads to more erroneous conclusions.

            My definitions:
            C=C_p+C_g; S=S_p+S_g; I=I_p+I_g
            C_p–Private Consumption; C_g–Government Consumption
            S_p–Private Savings; S_p–Government Savings
            I_p–Private Investment; I_g–Government Investment

      • @ Michael

        Thanks for this great article.

        I understand that we are talking about accounting identities and balances. What I generally miss in your presentation is a focus on the incentive structure that favors certain developments and I feel that monetary policy has a high impact on this incentive structure in that it produces too much of uniform behavior in trying to achieve artificial stability. As we all know stability will inevitably lead to instability and the idea of centrally planning the obvious outcome and result in the pursuit of such goals creates the environment that will lead to even higher forms of displacement comparable to a phase transition. The principles that haven been proven true again and again in history are for purpose of short term solutions and efficiency simply put aside and ignored. Life in itself is very unstable for the exact purpose that we act responsibly and carefully (there is simply no haven without hell). Therefore, policies that provide superficial and temporary stability, a goal that all large institutions aim at, undermine, when excessively adopted, life itself, which contains uncertainty, instability, dynamic energy, creativity etc. all necessary ingredients for successful societies. The drive to concentrate power in less and less hands is still in full swing (TPP, TTIP, TiSA) and contains clear indications of trying to undermine democratic rights of self-determination of individual nations.

        I know that I put the story into a wider scope, but still would be interested in an answer.

        • First off, the “democratic rights of self-determination” don’t exist. In many places of the world, “democracy” would lead to the most oppressive, dangerous, and dictatorial regimes out there.

          Secondly, the TPP is all about geopolitics (as are, I think, other free trade agreements).

          Thirdly, it’s foolish to expect politicians to make intelligent, prudent decisions with foresight because of “democracy”.

          With regards to incentive structures, a large part of the problem is that we’re dealing with regions in most of the world where there are no natural trade networks, harsh terrain results in very high development costs, high fertility rates exist among most of the population, and the easiest way for these places to have access to riches is via natural resource extraction (ex. most of the Middle East, virtually all of Africa). I’m sorry to say this, but in many of these places, there’s really not much hope. When most of your government revenue comes from natural resource extraction, there’s no incentive structure to placate the populace. Instead, the incentives are aligned in such a manner as to hold down the current regime at all costs and pay patronage to the people who’re on your side. It’s all built on rent.

          We need to get rid of this attitude that we can change all of these places. As sad as it may be, in many of these places, there really isn’t a whole lot of hope. The current amount of environmental degradation, the fertility rates, and population growth aren’t sustainable in these regions. It’s only a matter of time until something really bad happens. If these places became democracies, they’d be corrupt as all hell.

        • @ Suvy

          “democratic rights of self-determination”

          Well, I tend to disagree but then again I am a Swiss citizen with a system of direct democracy that allows people to vote on individual laws.

          TPP is to a limited degree about geopolitics but to a higher degree a means to concentrate ever more power on the top floors of the large corporations and banks.

          It is foolish to expect politician to make intelligent decisions in any system, that is the reason that their power has to be limited which is achieved by holding them accountable (cancellation of the unjustified right of immunity) and/or a system of direct democracy.

          I agree with you that we should avoid of being too full of ourselves by thinking that we can solve all the problems of the world by ever increasing central planning and ever higher power concentration. Excessive power concentration creates its own centrifugal counterforce that leads to political and societal distortions with an increasing risk of accidents to happen.

          • I agree with the cancellation of unjustified right of immunity, if by that you mean the right to get rid of bad leaders. Having many bad leaders while having no way to constrain their decision making is a way to cause blow-ups.

            My main worry about direct democracy is crowd behavior. It’s not uncommon to see the people go behind a dictator and follow him, whether that be good or bad. I think it’s important for the elite to have a significant play in the determination of the result. I think it’s healthy to have the elites be the rulers. The only caveat is that class mobility is very important to make sure you don’t get elites that stay in power via rent extraction.

          • To put it succinctly, any government’s ability to rule comes from the just consent of the governed. However, that doesn’t mean direct democracy.

            Let me make my point clear because the wording of my last comment kinda muddled what I was tryna say. The most important aspect of democratic institutions isn’t the “will of the people” or the principle of equal representation, but the ability to remove bad leaders. This is why I prefer elites and I have strong sympathies towards Constitutional Monarchies, although I do not like the idea of a monarchy. I like republican empires and factional systems. I prefer systems that allow for the decentralization of scale that’re hierarchical.

      • I understand, but if one country (the US) is printing money and sell bonds to foreign buyers indefinitely without eroding the value of its currency, we end up with a non zero sum game, no?

        • Not really, because if other countries are artificially blowing up asset values and printing money against these values, gaining loans, lending and similar and can access the international markets to buy dollars, or of this process can structure savings and investment to drive growth, employment, further savings, asset values, and account surpluses, and go into international markets and buy dollars, then….

          DvD and others, including likely yourself will discuss how the dollars value since 1980, 1950, 1900, 1850 has collapsed……while forgetting that, essentially, all currencies are derivatives of the dollar, insofar as the dollar is the international reserve currency through which many countries issue trillions of dollars in debt in, bonds, 6 trillion over the post crisis period alone, ad infinitum.

          Thomas, you must move on from those old continental fantasies.

  7. Professor,

    Are there any other blogs you check regularly? Do you recommend a reading list to your students, and, more to the point, would you be willing to share such a reading list on this blog?

  8. Yes, quite a few. At some point I will put up a list.

  9. Prof. Pettis, and I am curious on your thoughts (and Temin&Vine) on how floating FX rates can either provide a channel to ameliorate these global imbalances or possibly create a different rebalancing scenario that history has provided.

    Historically, the fixing of gold to currency value gave a political release valve when debts or trade imbalances became too burdensome. The re-adjustment was an explicit acknowledgement of a crisis and necessary rebalancing in price levels. Ironically politicians often use the same “cultural stereotypes” that you demagogue to justify emergency actions ex-post.

    The world post Bretton Woods is very different, and neither Obama or Merkel or Tsprias or Iglesias can use the price of gold to release the pressure- Perhaps Xi has that lever to pull. Money printing (quantitative easing) is a less explicit form of politically changing the price level, but the FX markets are effectively referenced off the USD. If the global imbalances must re-adjust as you persuasively argue, then could the FX markets be the main channel for that re-adjustment, rather than some cleverly tailored Brady-bond, bail-in or outs, or SDR rescue package.

    • Floating exchange rates, it is thought, and theory exists to support, would lead to adjustments that would re-balance trade relations and lead reduce differences in interest rates (such that a global real interest rate would occur); leveling the playing field such that factor advantages would drive trade and investment flows in a global market.

      The safety valve you imagine for Gold, in a crisis, would, theoretically, and it is supposed, would be a moving self-adjusting mechanism under the invisible hand, moving due to knowledge, information, practice, reflection and intuition of the synthesis of very many market actors. Rather than the decided actions of those who intervene to establish a certain objective as in the case of the PBOC buying or selling dollars.

      Post Bretton Woods, insofar as it is, and has been for decades, in a world of moving currencies, and different currency regimes as refernced against the dollar.

      The system as we, mostly desire it, insofar as people desire globalization and industrialization of “backward” nations, will require another currency to evolve, with a large enough population backing it, that is consuming, and providing rationale to the world for industrialization and modernization, alongside the USD. I guess it could have been the EU under different policies and values, or China, similarly and under a transparent financial system rather than a ponzi system, but it doesn’t seem either, thus, trade tensions will rise, as real work on global integration, stymied for two decades, further retrenches, while most misread trends that would seem to support the alternate other occurrence.

  10. Thanks a lot for your post. I am learning a lot reading your entries. Reading this one, I was feeling even more frustated when I realise that countries are not only seen as ants/grasshoppers communities but commonly viewed as corporations. It is often said that countries must be competitive (and run current account surpluses). Policymakers often see their countries as a commercial brand. At least in Spain we are continuously alerted on how this and that affects negatively or positively the “Spain Brand”. Such obsession with competitivity is often translated as a need for lower salaries. Thus , countries should be ruled as corporations which doesn’t sound like a democracy. It is like we have learnt nothing from history.

  11. Many people think the federal reserve should not care about the US dollar strength or weakness in its interest rate deliberations.Since dollar strength should affect capital flow in the world, could you elaborate whether the fed can afford to limit its deliberation to US domestic concerns in a future blog post? Thank you.

  12. Great post again Professor Pettis. Thanks for sharing your detailed thoughts with all of us. In today’s Twitter / soundbite world it is refreshing to share idea and concepts.

    As a big fan of ‘systems’ and history, I find your posts almost always very intellectually stimulating and forcing me to re-think some sort of event. I always find it funny when people are so easily able to explain complex events, like GFC by saying, “it was obvious, US housing prices were TOO high” or “it was all subprime”. The real causes were multiple and interconnected.

    I think Ignacio brings up an important point about how today’s media/politicians and even leading economists equate their country with a household or a business. Clearly a business can’t print money, set interest rates or have their own currency. Perhaps once the world wakes up and realizes this, we will all be better off. Maybe the working ants will no longer aspire to shove their austerity onto the rest of the world.

    Oddly enough I think it is only a few ppl at the Fed who get this, along with PBoC. The US congress and Europe are way behind here.

    The end result though I think will be a new currency regime at some point, which may or may not help to balance all the global imbalances.

  13. So la Fontaine may have been right that the ant is not naturally inclined to lend to the grasshopper. Probably prefers to invest the savings domestically, if given the choice. Fascinating how profound wisdom might be contained in apparently simple stories from centuries ago.

  14. Could you comment on the impact demographics, low interest rate policies, and general fear that social security will not exist have on trade balances? And what higher interest rates and a commitment to make social security whole would have on resolving trade imbalances and global demand?

    Many fear that the current deflation outbreak will turn into a “vicious circle of deflation,” in which consumption is postponed and investment plans are curtailed in anticipation of lower prices. These behaviors contribute to a further drop in demand and additional reductions in prices. – John Mauldin

    Deflation seems to be more complex or there’s a step missing in its logic:

    The first part is correct “Consumption is postponed and investment plans curtailed” but is it

    1) in anticipation of lower prices
    2) in anticipation of job losses, uncertainty of how much (if any) social security I will receive, not saving enough for retirement, low expected return on fixed incomes

    there are very different explanations for consumer behavior here.

    One claims that future liabilities (expenses) will be lower if I wait, the other is based off expectations of future cash flow from my assets (in essence I’ve written down my social security assets and goodwill (the value of my skills/labor) and must increase savings, lower expenses to meet future spending).

  15. I have one question. Turkey has been running for a long time a current account deficit and now is facing financial stress because most private debt is denominated in US$ while the Turkish Lira is depreciating sharply. It seems another clear example of inverted balance sheet as you say. My question is: can the German CA surplus be “blamed” on Turkish deficit?

  16. I’m not convinced that North America will be affected by any of this. And I know that wasn’t your point Michael. But I still read people calling for the sky to fall. Ok, if you are in EM or Europe. But not if you are in NA.

    My admittedly “back of the envelope” calculation is that exports represent only 6% to the North American economy and imports 10%. I am purposely excluding intra-north american trade because I cannot see it being affected by EMs or Europe. Me going to the grocery store and paying a buck for an avocado from Mexican is not going to stop. And the 6% we do sell abroad is so techy and diversified. Inelastic.

    Most discussions seem to look at America’s relationship with the world ignoring NAFTA, a huge trading ecosphere. Once you look at a NA economy, the facts on the planet change.

    And this is important to EMs. Demand for imports will only increase. And with those products usually priced in USD, and with the USD going up, all the better.

    • biggestbrotherofthe mall

      There is an enormous impact on real estate in North America due to Chinese Capital flight. Property Values back at pre subprime levels which is essentially destabilizing. Chinese paying much more for property than locals do. Values set by global not local forces. At some point the real estate market in California, Vancouver, Sydney, will recalibrate somewhat and this may come together with the bursting of the stock market bubble brought by QE, the failure of rebalancing in China and collapse of emerging market currencies with unwinding of carry trades.

      And that is just the economy.

      • On real estate in North America, this is not 2005. The construction industry can supply housing to match demand. We cannot use the few exceptions like Palo Alto to generalize to all of North America. And I must say, your comment about an influx of Chinese capital is very ethnocentric. Capital has come into North America from all over the world for the past 400 years. Miami receives capital from all over Central and South America. Wealthy Mexican families live in Texas without fear of abduction. And New York, well, we all know about New York.

        Not all of the money coming into North America is in housing. This museum just open in Toronto, built with foreign money, not a local government project.

        And this is not new, The Smithsonian (1846) in Washington was built with foreign money as well.
        plus ça change, plus c’est la même chose

        • biggestbrotherofthe mall

          Sure foreign direct investment has been going on a long time. But never before has this many people regardless of “ethnicity” to use your expression, taken hundred of trillions of dollars out of a country and invested in residential real estate without the intention of living in it full time. This has the effect of disassociating the value of housing from local fundamentals such as the capacity of people who live to pay for a mortgage based on income. This is enormously destructive to local communities – turning them all into asset banks for gangster money a la London (not sure how you got the French letters in there!) So we have prices in London, San Francisco, Palo Alto, Sydney, Vancouver inflated by this once of capital flight, locals priced out of the market, ghost housing in the heart of once were thriving communities. How can this be a good thing? How many hundreds of millions of Chinese plan to buy out of China? How much money will this involve? How many communities will be turned into London? is this legal under Chinese law? Is breaking the law the new normal? When will this mass exodus stop? What does this mean for Chinese nationalism?

          Mass movements of ethnocentric people and capital have enormous consequences. Can we talk about this?

          • hundred trillion dollars……………………uhhh…………such an amount wouldn’t exist in the US, let alone made it external to be invested back in, so, I guess, if that is your fact supporting opinion, your opinion can be discounted immediately.

          • biggestbrotherofthe mall

            yup I meant billion. Thanks for the subedit.

        • biggestbrotherofthe mall

          I appreciate this is a blog about economics but given you raised “ethnocentric” ity – The more isolated any ethnicity has been the more ethnocentric we are. It is vital to teach the rebalancing of ethnocentricity along with the capital and current accounts .

          • Where would that be needed to occur….not in the multi-cultural developed world!………….. would you suppose?

  17. When you say that high inequality leads to underconsumption and underinvestment, does that mean high relative to foreign countries, high relative to earlier periods in the country’s history, or just high on an absolute scale?

  18. The real issue is the persistent large trade imbalances, which have caused and are causing significant economic problems in the US, Europe, and elsewhere. I am surprised that I have not seen any serious push to deal with these imbalances either among economist, politicians or policy makers. There is some agitation in congress to get serious about “currency manipulation” as part of fast track approval.
    Currency manipulation is only one of many contributors to these imbalances, but has been identified in many peoples mind as “the villain” that is causing the problem. Addressing “currency manipulation” is difficult at best and does not fully address the real problem. The following outlines some thoughts on addressing the real problem.
    A better approach is to handle the imbalances directly. Persistent trade/current account surpluses occur when a country is successful at exporting but then does not spend its export earnings. The difference represents excess savings of the country. The excess savings must then be exported to the deficit countries either as loans/debt, purchase of assets of the deficit countries, or (less frequently) as direct investment to develop new assets in the deficit countries. As Prof. Pettis has noted many times any policies that affect the net value of savings minus investment in a country indirectly affect the country’s current account surplus. Picking on currency alone does not consider the many other factors a country can “manipulate” to increase or decrease its savings net of investment and/or current account surplus. Rather than attempt to determine if a currency is undervalued or is being manipulated the more appropriate indicator is the current account balance; i.e. a significant current account surplus that persists (on average) over a long period of time (say 5 years or more) is a clear indicator that a country has a “trade issue.”
    What should this “trade issue” be called? A negative sounding label could be picked, for example: currency manipulator, trade manipulator, trade abuser, mercantilist, beggar they neighbor, money hoarder, miser, money lender, scheming money grubber, enslaver (of debtor countries), etc. Or, perhaps a more positive sounding label could be picked, such as: persistent surplus country, thrifty, financially prudent, or champion saver. For now, I will use the term “Champion Saver.”
    I suggest is that in the current legislation proposed in congress, and in existing law that requires the president to report on potential “currency manipulators” that the terminology be changed from currency manipulator/currency manipulation to “Champion Saver.” Then the president would periodically report to congress the list of Champion Saver countries. The determination should be pretty much automatic, i.e. unless there is a specific exemption a country would be labelled a Champion Saver if its average current account surplus exceeds a trigger value (say 1% of GDP averaged over the last 5 years). There might even be additional categories, for example >3% average surplus are called “Super Champion Savers,” and >0.5% average surplus are called Prospective Champion Savers. Exemptions would be limited and specific, for example: countries paying down a large net external debt; countries whose exports consist of primarily nonrenewable commodities (e.g. oil or minerals), countries that need to build up clearly inadequate reserves, and possibly countries that have been specifically granted a temporary exemption by an act of Congress.
    Actions taken when excessive savers are identified could be referred to as trade sanctions, e.g. tariffs, quotas, non-tariff barriers, domestic production preferences or subsidies. However, I prefer to call them “trade assistance,” that is actions to assist the excess savers in developing the wherewithal to spend their excess export earnings. Spending the excess export earnings internally would generally stimulate their domestic economy and increase employment and the standard of living of the average person. However, it is often opposed by powerful constituencies, so that providing some “trade assistance” to help overcome this resistance can be important. For example initial tariffs on manufactured goods of 10% and 20 % could be applied to imports from Champion Savers and Super Champion Savers respectively. These would be increased by 5% per year until reasonable trade balance is achieved. For Prospective Champion Savers a letter would be sent to congratulate them on their success in selling their exports, and to remind them that to maintain relatively open access to our markets they are expected to spend their export earnings. If they have difficulty spending the money and achieve the Champion Saver level we will start providing them with “trade assistance” to help in overcoming those difficulties.

    • is it ok if one country wants to run a current ac surplus as long as the surplus is invested productively in deficit countries? the recent history of Germany and Southern Europe maybe prejudices the answer to that question, but it’s difficult to argue that it’s always wrong. as a starting point what could be sanctioned is accumulating foreign currency reserves or buying foreign gov debt above a certain percentage of domestic gdp – there are limits to how much ‘insurance’ a country can justifiably claim it needs

      • Generically, but if we want to be real about this, surpluses have to exist due to a special position (Saudi Arabia) where many countries in Asia, Europe, LatAm require their abundant resources, or agreed as part of a program of industrialization that will not lead to excessive burdens (as in the case of China, Germany, and others) and this is because the notions of invested productively in deficit countries fails to underscore that these surpluses and deficits can be and often become structural and the productivity of investments is a time relevant notions; investments unproductive of thirty years, may be productive over 5 years, and perhaps vie versa in some cases.

        As to justifiably claim, can any be claimed as such, if, then how does one determine justifiable and over what basis, and further then how determined (bilateral in a multi-lateral global system?) the notions fails of its own logic. a country claim, claim on whom, how, why, what basis?

  19. Prof. Pettis,

    Thank you for the informative post as always. There are a few things that are still unclear to me. For one, why are virtually all of the oil producing countries surplus countries? The reasons you list for countries to run a surplus (e.g. income inequality) don’t seem to fully explain this correlation. Unless oil production somehow leads to inequality.

    Yanis Varoufakis, who seems to share a similar focus on trade imbalances, suggests that differences in market power has something to do with the imbalances:

    This sounds plausible. Oligopolistic industries in Germany would have incentives to restrict production, causing domestic savings to exceed investment. This could also explain why oil nations run surpluses since oil production is controlled in a very oligopolistic manner. But then why is Germany and the US at opposite extremes? Why wouldn’t the oligopolistic nature of US industry cause a surplus? Is it because the US has been able to maintain a wider productivity-wage gap, enticing inflows of foreign investment into the country?

    • Low wage share of the people relative to GDP, which is composed of large reserves, production and sales of a single (or three) natural resource, that is desired, and sold in such quantities that the incomes generated are often not exhausted and thus are spent due to the unique problems of such economies (volatility in global commodity prices, direct conversion from USD, Yen, Euro to local currencies, under global market dynamics would lead to inflations, deflations, constant financial crisis in these economies.

      So in a way, the low wage share was mentioned by Michael, and can be considered an income inequality, because, actually there is great wealth, but even greater disparities than I suspect you imagine, if nationalization initiatives seek to ensure that benefits are spread widely.

      • A low wage to GDP ratio doesn’t say anything about trade imbalances in itself. Sure, saving will be higher relative to consumption. But investment will also be higher relative to consumption. To get a trade surplus, saving needs to exceed investment. Prof. Pettis’s post says that lower consumption discourages businesses from expanding production. But Saudi Arabia’s economy revolves around exporting oil. Why then should the consumption rate of the Saudi population affect the amount of investment made in oil production? If anything, the consumption rate of the nations importing the oil should be decisive.

        • Saving Will be higher, and investment may be higher and the employment of sovereign wealth funds to act as a smoothing function and to limit any dutch disease effects (resource curses) where external monies earned (oil priced in dollars) are invested globally (in UST or in Malls throughout the world, in D&G clothing franchises in Buenos Aries, national electricity systems in the Republic of Georgia, Water Companies in Africa, Farms in Africa), this is what exists for a large important commodity provider. But of course, important surplus countries, China and Germany, Singapore, etc….aren’t in the Saudi or Qatari position. Yet, anecdotally, and of course, there is great income inequality in these places, between Princes and normal citizens, even if normal citizens can not be considered poor.

          So it might be a bit disingenuous to use the GCC countries in this, whereas, more properly, for normally countries who wouldn’t suffer from Dutch disease of the export of important commodities, the conditions of China, Germany, Japan (historically), Hong Kong, Singapore, Thailand, Taiwan, might be more to the point of what Michael is discussing.

          Jonathon, increasing income inequality is present in the world, post Arab Spring, among Gulf Emirates, I would be willing to bet that income inequality retrenched, with all the GCC spending, but that the diveregences are substantial.

    • I won’t pretend to understand csteven’s reply, but increasing inequality clearly is common in oil producing countries, especially if production is controlled by the government and therefore decreases household consumption as a share of gdp. I’m tempted to dismiss varoufakis as a charlatan despite his academic credentials, but what happened to household consumption as a share of gdp in Germany compared to the usa between introduction of the euro and 2007? if Germany saw a relative decline I guess that’s your answer

      • Well, here’s a source for household consumption as a percentage of GDP:

        It shows German consumption falling from 56.9% in 1999 to 55.1% in 2007, while consumption in the US rose from 64.7% to 67.1%. Consumption in China and Saudi Arabia dropped more dramatically. However, the consumption share in Spain fell from 59.7% to 57% and in Greece from 66.8% to 65.9%. Consumption in the UK also declined by a percentage point. So I don’t think it tells the whole story.

        I still doubt that the falling consumption share in the oil producers is what is driving the surpluses. It could be that OPEC’s policies of restricting oil production promote a current account surplus by pushing investment below savings and diminish the consumption share of GDP by boosting the return on capital. Furthermore, it appears that OPEC’s recent decision to maintain high output and low oil prices has caused Saudi Arabia’s surplus to drop significantly:

        • What were the consumption shares of China and Saudi Arabia, for rather then a short term rise fall, a longer term experience is likely more toward the correlation, perhaps causation. It is telling that you listed the others, but not these. Low wage share, thus consumption, enables, but again the Cases are special cases in this, due to the need for oil in many people’s industrialization drives, so….again, perhaps, telling, but glaringly obvious…..small pops large primary sources of a needed global resource.

  20. Hi prof! hi everybody!

    Your theory is pretty much self contained but there are still some dark corners. Like central bank you oftenly complained about PBOC buying spree of american bonds, but you never acknowledge us what did you expect from a normal behavior of a central bank(low inflation like in EU?).
    Also i would like your opinion on financial imbalance. Because one biggest banking mantra is borrow short lend long. And this basically building a inverted balance sheet, like faking it’s saving rates. And to me a financial system to be healthy following your advice, stock of capital would search long and probably low interest rate. Money create by banks should looking for higher and shorter returns.
    On inequality do you think at some point get rid of rich can do good to growth? Because it means a lot for policy makes specially in China. To be a bit controversial, If you take WW2 Jewish genocide can be seen as a part of a rebalancing process.

    Prof Do you have any book advice to learn how central bank works in details?

    • Can take if you accept the propaganda that was used to justify the genocide in the first place.

      • I think on once prof stated that either Syriza or Gold Dawn would save Greece. And Gold Dawn is your average NAZI party that you can find pretty much everywhere in eastern EU. You should ask the prof himself.

        • I am not sure that I have ever heard, or could hear, or imagine the professor to ever isolate a construction around a notion like save, rather these groups would likely be the groups to see a Grexit, where a Grexit might be the least painful root, several years ago, and perhaps now, for the Greek people, but “save”, I am quite sure he doesn’t even think in such terms when his brilliance is found within the relativism and balance with which he projects his conjectures, considers his notions, a certain balance where fictions of save and heroism and other similar concepts, tend to be far from his review (I believe) (and frankly in a world of such poor analysis that is refreshing of Michael, and part of the problem of everyone else; moralizing, fictionalizing above reality {trivializing reality, for the sake of a pop-cultural value} )

          • Actually, Varoufakis’ solutions would work like a charm. Greece doesn’t have to leave the Euro, but if I was a dictator/king of Greece I would’ve left the Euro 6-7 years ago. If I was a dictator/king of Greece now, I’d quit.

          • Obviously i’m not going to talking MORAL here.
            I think it was Venizi Karim who ask he prof what consequence slavery/colonization process could have on balance sheet. And the prof basically said that as they were poor people it doesn’t change much to balance sheet.
            But it remains to be proven that by example killing Greek oligarchs would bring relief to Greece. Because there are foreign owner of the debt but there are still Greek people/banks who own this debt.

  21. Could someone please explain this:

    “Consumption + savings = Consumption + investment”

    This is the same as:
    savings = investment

    But then he writes:
    “If the ants save more than they invest”

    Which is impossible according to this equation as the ants cannot save more then they invest.

    • In the absence of a current or capital account, BoP, surplus or deficit, it must.

      Which is impossible, except that Michael is describing there to be ants in one country with a particular GDP, and grasshoppers in another country, with another GDP.

    • in a closed economy savings must equal investment. in an open economy you can import or export capital, hence the witticism above about the three prophets (if Jesus saves more than Moses invests, the economic system jesus and Moses belong to must export the surplus to Mohamed’s economic system)

    • saving = investment in a one country economy but in a two countries economy some lend to the other.

    • Savings = Investment in a closed economy.

      Germany is not a closed economy, i.e. it is part of the global economy network. Therefore, Germany could save and, rather than investing domestically, export its savings to Greece, who will then either invest it (increasing global I to = global S) or else consume it (reducing global S to = global I).

    • Anyone? Prof.?

    • Consumption + Savings = Consumption + Investment + retained savings

      is possibly what the equation becomes when savings is greater than investment. If it is not a closed system the retained savings become savings invested abroad and therefore become part of the investment identity. So you can save more than you invest within the national/system identity only if you assume a non-closed system.

      If the system is closed and consumption and savings must be equal to consumption and investment then if you specify a time period in which the investment from savings must occur and it must all happen all within that same time period then if Savings are greater than investment, savings must be used for consumption. So consumption becomes Consumption 1 (+ savings) = Consumption 2 + Investment.

      And Consumption 1 can be less than Consumption 2.

      • I should have put ‘ So you can save more than you invest and while maintaining a constant consumption amount only if you assume a non-closed system.’

  22. I find this whole business about causality and equational identities to be fascinating. ‘course, I know next to nothing about economics. but if you consider a physics ‘identity’ like F = ma, you could in principle read it as saying that force is what results when a certain mass is accelerated a certain amount. a ball of mass m that suddenly jumps off your hand with acceleration ‘a’ causes you to throw it with force F. we usually don’t read it this way when throwing the ball but we certainly do when someone throws a ball at us. Of course, the accounting identities Prof. Pettis works with are much more like Kirkhoff’s law, that says that sum of currents flowing into a junction equal the sum of currents flowing out. But still, there are lots of physical equations where causality is sort of implied by our intuition of things, but I think that one could get a perfectly consistent explanation of physical reality while assigning causality backwards in time, for example. Future physical outcomes determine earlier events and the relationship is given by the equations. I’m pretty sure this works. I wonder if Prof. Pettis has any comment, as I know he is familiar with physics. The thing it leaves me wondering is this: is it possible that if one digs down beneath the accounting identities to the events behind them, one really will find a causality (or a bunch of contending forces with a net outcome) and therefore it really might not sense to say that the argument for causality flowing in one direction is just as plausible as the argument for causality flowing in the other direction?

    • As far I know causality is kinda gone in quantum physics. So you can really expect to have causality in economics. Plus probability make more sense because you don’t really know who will succeed or not and you better put a probability on this than a fake causality of success.

      What it remain to be made in economics is a really theoretical background to really understand when you should use classical theory or other. And this would solve the problem prof often expose “when should i use my model?”.

    • I agree that, especially when following Prof. Pettis’ explanations, the notions of causality become blurred.

      However, there are other attributes that can indicate the causality of flows. For example, we can address the causality of German savings flowing into peripheral Europe, as Prof. Pettis did in a previous post. Did Greek demand for funds cause German savings to increase, or did Germanic supply of savings cause Greek consumption and malinvestment to increase? Well, what did interest rates and borrowing conditions look like at the time, relative to historical norms and conditions in other parts of the world? If interest rates were low and borrowing conditions such that Greeks could easily acquire debt, that would indicate funds were pushed into Greece rather than pulled by Greece. If interest rates were high and borrowing conditions stringent, that would suggest that the funds were pulled by demand.

      • I wasn’t so much saying that the notion of causality is blurred in Prof. Pettis’ writings. What I meant was that it is the very nature of equalities that they don’t tell you about causality. When there is a short circuit and consequent fire, is the cause the too-low resistance at the short itself, or is the cause the voltage being applied by a battery or other source of power? The equation V = IR doesn’t tell you; it just describes the relationship among the current, voltage and resistance. So if you say that too much savings over here ‘results in’ too much consumption over there, you are attributing a causality that doesn’t come from the equations; the equations just say that everything nets to zero, but that’s just an artifact of the structure of the equations; they have + and – signs on opposite sides of borders, and everything nets out because of that. If you think that there must be real human forces and actions at work underneath all that, with some forces as primary drivers and other actions as more passive consequences, then you can begin to assign causality based on your understanding of those forces. But I don’t think that any of that follows from the equations per se.

        • I think you are getting too far, if you get that in a one country economy it should be equal . So the problem is why specific countries do run large surplus for long time? From a market theory point of view nobody should always win or always loose. And prof explain how some countries manipulate their economy to always win.

        • Is it causality that is the most important thing at present, or recognition of the function, and all the associated impacts, inter-relations, of the elements at play in the system if is accepted, as in your example, “fire”, that something is awry. So, then, moving back to a simple analysis, for whatever the culprits, we all agree that something is awry. Further, most, that the factors that Michael sites are at the center, are related, to the problems we are concerned with, that Michael discusses. After all, we are all here, and whether w do or do not understand each other at times, we mostly participate civilly and discuss issues we think are at the heart of what Michael discusses, or related, although, more or less we may agree or disagree as to what those are, what is important or not.

          But, if the Fed does this, and the PBOC does that, the ECB, and further, if Michael uses his model to show why Germany, and Europe will see a result of X because of the recent decision to A, or China Y of decision B, an d further and so forth…I might, personally to choose to lean in the favor of Michaels analysis and suspicions of correlation or toward causality, at least necessity, as he often describes, if only for the near decade (more) of correct modeling/hypothesizing of MP since the days of FTM. Of course, as BS of FTM and others were quick to note, it is very difficult to extract exactly what is going on in these global flows. Broadly, Michales perspective, to me, as come the closest toward describing, the greatest part of it, in relation to most discussNts.

          DvD in his response to this blog post, is at his most impressive as well, if his Libertarian credentials do shine through.

          • One problem of looking at everything purely causally is the problem of the narrative fallacy. The real world is complex, which means there’s lots of reasons why things happen. What it also means is that each reason accounts for a differing portion of the variation of underlying state shifts. Usually, what we see are winner-take-all effects in the different reasons for the shifts they account that usually results in 3-5 factors accounting for anywhere in between 60-90% of the variation.

            The advantage of the view of balancing identities isn’t that it gives us a causal direction, but it shows us how different events must necessarily link because the identities must hold at all times. Understanding the linkages and feedbacks is far more important than knowing all of the possible reasons for why X occurred and writing a fancy narrative for why this or that happened.

            This brings me to my next point, narratives are–for a realistic, useful, and practical view of the world–usually completely useless. Economists or historians often portray a highly complex event (like say, the fall of Rome or the fall of Napoleonic France) A causing B by some fancy narrative that sounds cool. The typical example of an idiot who did things of this sort was Karl Marx. It then allows some kid to advocate for violence on the largest scale to do “justice” because he “understands” everything based on some theory that must be true because it fits his narrative. Alas, we have the story of Che Guevara and many others. Unfortunately, these people lack both logical rigor and wisdom.

      • At the very least, having the availability and competition of German banks, or of Greek banks able to avail themselves of German funds, coupled to local funds, drove down interest rates in Greece, and increased the availability of funds for use in the Greek economy; being a cause, and causing….of course. Similar to global GDP growth, and the running up of global savings rates, were a primary cause of the GFC in 2008; regardsless if it took Lehmans not being supported to start the global chorus of financial difficulties still felt to this day and no more simply related to Lehmans than to the Yen carry trade, East Asian manufactured surpluses and investment booms, global commodity spikes and resultant capital flows, etc and ad infinitum, it is, well glaringly obvious that all these large movements and alterations led to the blow-up. One can say profligacy on the part of American consumer, Japanese lender, Kenyan investor and borrower, etc, but of course it is all these factors of the pace of global growth in the 2000’s.

  23. The accounting identities that all national production generates an income either for labor (wage) or for capital (interest, rent, profit) which is either consumed or saved hence invested either at home or abroad which gives rise to a new round of production, while obviously circular, are nevertheless powerful in their simplicity in that they reveal that imbalances are fundamentally distortions in income distribution between production side and consumption side, between labor and capital. These distortions are allowed to develop in the first place by the credit system which creates purchasing power ex-nihilo to finance them so that they can perpetuate instead of correct in a self-contained system where the credit system would simply intermediate real savings. Economic policy is nothing more than the manipulation of the credit system to prevent the correction of these distortions.

    From the perspective of a particular country, these distortions between production and consumption can indeed be of internal or external origin.

  24. As an example of an imbalance of internal origin, take for instance the US situation between 1965 and 1971, leading to the Nixon shock:

    In the mid-1960’s, tight labor market conditions combined with still relatively strong unions from the New Deal and the welfare programs of the Great Society were pushing up labor share of income. The result was real wage growing faster than productivity gains, meaning companies profit share going down. Companies had to to ramp up debt to maintain investments they were unable to self-finance. While total-debt-to-GDP was stable during that period, business-debt-to-GDP was rising fast. This was facilitated by the Fed letting real short term rates drop from 3% in 1965 to 1% in 1968, well below real economic growth of 5% over the period. This resulted in fast money creation and rising inflation (given low corporate profitability and low real interest rates, newly created money was going into consumption back then, actually allowing companies to raise prices to bridge the gap left by wage growth in excess of productivity gains, if only temporarily because strong labor bargaining power was ensuring that wage were de facto indexed on inflation, thus perpetuating the imbalance and so requiring even more money creation in the next period, and so on so forth). Income inequality was the lowest since 1913. A predecessor to Thomas Piketty could have written “Labor in the 20th century” and explained that g > r. A predecessor to Michael Pettis could have written an article on “Economic consequences of income equality”. Because the exchange rate exchange couldn’t depreciate (the $ was fixed at $35 per once of gold), the competitiveness of domestic US companies was eroding relative to that of foreign companies with lower labor costs at the prevailing exchange rates. This pushed the US trade balance into deficit, even though the level of integration into world trade was very low (gross trade, ie. exports + imports < 10% GDP). The internal imbalance was morphing into an external imbalance: external $ balances were accumulating as settlement of the US trade deficit and were becoming bigger than the stock of US gold into which they were convertible. After it tried in vain to convince the US to reform the international monetary system it viewed as potentially dangerously unbalanced, France began asking for conversion of some of these $ balances into gold in 1965. Switzerland did the same a few years later. The situation was made worse by the costs of the Vietnam war. Finally, the time came when business debt was too high relative to business earnings, forcing companies to cut back investments and lay off employees. Real economic growth declined from 6.5% in 1966 to 0% in 1970. That was the balancing mechanism of the economy: with unemployment rising, the bargaining power of labor would decrease and the imbalance in the value added split would be corrected. Unemployment went up from 3.5% end 1969 to 6.1% end 1970. At that point, however, the government stepped in to "stimulate the economy" and counter the slowdown, ie. avoid the rebalancing. Perhaps answering positively the question by Thomas Rippel above (can an imbalance be rectified somehow by printing money?), the central bank cut interest rates from 9% in February 1970 to 3.7% in February 1971, turning them negative in real terms. By doing so, the Fed simply perpetuated the imbalance, for negative real interest rates enabled the supply-side to carry the accumulated debt load and to keep financing both investments and wage growth above productivity gains despite weak profits. Hence, to stay "effective", such policy necessitated ever accelerating money creation, which became incompatible with the $ being convertible into gold. And so, in August 1971, Nixon unilaterally canceled the convertibility, arguably to protect the $ against "foreign price-gougers", but in reality to resolve internal imbalances that were prevented from correcting by misguided domestic economic policy. Nixon unleashed inflation never seen during peace time, which continued to paper over the internal imbalance: real wage kept growing faster than productivity gains until 1978. Nixon exported the US internal imbalances to the rest of the world in what was in effect a gigantic bail-out of US living standards by the international community, a Marshall plan in reverse. Since then, the international trade and monetary system is no longer a cooperative one but a competitive one with successive attempts to claim back some of the wealth transfer from 1971, most notably from OPEC, Germany, Japan and more recently China. Whether Cjared likes it or not, the US is right at the epicenter of all these intertwined and conflicting global imbalances, and will remain in this position as long as it insists on keeping the international role of the $. Which brings us to the issue of external imbalances.

    • The r>g argument is wrong. It assumes no stochasticity and assumes away the risk of ruin. In other words, r>g is a necessity most of the time. Saying r=g should be the standard would wipe out capital over any extended period of time simply from the risk of ruin. What this implies is that r=/=E[r] outside of crises as well due to stochasticity and tail effects.

      Basically, all of the arguments Piketty makes are completely foolish (as are arguments made by most economists). Economic inequality is certainly a problem, but class mobility is a MUCH LARGER issue than class inequality. Wealth is created according to power laws (makes sense logically and is always the case empirically) and when we measure any parameter of power law distributions, we always overestimate the tail exponent, or equivalently, underestimate tail effects.

      One more note about the effects of fat tails is that fat tails DO NOT mean that tail events happen more often. What fat tails imply are that tail events are more consequential when they happen. Basically, wealth is accumulated in winner take all effects. The most important part is to make sure you’re having as many trials as possible to find the winners, which is where most of the variation is located in. This is mobility is of much more importance than inequality.

      Economists really shouldn’t be writing or talking about things they don’t fully understand and they should always try to understand every bit of the assumptions they make. Otherwise, it leads to egregious and horrific mistakes. Europe needs to work on class mobility before working on inequality. In the US, there’s plenty of mobility at the top, so here inequality is a problem, but productive investment opportunities exist here, which means those should take priority over inequality as well.

  25. As an example of an imbalance of external origin, take for instance the US situation since1980, leading to the Great Recession of 2008-2009:

    Michael Pettis has repeatedly described how Japan and Germany from around 1980 and then China from the mid-1990’s and more so from joining the WTO in 2001 have pursued domestic policies aimed at reducing labor share of income, resulting in high savings that have exceeded the investment needs of the domestic economy and have thus been exported, such excess capital exports corresponding to their current account surpluses. The flip side has been a rising US current account deficit within the context of rising integration into world trade (gross trade > 30% of GDP in 2008). To avoid rising unemployment, labor costs have started to grow more slowly than productivity gains, and this decoupling has accelerated after 2000. This has reduced labor share of income, thus increasing companies profit share. The external imbalance morphed into an internal imbalance. Households have had to ramp up debt to maintain consumption they could no longer finance out of current income. Household debt-to-GDP has been rising very fast since 1984. This has been facilitated by the Fed letting real interest rates go to 0% in 1992-1993 and negative in 2002-2005. This has resulted in fast money creation and rising asset price inflation (given rising corporate profitability and low real interest rates, newly created money has been going alternatively into equities in 1994-2000 and since 2009 and into residential real estate in 2000-2006, allowing households to borrow against rising asset values to bridge the gap left by wage growth below productivity gains, if only temporarily because weak labor bargaining power was ensuring that wage growth was inadequate to service debt, thus perpetuating the imbalance and so requiring even more money creation in the next period, and so on so forth). Greenspan unleashed a debt build up never seen during peace time. Finally the time came when household debt was too high relative to disposable income, forcing households to cut back on residential investments and consumption in 2006. That was the balancing mechanism of the economy: with imports declining, the imbalance would be corrected, especially if China had the symmetrical rebalancing of declining investment and rising consumption share. At that point, however, the US government stepped in to “stimulate the economy” and counter the slowdown, ie. avoid the rebalancing. The Chinese government did the same on its side, launching a massive investment program. Perhaps answering positively the question by Thomas Rippel above (can an imbalance be rectified somehow by printing money?), the Fed cut interest rates from 5% in summer 2007 to 0% by the end of 2008 and implemented QE to maintain interest rates negative in real terms until early 2012. By doing so, the Fed simply perpetuated the imbalance, for negative real interest rates enabled the demand-side to carry the accumulated debt load and to keep financing consumption despite wage growth below productivity gains, ie. despite continuously falling labor share of income until early 2014. On its side, China central bank was still able to let commercial banks create money and simply provided the fuel by keeping real interest rates negative also until 2012, thus lighting the credit expansion fireworks that funded massive increases in fixed assets, which perpetuated the excess savings imbalance. Income and wealth inequality soared even further than pre-crisis, reaching the previous peak of 1929 in the US. Thomas Piketty wrote “Capital in the 21th century” and explained that r > g. Michael Pettis wrote a great article on “Economic consequences of income inequality”.

  26. Through these two examples of internal and external imbalance, we see that “economic policy” is nothing more than preventing the correction of imbalances by manipulating the credit system so as to create enough purchasing power ex-nihilo to finance and perpetuate them.

    Domestic economic policies preventing the correction of internal imbalances in the non-integrated world of the 1960’s was one thing. The clash of multiple and mutually incompatible domestic economic policies deliberately favoring internal imbalances for the explicit purpose of exporting them in the globalized world since the 1970’s is a different game altogether. Internal and external imbalances are now inextricably intertwined in a Gordian knot that is increasingly difficult to unravel peacefully. That’s the result of several decades of “economic policy” that have consistently prevented the correction of imbalances and have instead capitalized them as deferred costs (debt) in the balance sheets of an increasing number of parties. The result is the “balloon economy” in which we currently live: balance sheets have been inflated by ever growing injection of newly created money corresponding to no real production whatsoever. Asset values are thus totally out of line with real economic flows ultimately backing them up. Not surprisingly, policymakers responsible for this headlong flight are now unsure how to proceed to gradually deflate the stretched balloon they have created without precipitating a disastrous economic collapse. Their confusion is total. So they go on with the headlong flight: create exponentially more money out of mere accounting entries, always more, more, more in a race they can’t win but can’t afford to lose. It is a leaderless economy, indeed.

  27. It is perplexing to see that the US official position has consistently been on the wrong side on these issue:
    – After WWI, at the 1922 Genoa conference, the US refused to revalue gold from its pre-WWI value despite the general price level having doubled because of the war. This mistake played a major part in the easy monetary policy and multiplication of paper claims post WWI to compensate for the resulting gold “shortage”, with the resulting asset boom in the US when paper money fled Europe in the late 1920’s due to rising reparation tensions.
    – At the end of WWII, at Bretton Woods, the US blocked Keynes proposal for a balanced international trade and monetary system and instead reinstated the $-gold exchange standard that had collapsed in the early 1930’s, remaking en passant the exact same mistake of not revaluing gold from its pre-WWII level despite the general price level having doubled because of the war. The causes of the Great Depression had not been understood and the same mistakes were made.
    – When the flawed Bretton Woods system effectively became imbalanced in the mid-1960’s largely because of internal US imbalances exacerbated by the Vietnam war, instead of redesigning a better system in an orderly and cooperative manner, the US unilaterally reneged its obligations and devalued in 1971, thus exporting its internal imbalances abroad and starting the current era of uncooperative and conflictual international monetary system.
    – Since then, the US has been pushing for trade globalization without any consideration whatsoever for an appropriate exchange rate framework to avoid the development of large and persistent current account imbalances. Unsurprisingly, current account imbalances have mushroomed, notwithstanding various ad-hoc currency agreements and countless G7 meetings along the way. The US has also pushed for financial deregulation, which has facilitated the mushrooming of ever more paper assets to plug the ever growing gap left by flourishing imbalances. The result has been the 2008-2009 recession. Which has prompted even more of the same policies that had created it in the first place.
    One can only be amazed at such damaging stubbornness in the face of nearly one century of accumulated evidence.

  28. At this critical juncture, the Gordian knot of globally intertwined internal and external imbalances is a nearly inextricable mess. It can only be possibly unraveled through carefully synchronized policies, each party taking gradual steps to correct its own imbalances while all the others do the same in a coordinated manner. The key is that the costs of these adjustments need to be perceived as being shared fairly and the benefits need to be clearly seen so as to provide an incentive for cooperation. Because of the time lost by policymakers who have ostensibly refused to take on board the lessons of repeated historical and current experiences, it is now an extremely narrow path. In light of the complete failure of the G20 to even begin to formulate such a roadmap, it is worth reconsidering and updating a few old ideas:

    – The credit system in its current set-up is incompatible with the proper functioning of the free market economy and must be reformed. By creating purchasing power ex-nihilo by mere accounting entries, the credit system finances imbalances and allow them to develop and persist. It thus disables the self-correcting properties the system would possess if the credit system was simply intermediating real savings. It is therefore worth revisiting plans (by the Chicago school and Fisher in the 1930’s for instance) for a full reserve money system whereby all cash balances (deposits) are backed by Government-issued base money and all deposit banks are not lending but simply processing payments and keeping accounts on behalf of clients. Term savings are clearly separated from cash balances and are intermediated by lending institutions and asset managers. These institutions are not able to create money and are simply intermediating real savings into debt financing on a matched duration basis so as to be always liquid. Credit risk is borne by savers, not by the institutions, exactly as is the case for mutual funds. These institutions also offer equity investments to interested savers. Of course, the institutions with the best track record will tend to attract a greater amount of savings at the expense of the institutions with a mediocre track record. Of course, savers will always be able to adapt their preferences as these debt and equity instruments will be negotiable at market prices, market risk being borne by savers. In this money and credit system, money can only be created by the Government, meaning strict constraints must be placed on its issuance to avoid abuse for political purposes. A simple solution is have money supply grow at a steady pace consistent with demographic and productivity growth and perhaps 1% to 2% inflation to facilitate adjustments given nominal rigidities. For most countries, money supply should grow at a constant +3% to +5% annual pace on a passive basis. In this money and credit system, complicated banking regulation is no longer necessary since the system is always liquid and solvent by design. Current banking regulation can be entirely discarded. Once the transition to this new money and credit system entirely made, central banks are also no longer necessary as the on-going matching of real savings and real investment needs along the maturity curve will always adjust interest rates to clearing levels across all terms. Historically, the emergence of central banks was a recognition of the defects of the fractional reserve money and credit system based on short term funding lent on long term basis. This inherently illiquid and unstable system was making the economy very volatile due to the erratic creation or destruction of money. A long and consistent experience has shown that central banks have not solved this congenital problem. They have simply dampened the short term local volatility at the cost of substantially increasing the long term systemic volatility. In the proposed system, central banks can and should be discarded.

    – Balance of payments must stay close to equilibrium. Cross exchange rates must therefore be fixed at levels consistent with equilibrium of cross trade balances, with only occasional adjustments based on consensual agreements of participating members. The reform of the domestic credit systems discussed above will greatly participate to the fact that adjustments to external value of money will indeed remain very occasional once the level equilibrating cross trade balances has been found. Equilibrium of cross trade balances is a necessary condition for international trade to be mutually beneficial, for goods are exchanged against goods based on real comparative advantages and not against credit due to FX arbitrage as currently. In this system, the international unit of account by reference to which cross exchange rates are set must of course not be the domestic currency of a participating country but a neutral supranational unit of account whose sole purposes is clearing international trade and establishing current account balances. It is therefore worth revisiting Keynes Bancor plan. For cross balance of payments to remain balanced, it is also necessary to remove tax havens so as to relocate the tax base where economic activity is really taking place. For that purpose, goods and services whose invoicing go through a tax haven at any point throughout the entire value chain will be excluded from the scope of international free trade.

    This dual reform of domestic money and credit systems and of the international trade and monetary system is the best – if slim – chance we have to gradually and peacefully deflate the current asset balloon without precipitating a major economic bust. In other words, the leaderless economy urgently needs exceptional leaders.

    • Good summary of DvD’s basic point here;

      But clearly both can be simultaneously true. In 2008-9 China provided a successful $4 trillion example. But bank money creation is not the only way governments can stimulate an economy. A recent variation is the lowering of bank reserve requirements causing 3 month interest rates to fall from 5% to 3% (now rising again – that’s how supply/demand works), while stimulating a government dominated stock market boom. As with bank created credit, both real hard earned savings and ex-nihilo margin investments fuel the boom. Meanwhile, rich Chinese have become the largest foreign buyers of houses in the US with average prices over $800,000.

  29. Hey Michael, this is not directly related to your article, but I am reading about how Chinese corporate leverage ratios are not that bad compared to other countries. I am wondering if corporate debt leverage ratios are comparable across economies or if different economies support different levels of corporate debt.

    • I think prof already talked about this problem in past entries. When you look at sustainable debt you looking at asset. Prof tell you that they way Chinese assets are valued is wrong because bad debt/asset are still there. So lot of people claim to have asset but these are simply fake or should be downgraded if you taking in account bubbles.
      One example is fraud with if i remember a locally owned mill gone bankrupt because the maid multiple mortgage on the same thing. And the other would be people who get mortgage on the value of their house but when market goes down they can’t pay.

  30. Biophysical economics has an attraction for the amateur. It would seem to imply that there is no actual global net savings, in the traditional sense of warehousing grain during the fat years. The quality rather than the quantity of both savings and investment is significant. Virtual savings, for example anything that pretends to compound interest, are for virtual worlds.
    Per capita stocks of real assets are diminishing, fish, water, soil and fuels. China has little savings just vicarious consumption by others. It is more about allocation of the losses. China seems more aware of this problem than the U.S. They do look for real assets. If the social security lock box held a few billion bushels of wheat we would be more aware of the inflation threat.
    Not that the Short Hand Abstractions are meaningless (accounting identities) but somewhere in the background they need to be translated into real biophysics. Both China Inc and USA Inc operate at massive annual losses when environmental contributions are removed.

  31. Very minor quibble: the title of Temin (and Voth)’s 2013 book is “Prometheus SHACKLED” not “Unshackled”.

  32. > three forms of dark matter in particular that countries like the US may be exporting

    it seems to me that the accounting system is slowly adapting, recognising invisibles/intangibles so may provide an “escape valve” over the pure trade in goods and services. For example a lot of book value of social media companies like Facebook is in the number of unique users and their activity trails. So the savings may be increasing if the “dark matter” is also increasing. Now extending the logic, that means there are unrecognised environmental and societal capital which previously was valued at zero, but is now perceived to have an monetary and thus economic value which can only be extracted by increasing technology R&D. For example radio spectrum rights, we breath the same atmosphere as last century but only this century can a concrete $$$ be placed on the EM spectrum. Thus improved knowledge creates more property rights which is reflected in financial capital which is treated as “investment”.

    I wonder if one can systematically catalog more forms of “invisibles” apart from know-how, insurance/guarantees & liquidity (as mentioned in the book), whether this would alter the perception of global balance sheets.

  33. Hi Michael, huge fan of your work. I agree with your emphasis of the need for equal if not more focus on the capital account versus the current account.

    I remain, alas, confused. Is there an empirical market inconsistency with the assumption that causality generally runs from capital account to current account? Current account surpluses typically drive appreciation of the domestic currency. But if the dynamic starts with the capital account, shouldn’t domestic demand for foreign assets drive the foreign currency higher?

    I’m left pondering various possible explanations for the contrary result we observe. One might be sloppy intermediation of fx transactions between current account trading parties and sophisticated intermediation between capital account trading parties. If so, perhaps it would reverse as globalization matures. Another could be more inertia in bilateral current account relationships versus capital account relationships.

    Or am I mistaken about the inconsistency in the first place?

    Thank you for your posts. They are wonderful. Also you have inspired me to dust off my copy of Chernow’s Alexander Hamilton and finally read it. And to see the Broadway musical.

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