China’s rebalancing timetable

We often read in the press rather alarming stories about the rise of an ugly and belligerent nationalism in China, buy cialis but while these stories are certainly very real, sovaldi after the November 13 bombings in Paris I was struck by a very different kind of Chinese behavior. A lot of young people that I know in Beijing – high school and college students, store young professionals, musicians, etc. – were horrified by the violence that occurred in Paris and very eager to express a real sympathy for Parisians, which they did in the ways that young people express themselves today, via smart phones, social media, and all the other things that wouldn’t have occurred to me. I saw an awful lot of these expressions of sympathy and while these are no more than small gestures, of course, they are personal, not official. As someone who loves Paris I was very happy to see lines of solidarity immediately stretch out to include so many young Beijingers, most of whom have never even been to France.

To turn to more mundane topics, last week I received an email from Jorge Guajardo, the former Mexican ambassador to China, with whom I regularly exchange emails in which we discuss the political and economic challenges associated with China’s economic adjustment, along with any insights that his knowledge of Mexican history might provide. While the differences between China and Mexico are obvious, too few of the analysts trying to understand the political economy of China’s adjustment seem to know much about Mexico, or indeed about other developing countries that have undergone similar experiences and whose histories can provide a useful framework with which to understand China.

It is far more common for example to look at the US and Japan for external references and comparisons, even though these two countries have social and political institutions that are far less like those of China than many, if not most, other developing countries. The differences in wealth alone are quantitatively so great that they also become qualitative hurdles. The US, after all, has 7.2 times the per capita GDP of China, according to the IMF, and American households earn around 11 times the per capita income of Chinese households. Japan has 4.8 times the per capita GDP of China and Japanese households nearly 6 times the per capita income. Mexico, on the other hand, has only 1.4 times China’s per capital GDP and less than 2 times the per capita household income.

By the way one of the ways of expressing Chinese rebalancing is to think of it as a closing of the gap between the difference in per capita GDP and per capita household income. In his email Guajardo asked me for details on Chinese consumption levels in order to understand China’s progress on rebalancing demand within its economy, and in my response I referred to this release in October from China’s National Bureau of Statistics:

Based on the integrated household survey, in the first three quarters of 2015, the national per capita disposable income was 16,367 yuan, a nominal growth of 9.2 percent year-on-year or a real increase of 7.7 percent after deducting price factors, which was 0.1 percentage point higher than that in the first half of the year.

I am not sure how comparable the two numbers are, but with real GDP growing at 6.9% and nominal GDP at 6.2%, it seems that disposable household income is growing 0.8 percentage points faster in real terms and 3.0 percentage points faster nominally (I am assuming population growth is more or less flat as the household income numbers are per capita). I don’t know how to reconcile these two numbers, but the gap between the growth in household income and growth in GDP, which is at the heart of rebalancing, is clearly reversing. After decades in which GDP growth sharply outpaced the growth in household income – and, with it, consumption growth – we must see this reversal, so that the growth in household income exceeds GDP growth by enough that the consumption share of GDP can return to healthy levels.

But the gap is not narrowing quickly enough to rebalance the economy by the end of President Xi’s term in 2023. There are different ways to measure the household income share of GDP and I have no strong arguments in favor of one way or another, but, according to the Economist Intelligence Unit, “Chinese Disposable Personal Income as a Percent of GDP” bottomed out in 2011 at 41.5% and is now rising, reaching 44.0% in 2014. According to the World Bank the “Share of household disposable income and labor (wages) in GDP” bottomed out in 2011 at 60% but in their June 2015 China Economic Update their data only runs to 2012. I am not sure why these numbers are so different.

If we assume that disposable household income is currently half of GDP, eight years of real GDP growth of 6.9% and real disposable household income growth of 7.7% will only raise the household income share of GDP to 53.1% in 2023, a little more than 3 percentage points higher and still below its 21st Century average and leaving China as dependent as ever on investment and the current account surplus. At this rate it would take 25 years for disposable household income to raise by 10 percentage points of GDP, which I would argue is the absolute minimum consistent with real rebalancing.

Even if the gap were to narrow twice as quickly as it is currently narrowing (i.e. if the growth in household income exceed the growth in GDP by 1.6 percentage points) it could easily take 10-15 years for China to adjust sufficiently that its economy can return to sustainable growth. Unless there are far more radical policies implemented to speed up the growth in the household income and consumption shares of GDP, in other words, (and this basically means stepping up the transfer of wealth from the state sector to the household sector), at the current rate we are not going to see sufficient rebalancing for at least 10-15 years.

But does China have 10-15 years? The maximum adjustment period, as I’ve long argued, is largely a function of the country’s debt dynamics. Beijing can keep growth high enough that unemployment is held to acceptable levels only as long as debt can grow fast enough both to

  1. Roll over the large and growing amount of debt whose principal and interest cannot be serviced from earnings generated by whatever project the debt funded, and
  2. Fund the required amount of additional investment or consumption to generate enough economic activity to keep unemployment from rising.

In order to answer the question of how much time China has I thought it would be useful to work out a simple model for the growth in debt to see how plausible it is to assume that China has another 10-15 years in which to manage the adjustment without implementing far more dramatic transfers of resources, either to pay down debt or to raise household wealth. The model shows pretty clearly that China does not have that much time unless we make extremely implausible assumptions about the country’s debt capacity and, just as importantly, about market perceptions about this debt capacity.

The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.

But if financial sector reforms fail to result in a sharp improvement in the efficiency of lending, and if Beijing does not permit the economy to slow rapidly, it will be almost impossible to keep debt from rising significantly. Even assuming that higher debt levels do not generate financial distress costs that depress economic growth further (an assumption with which I strongly disagree), there is a real question about whether China can continue another five years without sharply adjusting its growth model during this time.

Making debt sustainable

The model must start with current debt levels, and then project both the growth in debt and the growth in GDP. Although there is a lot of concern about the quality of the data, we do have enough information at least to establish the minimum debt levels. As of the third quarter of 2015, total social financing (TSF), often used as the best proxy for total direct or indirect obligations of the Chinese government and banking system (although it excludes a number of relevant debt categories), had grown by around 12% year on year to RMB 135 trillion, which is equal to about 208% of China’s GDP.

Because of the provincial bond swaps completed this year, in which TSF debt was converted into non-TSF debt, debt actually grew by at least one percentage point faster than the growth in TSF, so with nominal GDP during that same period growing by 6.2%, to say that debt is growing twice as fast as nominal GDP is probably conservative. If we make the heroic assumption that debt-servicing capacity is growing in line with nominal GDP, we can assume, very conservatively, that debt is growing a little more than twice as fast as debt-servicing capacity.

Of course debt growing faster than debt-servicing capacity is unsustainable, so we will set as our first financial sector target the point at which the two grow in line with each other. Once China can reach this point, we will assume that it has resolved its adjustment and that any further increase in debt is sustainable and no longer causes uncertainty about the allocation of debt-servicing costs, and with it financial distress costs, to rise.

This is also a fairly heroic assumption. All the historical evidence – even more so for developing countries – suggests when an economy is perceived as being excessively leveraged, there is significant downward pressure on growth and increasing financial fragility until the economy begins systematically to deleverage. Deleveraging usually occurs either because the government has implemented policies that explicitly assign losses to sectors of the economy that are able to absorb these losses without creating financial distress conditions, or because creditors are forced into explicit or implicit debt forgiveness (for example through debt restructuring). We will assume however that deleveraging isn’t necessary, and that it is enough merely to keep the debt-to-GDP ratio stable.

For our model we are going to propose an average growth rate for a ten-year period, and we will assume that during this period, nominal GDP growth drops by a constant amount every year to reach this average growth rate. Nominal GDP growth will decline in a straight line from 6.2%, in other words. We will also assume that at first debt will grow just over twice as fast as GDP, as it is doing today, but this ratio will decline in a straight line until, at the end of ten years, debt is growing at the same speed as nominal GDP, so that the debt-to-GDP ratio is stable.

That is all it takes. If the total amount of debt today is equal to 208% of GDP, the total amount of debt as a share of GDP in ten years in our model will be wholly a function of the GDP growth rate. Here are the numbers:

Nominal GDP growth Debt as a share of GDP
6% 274%
5% 267%
4% 259%
3% 251%

If Beijing tries to maintain high growth rates of around 6%, unless there is a dramatic and disruptive change in the financial system it is unlikely to be able to do so without seeing debt grow at the end of ten years to 274% of GDP, something that no country under relevant circumstances has accomplished. Even if Beijing sharply reduces growth, to 3% on average (if household income grows at 5%, as China rebalances, household income will rise from 50% to 61% of GDP), debt must still reach nearly 251% of GDP without disrupting the economy.

One great advantage of this model over most others is that it makes very explicit the relationship between credit growth and GDP growth, so that it is impossible accidentally to posit scenarios in which debt is implicitly assumed to decline inconsistently with GDP growth acceleration. Debt levels in this model are specifically associated with different GDP growth levels, so that this model allows us to acknowledge that a country can safely service and refinance higher debt levels if it is believed to have greater growth potential.

It is clear from the model, however, that without a major change or disruption in policymaking, current debt dynamics will be hard to sustain, even with assumptions underlying the logic that are very conservative. What the model tells us is that if GDP growth declines in an orderly way – which assumes that there will be no unexpected shocks or disruptions – and if Beijing is able to reform the financial system and improve the relationship between credit growth and nominal GDP growth so that the two are sustainable at the end of ten years, there is almost no scenario under which debt does not rise sharply, in many cases perhaps out of control.

Many analysts argue that total debt in China in fact exceeds TSF, and believe that the true debt level is closer to 250% of GDP, and perhaps even more if we include the substantial number of corporate receivables that have surged in recent years. If this were true, and for those who want to make the appropriate adjustments, increasing the initial amount of debt by 42 percentage points, to 250% of GDP, would cause an increase in the final debt numbers ranging from 51 percentage points of GDP for growth rates of 3% to 54 percentage points for growth rates of 6%.

Tweaking the model

A more serious criticism is that Beijing has been trying to reduce the credit intensivity of growth at least since Wen Jiabao’s famous “Four Uns” speech of March, 2007, but has failed to do so. Credit is growing more slowly than it has in the past but not because the financial system has become more efficient but simply because debt levels have become too high, causing regulators to force down the growth in credit without seriously improving the efficiency of the financial sector. The result is that lower credit growth simply means lower GDP growth.

It is difficult to model the many ways credit intensivity of growth can change, but if we simply assume that there is no improvement except as growth slows, so that the ratio between credit growth and GDP growth stays constant, the table below shows debt levels at the end of ten years at different GDP growth rates:

Nominal GDP growth Debt as a share of GDP
6% 380%
5% 346%
4% 314%
3% 284%

On the other hand if we make assumptions that are far more favorable, if less plausible, and propose that nominal GDP will grow at 3-6% on average for the next ten years, but that the relationship between the growth in credit and GDP growth will improve much more dramatically than in our first set of scenarios, it is still hard to work out a good scenario. Let us propose that at the end of ten years, instead of debt growing at the same pace as GDP, as in our first set of scenarios, the efficiency of the financial sector will have improved to such an extent that it can generate up to 6% GDP growth without any increase in debt at all. We will also assume that to get there does not require a financial crisis or any debt forgiveness, and that the financial sector gets there smoothly.

This would be a remarkable achievement, and probably unprecedented in history, and it would be just barely enough to solve China’s debt problem. Here is the table that lists the debt-to-GDP ratio as a function of GDP growth:

Nominal GDP growth Debt as a share of GDP
6% 201%
5% 209%
4% 216%
3% 225%

It is in my opinion almost impossible that China would be able to improve its financial efficiency so dramatically without a significant slowdown in growth, but at least mechanically it is clear that if China were able to do so while maintaining nominal growth rates on average of 5-6%, by the end of ten years China’s debt to GDP ratio would be largely unchanged, although this would only happen after having risen to 235% during the first five years.

This set of scenarios probably represents the absolute upper limit of optimism for anyone who hopes that China can adjust smoothly and non-disruptively over a ten-year period without a dramatic change in policy, most importantly a process of wealth transfer in which as much as 2-4% of GDP is transferred from the state sector to ordinary households every year for many years. Under these scenarios debt stabilizes at a sustainable level at the end of the ten-year period, and growth rates remain reasonably high, but it is important to specify the assumptions to make clear just how difficult and unlikely this set of scenarios is likely to be:

  1. We are assuming that TSF captures the total relevant amount of debt.
  2. We are assuming that the growth in debt-servicing capacity is on average equal to the growth in nominal GDP.
  3. We are assuming that the financial system will adjust smoothly and without friction.
  4. We are assuming that there are no financial distress costs, so that as debt rises, it does not put downward pressure on GDP growth.
  5. Finally, and this is a fairly complex assumption, we are assuming that if there is unrecognized bad debt in the banking system that is being rolled over regularly, the interest cost is effectively zero. If the amount of bad debt in the system is low, we can safely ignore this assumption, but if say 20% of the loans consist of unrecognized bad debt, this will increase the growth rate of debt by perhaps 1-2 percentage points annually.

Obviously this set of scenarios – in which GDP grows on average at rates between 3% and 6% for ten years while credit efficiency is improved so dramatically that in 5-6 years China begins to deleverage and by the end of the period these growth rates can be maintained with no growth in credit – is theoretically possible, but just as obviously it is highly implausible, and I cannot think of any country in history that has achieved such a turnaround in its financial sector without having first experienced a brutal financial crisis. No matter how I work the numbers it just seems to me very obvious that unless it sharply speeds up the process of transferring wealth to the household sector so that consumption can grow much more quickly, China simply does not have ten years in which to manage a non-disruptive adjustment unless we are willing to make assumptions so heroic that even El Cid would blanche.

Varying the adjustment period

If we do the same exercise using the same assumptions we used in our very fist set of scenarios, but allow for a longer adjustment period, say fifteen years, we get the following results:

Nominal GDP growth Debt as a share of GDP
6% 307%
5% 297%
4% 286%
3% 276%

These numbers are clearly too high and show that there is no point in trying to develop scenarios in which China adjusts more slowly over a longer period of time. The argument that the more carefully and slowly Beijing manages the adjustment process, most especially the reform of the financial sector, the less likely it is to be disruptive, can only be true if we assume that there is no limit to Beijing’s ability to raise debt credibly.

If instead we go in the other direction and assume that Beijing adjusts more aggressively, and if we do the same exercise using the same assumptions but this time posit a seven-year adjustment period, we get the following three sets of results. The first set assumes that at the end of the 7-year period debt is growing at the same rate as nominal GDP:

Nominal GDP growth Debt as a share of GDP
6% 250%
5% 245%
4% 241%
3% 236%

The second set assumes that at the end of the 7-year period the nominal growth in debt is zero:

Nominal GDP growth Debt as a share of GDP
6% 200%
5% 205%
4% 211%
3% 217%

In this scenario debt rises to roughly 225% of GDP during the first four years before declining. And finally the third set of scenarios assumes that there is no improvement in the credit intensity of growth:

Nominal GDP growth Debt as a share of GDP
6% 317%
5% 297%
4% 277%
3% 259%

For the sake of completion, I will make the same set of assumptions and assume that Beijing moves even more aggressively, and in the first set of scenarios gets the growth in credit to keep pace with the growth in nominal GDP within five years, and in the second set of scenarios gets credit the growth in credit to drop to zero within five years. Here is the relationship between credit growth and GDP growth:

Nominal GDP growth Debt as a share of GDP
6% 235%
5% 232%
4% 229%
3% 226%
Nominal GDP growth Debt as a share of GDP
6% 199%
5% 203%
4% 207%
3% 212%
Nominal GDP growth Debt as a share of GDP
6% 281%
5% 268%
4% 256%
3% 243%

Once again in the second set of scenarios, in which the improvement in the financial sector is so dramatic that within a few years China begins to deleverage and in five years GDP is able to grow with no growth at all in credit, debt rises to 27-19% of GDP in the first three years before declining.

I can keep going but the conclusions are pretty clear.

  1. Credit growth in China is too high as are current debt levels, and the sooner Beijing gets credit growth under control, the better. This latter statement in itself is not controversial of course, but my simple debt model shows just how urgent it is for Beijing to get credit growth under control. It clearly does not have ten years or even seven years. It might have five years, but only if the markets – Chinese investors, businesses, and savers, both wealthy and middle class – are convinced that it is moving in the right direction.
  1. There is no obvious level at which debt levels for any country are too high, but China is already at the very high end among developing countries, and of course the more debt rises relative to GDP, the greater the risk of some kind of debt-related disruption.
  1. If you ask most economists why “too much debt” is bad, they will tell you that it is because the higher the level of debt, the greater the risk of a debt crisis. Unfortunately this very unsophisticated answer turns the discussion about debt into a discussion about why China will or will not have a debt crisis at current or future projected debt levels.

It also means, unfortunately, that for those who believe (and I include myself in this group) that the structure of Chinese financial markets and Beijing’s high credibility give it protection from the risk of debt crisis – so that a debt crisis is unlikely except at very much higher debt levels – there is little to worry about. In fact the real cost of excessive debt levels is what finance specialists call “financial distress” costs, and I have explained elsewhere how debt can become excessive. China is already experiencing financial distress costs and as debt rises, these costs will make it harder and harder for China to achieve target growth rates except at the expense of even more debt, so that rising debt automatically means lower growth than otherwise.

There is so much evidence supporting the view that high debt levels in an economy reduce that economy’s growth that it is surprising how few economists understand the urgency of getting credit growth under control. In the past whenever growth has slowed sharply in an overly indebted economy, economists blame the inadequacy of reforms and the cowardice of policymakers, but if slower growth has happened in every single case of excessive debt, it is absurd to blame the pusillanimity of policymakers. We are already seeing how rising debt levels have caused Chinese growth to drop below projections year after year, and already economists are shifting the blame from their ineffective models to the incompetence of Beijing’s economic stewardship. And as debt continues to grow, the economy will continue to slow, and economists will continue to blame Beijing’s incompetence.

  1. The great difficulty of reducing credit growth is that it will lead to higher unemployment as manufacturing capacity is closed down and less infrastructure built. The only way to prevent rising unemployment is by opening up or increasing other sources of demand that do not require even faster growth in credit.

Some of these other sources of demand, like a greater current account surplus or enough of a realignment of the financial sector towards productive investment, are too impractical or uncertain to rely on, and in the end the only certain alternative source of demand is domestic consumption. Domestic consumption, however, is constrained by the low household income share of GDP, as I explained in the opening section of this essay, and so Beijing must speed up the process as much as it can. Ultimately the only way it can do so is by transferring wealth from the state sector to the household sector, something it is trying to do and which is recognized in the Third Plenum reforms, but this is politically very tough.

I would argue that if China can engineer a process by which at least 2% of GDP is transferred directly or indirectly to the household sector every year (or is used to pay down debt), it can easily avoid a debt problem or many years of economic stagnation. If it doesn’t, however, it is hard to see how China can adjust quickly enough to avoid at the very least a “lost decade” or two of low growth.

  1. In every one of its economic policymaking choices, Beijing must ultimately choose between higher debt, higher unemployment, or higher transfers of wealth from the state sector to the household sector. Every single policy results in some combination of the three. The time frame within which this must be resolved is set by deb capacity limits, and as my model shows, Beijing probably has no more than five years, perhaps much less, within which to resolve the rebalancing if it wants to avoid a disruptive rebalancing.

What I like about the model I have described above is that it doesn’t allow analysts to hide their implicit assumptions about credit growth, GDP growth, and the relationship between the two. With this model an analyst can make any assumption he likes about the economy and about economic reforms, and from there make explicit assumptions about the consequent growth in debt and the growth in GDP, and see if these are at all consistent. It also makes clear that the real difference in opinion about sustainability will only show up in terms of medium- and long-term growth forecasts. It doesn’t tell us anything that China grows by 7% next year, for example. As long as China has sufficient debt capacity, the economy can grow at any rate Beijing chooses.

What matters is the associated growth in credit. If growth next year of 7% were achieved with 18% growth in credit, things would actually be getting worse, not better. On the other hand if China grew next year by 5%, with credit growing at “only” 8%, this would represent a significant improvement in China’s medium- and long-term growth prospects. This is something that a lot of economists seem to have real trouble in understanding. There is no “good” level of economic growth independent of the associated growth in credit.

Ultimately, and to repeat Conclusion 5 above, Beijing must continuously choose between a rising debt burden, rising unemployment, or rising transfers of wealth from the state sector. All of its policy options boil down to one or more of these three. So far it has mostly chosen the first, but this can only go on until the country reaches debt capacity limits.



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  1. Thank you for another excellent article, Michael; I must confess, I hold an academic disdain towards most (capital) economists surpassed only by my contempt for those with degrees in TCM and homeopathy, but the accuracy of your predictions and well-constructed arguments have made me a fan. Indeed, you’re one of the only economists whose words I put much stock in and, among the few I do, I give yours the most deference.

    In this, I have a question: Yukon Huang, in China’s Debt Dilemma, argues that views like yours (indeed, he specifically cites you) are overly pessimistic because asset price increases are sustainable and thus debt buildup is not an issue; he argues that the decline of growth impact from credit is due to most credit being allocated to FAI rather than GFCF, and that the only partial nature of FAI’s impact on growth figures means that we are underestimating added value to the economy. Thus, he believes that:

    “[M]uch of the recent surge in China’s credit-to-GDP ratio can be thought of as financial deepening as China moves toward more market-based asset values. Once those values are established, land price growth and the
    amount of credit being channeled to these uses will level off. This will lead to a gradual shift in the allocation of credit back toward growth-enhancing GFCF investment and to a rebound in the growth impact of credit, allowing over 7 percent growth to continue even as credit slows. ”

    How would you respond to this argument, given it seems almost the polar opposite of the one you have made?

    Also, apologies for any errors this post contains; as noted, economics is not my field.

    • Thanks for the kind words, Oro. I completely share your disdain towards most academic economists and the direction economics took during the 1960s and 1970s. In fact I am often bewildered by the whole project.

      As for Huang’s arguments, aside from the fact that China has evolved very much as I have been saying for the past six years, and not as Huang and the other optimists claimed (until 2009-10 they usually argued that a slowing China meant that growth would stabilize around 9%, but since then, perhaps for good reason, they have been very reluctant to provide a growth forecast, and have instead have simply accepted each new, lower growth rate as their growth rate they all along expected) I think there is a lot fundamentally wrong with the model he and most economists use and with which I strongly disagree. For example he argues very consistently that China’s high savings rate is the natural outcome of a rapid rise in income, in the sense that an increase in consumption tends to lag an increase in income when a person’s income rises very quickly. The problem with this is that it would be a good explanation only if China’s soaring savings were caused by soaring household savings, but in fact the household savings rate has not risen much (except of course in the past few years as uncertainty rose sharply), and anyway China’s soaring savings rate can so much more easily and logically be explained by the falling household income share.

      Huang is of course right to say that debt used to fund investment is better “protected” by debt-servicing capacity than debt used to fund, say, consumption, but this much is obvious, and has never been doubted by me or anyone else. But when you misallocate investment, it is as if a portion of your debt is used to fund investment and a portion used to fund “nothing”, and when you misallocate it on such a massive scale, there is likely to be a lot of debt that cannot be serviced by the assets. It is obvious that borrowing $100 for consumption leaves you more exposed than borrowing $100 to create investment, but if the value of the investment is only $50, then if you do the latter twice, it is not obvious that you are any longer less exposed. I don’t see why they have trouble understanding this. If investment misallocation goes on long enough, at SOME point it must be too much.

      It is not as if I am making the argument that this is the first time this has ever happened. Huang’s defense of bad investment is the same one used to explain why the Soviet investment spree in the 1950s and 1960s, or Brazil’s in the 1960s and 1970s, or Japan’s in the 1980s, and many others, could not lead to a debt crisis or a long period of stagnation, and it has always been wrong. If you misallocate investment long enough, simply refusing to recognize the fact is not a way to avoid the consequences. Eventually you will be forced into taking the loss.

      • I would argue that the reason most economists don’t understand this is that there are a whole host of embedded, yet rarely examined, assumptions in their models that are incorrect. These assumptions are typically reasonable in studying advanced economies with largely market rules and stable property rights, but are often way off the mark as soon as we move beyond this group of countries. In this case, the assumption of an at least somewhat efficient financial sector (whether disciplined by market forces or a decently neutral government allocation policy) is the incorrect assumption at work here. Economists are so reflexively willing to assume that credit will be allocated based on some rules governing assessment of risk and how potential losses will be allocated/covered, as is the generally the case in the advanced economies, that when the see allocation of credit and resultant growth they ASSUME this also reflects creation of sufficient value to pay back the loan, and if not, that there are seizable real assets to cover the losses. As we know from Japan’s experience, and now China, and in fact most developing countries that use the financial sector to extract the resources for funding development, this is just not the case.

      • So why doesn’t China just DO the transfers? FDR just DID the transfers. Clement Atlee just DID the transfers. China is supposedly socialist — it should be easy to just DO the transfers of wealth, to tax the rich and hand “basic incomes” to the poor. (I give the reason why China won’t do this at the bottom of this comment.)

        The Soviet investment spree in the 1950s and 1960s is an interesting case but not comparable to really anything else. They suffered from a couple of serious problems. Firstly, substantial amounts of it were direct destruction of wealth — spending money to create actual liabilities, like nuclear waste sites. The agricultural “investment” effectively seems to be have been destruction of wealth too, as I note next…

        Secondly, the slack in the Soviet economy disappeared quite suddenly in 1959-1961 when dumb agricultural policy mistakes meant that they stopped successfully feeding themselves. With a shortage of food, the economy has zero slack even if there is high unemployment, etc.

        This food crisis, and this alone, is the reason why money-printing internally and devaluation against foreign currencies externally couldn’t help the USSR revive its economy: they had to import food and pay for it with foreign currency.

        “Anyway China’s soaring savings rate can so much more easily and logically be explained by the falling household income share.”
        Someone is getting control of that generated wealth which isn’t going to household income. The “Vested Interests”, presumably. This is the process by which an entrenched elite takes control of the economy. That elite always has selfish political agendas which *are not* in the best interests of the general public; they prefer to increase their relative wealth even if it immiserates the population.

        As a result you’ll see all kinds of behavior in the next decades which makes no sense if you look at it from the point of view of “helping the economy” but makes lots of sense if you look at it from the point of view of the relative position of the Vested Interests.

        This is of course why a supposedly socialist country like China will not engage in wealth redistribution to the masses, which is the obvious socialist solution to their economic problems. The Vested Interests are a rich elite and typically oppose this solution for their own personal reasons of relative position.

  2. Interesting conclusions. I wonder what the tipping point looks like. Clearly the world is awash in debt yet it still seems to be running ok. I guess, like you alluded to, in a slowdown over indebtedness causes a sluggish rebound and more write offs longer term, bc with aninsulated banking system credit is unlikely to be written down quick.

    Also how might inflation play a role? Can’t China just drop money like helicopter Ben and hope that inflation reduces the burden. Though clearly developed world experiences with Qe haven’t yet been inflationary. But Japan is clearly on the way to monetizing debt. Can’t China just do nominal gdp targeting, or perhaps that leads to more unsustainable credit growth.

  3. Thanks for the insightful piece Prof. Pettis. I was wondering if it is possible for China to shift the intensity of credit growth towards households? i.e. instead of effecting the wealth transfer that you suggest, the authorities make it easier for the households to borrow (and spend, hence supporting consumption, GDP etc.). Given that household balance sheets in China are quiet healthy, this policy might enable China to continue a high credit growth rate for some more time and maintain high employment. Although this might be just postponing the inevitable, this might buy the authorities more time to work on the bad debt in industrial sector and in the short run might be easier to implement than wealth transfers, so might be a tempting policy choice?

    • It would add time but at the expense of adding debt and so making the ultimate adjustment that much more painful. I worry that in fact this is what China might do, along with increasing its external borrowings, which have the same effect.

      • Until the adjustment, this approach could also boost global growth, which would cause increase in global debt, decrease in risk aversion and so the eventual global impact would be even worse. That’s what my often-wrong common sense says.

  4. Any concerns the relative value of the Yuan or Chinese state asset values may mitigate or worsen your projections?

  5. Thank you for sharing your wisdom with us, Prof. Pettis. Your posts and books have enlightened my life and added great value, as you might say none of it was included directly in any GDP numbers… looking forward to your upcoming new book!

  6. Thank you for another fascinating article. There is one question I would like to ask. Here is an excerpt from an analysis on The 1997-98 Korean Financial Crisis by Kim Kihwan which demostrates the amount of NPLs in the Korean case. What are your estimates regarding real Chinese NPLs as a percent of GDP?

    “Once the government decided to inject public funds to rehabilitate the financial system, the first question it had to resolve was what exactly constituted “non-performing loans.” Before the crisis, only loans in arrears for six months or more had been classified as non-performing loans. In estimating the true magnitude of the NPLs, the government decided to include loans in arrears for three months in line with internationally acceptable standards. Using this standard, the government estimated the total size of the outstanding NPLs at 118 trillion won or roughly 28% of Korea’s GDP in 1998 This was twice the amount of NPLs estimated earlier on the old asset classification standards.
    The actual amount of funds disbursed by 2002 substantially exceeded both estimates. It was no less than 160.4 trillion won, or 30% of the 2002 GDP.”

    • There is no accurate way of estimating the voluma of bad loans if we define them economically not just because the information is very poor but also because for our definition any loan that went towards a project that created less value than the cost of the project should be treated as a bad loan, and the value created by that project depends in part on the country’s future economic growth rate. If you borrow money to build a seaport, for example, a faster growing China will increase usage and thus the economic value of the seaport, whereas a slower growing China will make that port less valuable. This means that there is a highly self-reinforcing component of the loan portfolio such that makes “small” over- or under-estimates quickly become large ones.

      What you are describing above is an attempt to measure the accounting value of NPLs. This is useful because it may serve as a proxy, but it masks bad investment by transferring resources from good investments. For example assume two companies, one of which is insolvent and unable to service its debt and the other solvent and easily able to do so. if you merge the two, it is possible that suddenly all loans can be serviced and the former NPLs will no longer be included.

      If you are interested in the profitability of a bank, it makes sense. If you are interested in estimating the amount of resources China will need to cover for misallocated investment, it doesn’t. However for what it is worth if you were to tell me that you had completed a very sophisticated analysis whose conclusion was that bad loans amounted to 30% of GDP, while I would be skeptical about your methodology, I would not be skeptical about your conclusion. It could easily be 30% or even more. The quicker Beijing recognizes and resolves the bad loans, the lower the total amount will be.

      You might recognize process this if you had followed the US S&L crisis. If the US had closed down the S&Ls in the late 1970s, when it was clear that most of them were insolvent, the estimates are that it might have cost 1% of GDP. By waiting a decade, hoping that they might “earn” their way out of insolvency, the government may have quadrupled the total cost to taxpayers, although this cost was stretched out over a longer period.

  7. You’re assuming that a debt/GDP of over 300% is hopelessly unsustainable but is this necessarily so? Britain crossed a national debt of 250% after the Napoleonic wars and it did great. Japan is above 200% now and they are getting by, if not particularly well.

    Now that’s the governmental debt, and this is about private debt. However, a lot is various state-associated entities and governments do sometimes prop up private entities as well. We’ve seen that China has surpassed all previously countries in marshalling private resources for economic growth. Could they do the same for supporting existing debt?

    I’m mostly saying this as a devil’s advocate, but I think we have to consider how much debt China will be able to bear when the government gets behind bearing it. These numbers might be too much, but I don’t think you can dismiss the government’s capacities out of hand based on prior examples.

    • First off, it wasn’t Britain that crossed over 250% of GDP, but the British Empire. There’s a HUGE difference there. Empires allow you to combine the balance sheets of many different nations across your empire creating a different dynamic in the payment system (like running a current account surplus through another country to make up for your current account deficit inside the leading nation).

      Secondly, if you’re using Japan at 200% of GDP as a good example, I don’t know how that’s a good example. Japan has basically stagnated for 25 years now. 50% of their tax revenues go towards debt servicing costs while their yield curves are effectively flat. China has similar population demographics to Japan in the late 80’s and early 90’s too. The only thing we have to remember about China is that China is coming from a lower level of development, but much of China doesn’t have the same geographical advantages (basically the parts of China outside of Cantonia) for capital formation as Japan either.

      Thirdly, China isn’t a developed country. Both the UK and Japan are at very, very high levels of development with liberal institutions that’ve been credible for centuries. For China, none of those things are true. There’s lots of internal divisions in China and, for all practical purposes, around 60-70% of Chinese territory is basically viewed as occupied territory.

      Fourthly, there’s no real distinction between private debt and public debt in places like China or Japan. The entire financial system is basically a power-brokering mechanism for the ruling class. Thinking of China as a modern-day nation-state leads to faulty conclusions. China has an imperial governance system where the financial system’s existence is purely to build/maintain geopolitical momentum while serving as a power-brokering mechanism between elites. Almost all debt is probably explicitly or implicitly backed by the state. China also doesn’t have liberal institutions like the US, so it lacks the same flexibility to adjust.

  8. “You might recognize process this if you had followed the US S&L crisis. If the US had closed down the S&Ls in the late 1970s, when it was clear that most of them were insolvent, the estimates are that it might have cost 1% of GDP. By waiting a decade, hoping that they might “earn” their way out of insolvency, the government may have quadrupled the total cost to taxpayers, although this cost was stretched out over a longer period.”


    I’m reading Schiller/Akerloff’s “Phishing for Phools,” where they talk about how S&L managers were incentivized to loot their companies once it became clear they were insolvent (but were allowed to keep operating anyway). They make the point that bankruptcy law is in fact intended (in part) to prevent this kind of looting. I understand that bankruptcy laws and other rules are not the same in China now as they were in the US in the 1980s, but I wonder whether Chinese managers of insolvent companies also face similar incentives to loot.

    As an aside, Schiller has an incredible knack for being timely with his books (2000 about the stock market, 2008 about the housing market, and this year more broadly about deception and manipulation). I wonder if he’s gotten lucky with his timing again.

    • The problem is not so much looting but rather that when you are insolvent but your borrowing is explicitly or implicitly guaranteed, you effectively are long an out of the money call option on your assets. It is in your best interests to maximize volatility in that case because the gamble is essentially one of those “heads, I win; tails, you lose” games, in which case you would be foolish to invest in prudent, low-risk projects, even if these had a high net present value, and smart to bet on very risky projects, even if they had a negative net present value. This is exactly what happened to the American S&Ls. They became the buy-side foundation of the explosive growth in junk bonds in the early and mid 1980s. In the end not only were there more losses than profits, but the owners of the profitable ones paid back the deposits and pocketed the profits, while the owners of the losers turned the losses over to the FSLIC as they were forced to repay depositors.

  9. Very nice piece, as usual!

    I have a question. You have written on a number of occasions about transfers of wealth from the state to the household sector. This makes good sense to me in the abstract, but I have such a hard time understanding what it could mean in concrete, practical terms.

    To pick an example: there is a certain industry, let’s call it M, for which China has built a large number of state-owned facilities. These are sometimes owned by regional gov’t and sometimes by the central gov’t. I’ve visited lots of these as I’ve had some years of dealings in the M business. They are uniformly unprofitable. It is impossible for them in their present condition — they way they are managed mostly, but in some instances even considerations about the physical facilities themselves, their locations, and above all the people who are available to staff them from top to bottom — to be competitive with M companies from other countries.

    It seems obvious to me from a business point of view that selling or even giving these facilities (and their employees and intellectual property etc, whatever) to the private sector won’t change the basic fact of their unprofitability. What would be required is a wholesale reinvention of business M in China, which hasn’t and can’t happen precisely because of the existence of these facilities and more importantly their ownership. But such a wholesale reinvention will take decades, possibly generations. If on the other hand these facilities are simply sold as scrap or real estate, it will be a tremendous markdown and the household sector won’t get especially much out of it.

    Now, if M is an isolated case then it’s perhaps no matter. But I can’t imagine why it would be an isolated case.

    In brief, I don’t quite get the transfer from state to household thing. If what the state owned were very liquid assets that could be easily redeployed and if all the necessary conditions for successful redeployment were in place, I could see it. But it doesn’t look at all like that’s the case to me.

    • Most of these businesses generate operating profits, but they are bankrupt because they borrowed too much and invested poorly, and the fact that they are bankrupt causes them to be mismanaged in specific ways in which the additional losses are referred to as financial distress costs. In that case if you clean up the company by transferring its debt to the government balance sheet, you have an operating company that not only can be profitable but whose revenues will actually increase once its debt burden is lightened. This is similar to the mistake that Huang makes to which Oro Invictus refers in his comment. There is no need to assume either that investments are fully profitable ot that they generate nothing. If you borrow $100 to invest in a project that is worth $80, it is a bad investment that will drive you into insolvency, but it is not worthless.

      • Michael writes: “In that case if you clean up the company by transferring its debt to the government balance sheet, you have an operating company that not only can be profitable but whose revenues will actually increase once its debt burden is lightened.”

        But this statement can’t be true in the abstract; it will depend on each company, its position in the national and international economy, etc. A film-making company that makes films that no one wants to watch will not find that people automatically like its movies more if it has less debt. A steel-making factory with a lot of debt will, even if that debt is transferred off its balance sheet, find itself in an industry with tremendous overcapacity in a marketplace that is slumping internationally. And so on. Admittedly offloading all the debt is a big help in pushing the company toward profitability, but … there’s also the question of whether the remainder of the balance sheet and the people in the company amount to a business that can at least break even.

        • oops. my mistake: you already stipulated that the company has an operating profit. the conpanies i am referring to either have an operating loss or (more commonly) would have if their income statements were more reflective of reality.

          • I’ll give it an attempt, if only because I am wondering the same thing:

            If a company has no operating profit, and is restructured until it does, then it becomes profitable and thus the cost of its debt (once removed) is no longer being carried by the household sector.

            If the company is closed for whichever reason, again, the cost of debt is removed from the household sector. In addition, it allows the household sector to compete for the same products (if they still exist and if it is possible, of course), it releases employees to the private sector; it might reduce pollution, which again is an external cost on the household sector etc. This of course has been done before, it’s very common in the textile industry for example to see private mega-companies which used to be SOEs. Then again, some of these companies might in fact have the same low cost of capital as SOEs due to their size and history.

            But, yes, you are right in a way. The more I think about it the more it seems very unlikely to succeed, other than theoretically as an equation on a paper.

            Increase in household debt can also be done via RE I guess, allow 20%, then 15%, then 10% equity, and if that is not enough go for 0%. This already started to some degree and of course will not end well.

          • John,

            (I’m replying to your comment below; for some reason the “Reply” button doesn’t appear below your comment in my browser.)

            you write: “If a company has no operating profit, and is restructured until it does, then it becomes profitable and thus the cost of its debt (once removed) is no longer being carried by the household sector.”

            the thing is that there is no easy way, probably no way at all in general, to restructure unprofitable companies so that they become profitable. there is no inexorable law that says that every company can be tweaked until profitable.

            In China, there are many kinds of companies. There are some that are predominantly private-sector companies, that are very strong and well-managed companies with big markets, good solid management, and a staff of able employees. Huawei is a good example of this. So is Haier. But there are lots of examples. There are for examples lots of OEM manufacturers that are basically profitable enterprises; one sees hundreds of them advertising their products and services on alibaba and taobao. But because these companies are generally private-sector companies, there is nothing to transfer to the household sector from them.

            Then you have SOEs. There are some big ones that are obviously profitable in the sense of operating profit. China Mobile is an example; it’s a real, solid company. But there are a huge number of gov’t-owned companies, ranging from these top-shelf big names down through the thousands of smaller companies that are owned by regional governments and cities and what-not. And a whole host of companies that are effectively government owned, because they are created by people who are closely connected to the government, using their extensive gov’t connections to raise money for the business, get special inputs for the business like land and buildings and special licenses and what-not.

            I have had the good fortune to visit many such companies in China in a fair number of different industries. At the risk of painting with too broad a brush, one can make some fairly categorical statements about them. First, they are very much focused on the government as an ultimate source of “revenue”. They are highly tuned to gov’t initiatives, know how to get money from the gov’t, whether in the form of loans or in the form of purchase commitments from other such companies, or what not. They are machines for turning guanxi into cash. These companies are deeply unprofitable, regardless of what their income statements may indicate, for the simple reason that they don’t really exist for the purpose of turning a “profit” in the ordinary sense of the word. Yes, they have products and services; but invariably when one digs, the appearance and the reality diverge enormously. It’s a big mistake in my opinion to think of these in the same way as one thinks of, for example, an electronics manufacturer in Shenzhen that is making components for inclusion in exported electronic products. The companies I’m talking about would not exist at all were it not for the very distorted dynamics of the economy of China and its intimate relation to the government. They are backstopped by the government; they don’t “go bankrupt”; instead, heads roll. It isn’t realistic to think that such companies can be “transferred to the household sector”. Transfer what? The guanxi? That is their real asset. It isn’t the kind of asset that transfers well to the private sector, whatever that would mean. The critical point is that the management structure of those companies isn’t built in such a way that would allow them to be successful as private enterprises. Restructuring them so that they are profitable would mean firing the entire company — the managers who are not really managers at all, in any meaningful sense, and the employees who have been trained to please their non-managers while eeking out a meager living in exchange for a degree of financial security. The plant and equipment is in most cases lacking in one of a number of ways. Have been secured by people who are not really serious about the business for its own sake, the assets are often weirdly imbalanced (too much of this and none of that). It is often badly maintained; in other cases it is brand new having never really been used for its ostensible purposes. One sees every kind of weird thing.

            Now, the question is, are there a bunch of SOEs out there that have an operating profit but that are weighed down by excessive debt, so that the main problem they face is debt load? I’m really skeptical. Michael indicates above that many of these companies have made bad investments, and that’s the origin of their balance sheet woes. What I have seen is that, in the first place, most of these companies *are* the bad investment; secondly, such investments as they have made have a heavy component of physical plant and equipment and recovering value from that means either simply selling those assets or else hoping against hope that the rest of the missing management structure and expertise can be filled in around it to make the company profitable. That seems fantastic to me.

            (I wonder if Michael is thinking of investment companies of some kind, so that they have in effect entire secondary enterprises on their balance sheets that could be lopped off? But of what quality can an investment company be if it knowingly goes to the till in order to get some money to invest in a secondary enterprise that it almost certainly knows in advance will not be profitable?)

            This all sounds very harsh; in fact I feel bad writing it down. But it’s what I’ve seen! Over a ten year span in China.

            For emphasis: I know perfectly well that there are many good businesses in China with good management and able employees. But in my experience — the experience of only one person, admittedly — one seldom sees that in government-owned companies.

            Of course, it’s really possible I’m just plain mistaken, that what I’ve seen isn’t representative, numerically. (I don’t believe that, haha, but I suppose it’s possible.)

            Many years ago I spent several days visiting companies in Beijing in a particular field, with a Chinese companion. Every time we went into a business we could immediately know whether it was privately owned or a state-owned company. The privately owned businesses were bustling, had a bunch of recognizable stuff on display, a bunch of employees who were quite busy, and so on. The state owned ones had, invariably, the feel of walking into a gov’t office. Spartan surrounding, numbing colors or non-colors on the walls; and almost always a boss who either wasn’t in or who didn’t seem to be engaged in the way come to expect when you visit a “going” concern. Anyone who has visited companies in China will know what I’m referring to, I think.

          • Luddy wrote: “First, they are very much focused on the government as an ultimate source of “revenue”. They are highly tuned to gov’t initiatives, know how to get money from the gov’t, whether in the form of loans or in the form of purchase commitments from other such companies, or what not. They are machines for turning guanxi into cash. These companies are deeply unprofitable, regardless of what their income statements may indicate, for the simple reason that they don’t really exist for the purpose of turning a “profit” in the ordinary sense of the word. Yes, they have products and services; but invariably when one digs, the appearance and the reality diverge enormously.”

            So these Chinese companies are the equivalent of the Military-Industrial Complex companies in the US, which exist to convert social networks into cash, and take money from the government to produce worthless garbage (weapons which don’t work)?

            These leeches seem to be a force in any economy. I haven’t seen a good analysis of their economic character, and it would make a good paper.

    • Luddy,

      In the West, if a business is unprofitable, in some cases it is sold for scraps. However, while there is no value in the operation itself, there is usually value in the customer base and the brands. This is more true in China, where the state own entities also come with a often captive customer base. In this way, state entities could be privatized and the proceeds going to provide social safety net etc. Not saying that this will happen, but this is certainly one of the ways to transfer wealth to the people.

      • John,
        I guess there is a lot of variety among Chinese state-owned firms. Some may have a captive market. Many others have arisen due to artificial “drives” and “campaigns” to create specific strengths and capacities in the economy. I think it is difficult to assess the income statements and balance sheets of the latter. Among other problems, there are long chains of receivables strung through the economy, and I suspect that a lot of what has been booked as “income” is in fact non-recurring or even non-occurring (haha). It is what goes under the general heading of “overcapacity” in the state press, or more recently, under the heading of supply-demand mismatch. It’s just a fancy way of describing a company that can’t sell what it makes at a profit. I have seen only anecdotal cases, but quite a few such anecdotal cases.

  10. Prof pettis thanks for the article… Is your new book coming out this year?

  11. Prof. Pettis,

    What do you think are the implications of the IMF putting CNY in their SDR basket? If China does liberalize–and it seems like China is starting to liberalize, albeit slowly–is it likely we’ll see something similar to a Bancor system?

    On another note, I found this. It was basically Jack Lew saying he wants the USD to remain the world’s reserve currency. From this, I gather that he’s either a fool or a paid shill or some combination of both. The current leadership and the people in charge of the administration have no clue what the actual problems of the US are. Why does it make sense for the most capital rich country in the world to keep importing capital?! And how does the US providing a global public good make the US a stronger economy? It makes no sense.

    • Oh, there’s more stupid stuff said by Lew. Including how Dodd-Frank makes the financial system safer. Dodd-Frank doesn’t do anything and really just adds regulation to prevent competition in the banking system. Why do you need a bill that’s hundreds of pages instead of forcing financial institutions with assets that’re larger than, say $5 billion, to have capital ratios at 25-30%? Why do you need anything more? If you’re still worried about the risk, then just jack up capital ratios even more so you have more of a cushion.

      Lew talks about risk, but I don’t think he understands risk at all.

    • It doesn’t make sense, Suvy, and more likely represents intellectual inertia than serious thinking. For many people reserve status is like waving the flag, or, as van der Kamp says in a recent SCMP article about the RMB joining the SDR, it is like winning a beauty contest. I’ll be writing a lot more on the tropic and my goal is eventually to get a new “Bretton Woods” reconvened.

      • SDR…is obviously a political decision, not dissimilar to the one that led to NME’s being engaged in GATT/WTO. As Michael, notes, an intellectual inertia, in the frame of a world that is stagnating, and whose understanding of economics, and the systemic inter-relations between nations, and people, and the premises of development, in a world where economics is seen through the vein of short-term financial considerations, is slowly evolving.

      • If you do get a new Bretton Woods convention, will one of the topics be a simultaneous abandonment of a quantity of government bonds by the major nations at the meeting? Because if the meeting ends with the current levels of unpayable debt still on the governments’ books, we will still be left wondering when country X will implode.

        • A new convention will require either:
          (1) a massive monetization of debts worldwide
          (2) a coordinated worldwide tax on the rich and transfer to the poor. Yeah, good luck with that one.

          Monetization might be possible.

          • You don’t need a new convention. You can do a few other things:
            1. tax the accumulation of American assets abroad
            2. protection to prevent persistent current account deficits

            Given the current state of the 2016 election, I think #2 is becoming more and more likely. American manufacturing is getting crushed while the American economy experiences consistent demand leakages.

  12. Hi Michael,

    A great article here and you laid it out in laymans terms pretty much. China is currently growing at 6.9% GDP and you say if they grow at 5% next year with 8% credit growth than this is good. How do we know that they are not growing at 5% or even 3% already because as premier Li said years ago- we can’t trust the figures?

    • Laurent,

      I have the same question. It seems a easy way to re-balance is by stealth. If the GDP numbers are overstated, then would it not have the same effect as advocated by Prof. Pettis?

      • I believe the actual Chinese GDP figures are something that Michael doesn’t want to comment on because hey- he lives in China and probably doesn’t want to be too controversial. Premier Li has said the figures are unreliable and prefers to look at things like energy usage and train cargo traffic for a better idea so I definitely take gdp with a grain of salt. One fund manager was on to recently and said “the 6.9 GDP figure was because they couldn’t say 7 with a straight face”.

        We are definitely feeling the China slowdown more in Australia. Western Australia (where most of the iron ore comes from) is reeling with very high commercial vacencey rates (around 20%) as companies leave, falling residential property prices (Perth fell 4% in September), state government diving into defecit. In November property prices for Melbourne falling 3.5% and Sydney falling 1.5% (albeit off all time highs) where real estate agents are saying they have noticed a lot less Chinese people at auctions and in western Sydney some properties had no bids at all.

  13. Your simple yet elegant models are much appreciated. I was wondering if you condensed a number of Beijing’s policy options into the transfer wealth from the state to household sector category. For example, I believe in Avoiding the Fall you separated policy options such as raising interest rates, RMB appreciation, and raising wages. Would you consider each of these to fall under the “transfer wealth” category? That would make sense to me (e.g., a state owned company paying higher wages might be viewed as transferring wealth, unless the paid wages are confiscated in some way from Chinese households). I ask because when I hear “transfer wealth from the state to household sector” I think of a government selling/privatizing state owned companies. That seems like a one-off kind of thing and fundamentally different than raising wages, for example.

    • You’re absolutely right, Deek. These are all ways of transferring wealth to the household sector (unless, as you point out, the transfers are then funded by direct of indirect household taxers. Privatization is more forceful and direct than, say, raising interest rates and its impact can more easily be understood and contained.

  14. Hi Michael,
    I know this blog focuses on Economics, but Economics always overlaps with Politics.
    A lot of Asian countries changed from an authotarian government to a democracy. Why do you think some countries such as Taiwan and South Korea did pretty well wheras some such as Indonesia did poorly in building a democracy?

    • Has Indonesia done poorly?

      Read Fukuyama,

      Larry Diamond, Stanford, is another’s whose research you might want to review, he would be famous for the notions (memes), common in society, and part of the intellectual inertia. group-think, poor sense-making ability, that posits, that chances for democractic development are more likely to be increased as countries advance in middle income status, from an LDC through Middle Income Country.

      Of course this is an issue that is at play in the discussion surrounding countries transiting the middle income trap. the Financial Narrative has repositioned this narrative of late, in support of China, to emphasize advances in ability to absorb technology, and climb the value-added manufacturing ladder, along with growth in serrvices in a society, but of course this has to do also with the advance of institutions. Diamond’s work is behind the notions that support growth in Middle Income dynamics, and changing expectations of the middle class lead to the evolution’s of institutions in a society that lead to, support, the development of democracy. Fukuyama takes a much longer term view of the development of the Political Order on this matter. Both support institutional development. this is of course, one of the reasons, China has been emphasizing a moderately prosperous society, not merely of the altering economic trajectory, but in the re-emphasis upon the Party as the Guardian of the nation (insofar as the HAN ethnicity).

      Another interesting addition to this Rodrik, in his globalization Paradox, which looks at the current state of affairs, and its impact on the current status of Democracy. The lack of foresight on the part of international actors, in relation to Rodrik’s perspectives, are a glaring component of the intellectual inertia that Michael mentioned in another response.

      Taiwan and South Korea can also be relative to geopolitical considerations of another era.

      Intersting in all this, especially as relates to notions of some actors, and their perspectives, is the Bush Administrations discussion of a League of Democracies, which seems so far removed from the present dialogue. This points again, to the oft contrary makeup of actors, and the intellectual inertia mentioned by Michael previously may illustrate the ongoing influence of International cosmopolitanism, rather than mere Laissez-Faire Liberalism, in the current frames that dominate many dialogues, which would not be opposed in many of the centers of high finance globally. Do the ire of Post-Modernist and Marxian Sociological critics, paid newspaper commentators, and left-leaning Academics more generally.

      • On the geopolitical considerations, it’s also important to see how these geopolitical considerations interplay with financial aspects as well. If we think about trade networks, the dominant trade network from roughly 1000-1500 was the Indian Ocean. Around 1500 or so, that dynamic started to shift and the dominant trade network from roughly 1600-2000 became the Atlantic trade network.

        Now, we’re at a point where the trade and economic activity in the Pacific is larger than the Atlantic and we’re only at the beginning of this shift. We’re entering the heyday of the Pacific Ocean trade network. So financial institutions must develop and adapt in such a way as to allow for the integration of the Pacific trade network. Alas, the TPP is just the very beginning here.

        This is also where I find Rodrik kind of wrong. He seems to be operating with this nation-state paradigm that’s looking at the past. Nation-states are fine structures for Europe, but trying to impose those structures on Asia won’t work and will probably lead to (and is leading to) blow-ups. Nation-states are, by definition, states with homogenized polities. Countries like India and China are not homogenized. Some “nations” like Indonesia, Malaysia, Vietnam, etc all have similar economic and financial interests, but they will not be ethnically homogeneous. There needs to be financial structures that can adapt to these geopolitical constraints.

        What I’m basically saying is that you need empires. I was at a family reunion recently, we were all drinking, so I asked everyone if India will still be united in 150-200 years and everyone cringed. I have a similar view of it as well. Look at what’s happening in the Middle East with its nation-states. The world needs empires. We can say, oh well they can have federal systems, and I’ll say sure, but as Alexander Hamilton seems to have understood, the concept of federalism is the idea of empire.

        As for economic development, we must remember that some areas aren’t gonna be materially rich. I’m sorry, but Bihar will not be super wealthy regardless of whatever we do to try and make it so. However, you don’t need to be materially rich to have a functional society where everyone has a sense of dignity and self-respect.

        Keep in mind that in the heyday of the Indian Ocean trade network, the entire policy across the entire region really was 100% free markets and 100% free trade (all duties were purely for revenue purposes and the size of the states was very limited). It was the heyday of the Atlantic Ocean trade network where all of this changed, but the Atlantic Ocean is no longer the key zone.

        • There are many ways to define “empire”, Suvy, and, needless to say, many connotations that make it nearly impossible for a lot of people to accept any organizational system or principle that might be called “empire”. I suspect that is part of the reason you insist on calling it “empire”, which is exactly what I would have called it at your age, and for the same reasons, but as I’ve gotten older and wisder I would suggest that if you want to convince people of your thesis, rather than alarm them, you might want to use a more neutral word for what is essentially a federation with a centralized ruling bureaucracy.

          The meaning of “federal system” or “federation” may have been changed by the US usage of these words, so they might not work either. Thanks to Star Wars however maybe “federation” has become a useful name again, although only if you don’t mind the connotations of jedi knights and such.

          • Okay, so I grew up in the South. When I mention that the United States is an empire, most people I know generally agree. Even people with leftist sympathies, when I say that even a half-baked understanding of American history would tell you that the US is an empire, don’t disagree. With those in my generation, they (for the most part) seem to get what I’m saying. When I explain how the Civil War wasn’t just about slavery (it was a factor, but not the only one) and start discussing the trade routes, trade networks, and financial structures, everyone from the South understands it. Many Latin Americans (who really wanna be here) get it too.

            I take your point on empire, but don’t you think it’s also important to change the underlying philosophy that gives rise to these conceptions? For example, I’ve actually been trying to understand Marx so I’m getting much more into Capital (it’s actually a really easy read and it’s clear to me that Marx doesn’t understand anything about finance, capital, or capitalism) and I’m currently ~25% through Volume I. There’s so many assumptions he makes that he doesn’t realize he’s making. His general approach is completely wrong. He simply mistakes what he doesn’t understand or see as something that shouldn’t be so. The real error is fundamentally philosophical.

            I usually don’t watch movies or TV shows, but I LOVE Star Wars. I’ve also really gotten to appreciate the symbolism in it, the plot line is really good and exciting, and the entire series (including the Star Wars TV shows) is really incredible. I actually think the plot line and symbolism shows us the dangers of this leftist (by leftist, I mean Marx-based) thinking.

            The typical example of such a person would be Anakin Skywalker in Episode III. Anakin is effectively a social justice warrior (SJW). The typical scene of such an example is the Mace Windu vs Chancellor Palpatine scene where Mace Windu comes in with 3 other Jedi, who get wiped out immediately, takes Palpatine one on one and wins. Anakin shows up at the last minute, Palpatine plays to Anakin’s sentimentality, and “proves” to him that the Jedi are evil because Windu would kill Palpatine immediately instead of letting him go to trial. Mace Windu was a wise Jedi who understood that with horrible people, you have to do bad things to prevent worse things from happening. Anakin wanted to eliminate all pain and suffering, and in this process, ended up as nothing but a self-loathing psychopath.

            To be honest, I don’t see much of a difference between what Anakin did in Episode III and people like Lenin. These are people with an elevated sense of self, that claim to fight for justice, have this idealistic world view, confuse the world for something it’s not, and justify the most horrific acts in the name of the people.
            “This is how liberty dies: with thunderous applause”

            Another place where this shows up is in the fight between Obi-Wan and Anakin again, in The Revenge of the Sith.
            “I have brought peace, freedom, justice, and security to my new empire”–Anakin
            “Your new empire?”–Obi-Wan
            “Don’t make me kill you?”–Anakin
            “My allegiance is to the republic, to democracy”–Obi-Wan
            “If you’re not with me, then you’re my enemy”–Anakin
            “Only a Sith deals in absolutes. I will do what I must.”–Obi-Wan

          • Suvy, the Civil War was *entirely* about slavery. You really need to study more history. The Confederate leadership seceded explicitly because they wanted to *expand* slavery and could not tolerate any limits on slavery whatsoever.

            Slavery is of course an economic phenomenon.

            This was of course a serious economic issue for the Confederate slaveholder elite: they were a small elite governing over an empire, and their wealth in the form of slaves was their source of elite power. The non-slaveholding whites in the Confederate states were generally opposed to secession… but also generally didn’t have the ability to vote, thanks to high property requirements for voting.

            When the Confederate elites lost control of the national government of the US (which they had controlled since the start) they couldn’t tolerate losing control of their empire. Hence their decision to (a) secede, (b) violently assault federal military installations such as Fort Sumter, (c) overthrow the legal governments in the western territories by force and violence, and (d) invade Pennsylvania (remember where Gettysburg is).

            However, since the Confederacy had very little industrial production for steel and gunpowder, a shortage of manpower, no Navy, and half of its residents utterly opposed to it, this elite obviously lost. Unfortunately the traitors were pardoned by Andrew Johnson rather than being executed for treason, and the result was violent KKK overthrows of the legitimately elected state governments in the South, followed by Jim Crow.

            P.S. If you think Marx doesn’t understand finance or capitalism, you’re simply wrong. Read it again, and this time pay more attention to what was actually going on at the time. He was the best analyst of capitalism to date when he published. What Marx didn’t understand was *socialism*.

          • Clearly, the trade routes of the Mississippi could have played no part in the Civil War? But wait, that wouldn’t be correct because that was the biggest factor of the war.

            There was this guy who made a living off taking raw materials in the Midwest and shipping them down the Mississippi by building a raft, then riding back up to the Midwest and doing it all over again. That same guy was also a lawyer who dealt with Swamp Act claims and land designated for railroads, which were critical for lines of supply and getting goods to the Mississippi where they could be shipped off. He was Abraham Lincoln, who you may have heard of.

            List me the wars in the 19th century over slavery. I can think of one war that truly fits that bill: the Haitian revolution. Now give me a list of wars in the 19th century for trade routes, trade networks, and securing lines of supply. Of course, that’d be basically every war in the 19th century including the Haitian revolution (at least partially).

            I’ve read my financial history and the Civil War was created by capitalist elites as a way to finance expansion, provide investment opportunities, increase the size of their markets, to secure trade routes, and secure the Greater Mississippi trade network.

            Any complex event doesn’t just have ONE CAUSE. There’s usually 3-5 causes that account for 60-90% of the variation. In the case of the Civil War, these causes were the trade routes of the Mississippi, the resources of the entire South, the Greater Mississippi trade network, battles between various elites, and slavery. So yea, the chance of the Civil War being ONLY caused by slavery isn’t true.

            For a person who claims to know so much history, why do you avoid basic facts that disagree with your theories and claims? Using only facts with casuistic reasoning will not tell you nearly as much as using facts with rigorous reasoning.

            Going from slavery was A FACTOR to slavery being the ONLY FACTOR involves many assumptions that can be disproved by many different facts. So to say that the Civil War was CAUSED ONLY by slavery IS NOT a rigorous claim.

            “If you think Marx doesn’t understand finance or capitalism, you’re simply wrong. Read it again, and this time pay more attention to what was actually going on at the time. He was the best analyst of capitalism to date when he published.”

            Really, like when Marx says “capital is commodities” and “capital is money”. I’m sorry, but that’s straight up wrong. Real capital lies in social relations and institutions. Capital is about LEVERAGING the resources you have. Work is trading time for money, but since time is the most valuable resource you have, trading time for money can’t possibly make you wealthy. So the key to wealth LIES IN LEVERAGE, not work. Focusing on the struggle between capital and labor makes no sense.

            At some point, it becomes beneficial for the capitalists to increase wages, which Hamilton actually recognized. Hell, it was an essential part of the American School of Capitalism to even target high wages to sustain strong internal demand. So no, Marx didn’t have a good interpretation of capitalism. He had no understanding of how capitalism actually operates. He’s an idiot who didn’t understand the assumptions he made.

            The fact that you think “history” supports the kind of blatant claims you’re making is just absurd. It does no such thing of the kind. And your understanding of financial history is poor at best.

        • Have you read anything by the recently deceased Douglass North (R.I.P.)?

          • Actually seen his work referenced, and after your question watched his youtubes, am gonna buy his work.

            Such led me to Marcello de Cecco, and watched his as well.
            His INET video’s are worth watching, if he and the reviewer seemed a bit to cynical, generally, their knowledge of different monetary era’s were deep, such left me wanting for more, overall, but they didn’t express anything too earth shattering.

          • A while back on this blog, Prof. Pettis told me to pick up and read every single financial history book I could get my hands on. I decided to take up his advice, so I started to read every financial history book I can get my hands on. Almost all of what I’ve read in the past few months has been financial history and, at times, it feels like I’m banging my head (not too unfamiliar considering that I do lots of math) against a wall although I’m understanding a lot.

            Anyways, Douglass North ALWAYS gets referenced. I’ve heard good things coming from fellow grad students who study politics, but I’ve never read him. He’s clearly very influential.

          • Suvy If you get a chance list your bibliography…also, relist your blogspot site. I will PM you through there.

          • So on my blog, I just added both my contact info on the “About Me” section. As for the bibliography, by which I assume you mean my reading list, I’ll figure out a way to put it on my blog.

            Since I finished my research early–it should be online for the world to see by the end of the month (hopefully earlier)–I’ve been focusing my most of my time on financial history as of late.

            My favorite financial historian would have to be the late and great Charles Kindleberger, who leftists (as usual) always distort to make him support their own ends. To be quite honest, I find his wonderful Manias, Panics, and Crashes to not be that good compared to the rest of his work. His best book, that I’ve read is World Economic Primacy.

          • Read Kindleberger’s “Financial History of Western Europe”

          • Feel free to shout out to me any time. I’m usually up at weird hours and have strange sleeping cycles, so even if it’s “late” I’m still probably up.

          • I have A Financial History of Western Europe, but I haven’t really gotten into it yet.

          • Now I have gotten into it. It has been excellent thus far. Kindleberger is brilliant.

      • I suggest you consider what a government, being the majority party in a Democracy does to govern, and compare that with the government of a dictatorship handling of the same role. In fact there is very little difference. The government takes control of the levers of power, ensures the armed forces are behind it, tweaks the membership of the Judiciary – if they have a role in frustrating policy, and governs with the majority in an active parliament or with the rubber stamping of a politburo.

        The difference is in what the losers of the popular vote or other power struggle do. In a democracy they grudgingly accept being governed by a party they did not vote for and hope to unseat them at the next election. At worst they paint their placards and demonstrate outside the seat of government. In a non-democracy the losers reach for their guns ready to fight the government’s actual soldiers or bureaucrats. Or they may if it is geographically possible demand regional independence.

        In essence you must first look at how the opposition to the government behaves, or would behave if it were not repressed. If most of the people feel they are in a land occupied by “foreign” troops, they are likely to seek direct action to oppose the government, not via the ballot box.

  15. Professor Pettis, what will your new book be about, regardless of when it is written or released? Just curious. Thanks.

    • In the new book I will try to introduce debt and balance sheet analysis formally into economics. In a sense it will be a more general version of “The Volatility Machine”

  16. A lot of this boils down to how much of the current investment is supporting projects that will not provide adequate returns. There can be no clarity about bad debt because as you pointed out, it depends on the growth of the economy. How do we know the extent of bad debts in the system? The government will claim that a ghost city today (for example) was still viable because it will be populated down the line as the economy keeps growing – after all investment in physical infrastructure (ahead of time) is a component of the China growth story.

  17. “Beijing must continuously choose between a rising debt burden, rising unemployment, or rising transfers of wealth from the state sector.” Doesn’t supply-side deflation in China eliminate “a rising debt burden” as a policy option?

    • I am not sure if you mean something different, Dan, but deflation is actually a brutal cause of a rising debt burden, as Fischer pointed out.

      • Sorry; will try to clarify. If European (the West generally) deflation can be characterized broadly as demand-side (aggregate demand curve shifts to the left) – falling output, rising unemployment, falling prices causing (as Fischer pointed out) a rising debt burden, the solution (counter-intuitively) is more debt: stimulative monetary and fiscal policy.
        In the Chinese political economy deflation is supply-side (aggregate supply curve shifts to the right); increasing output and ffalling prices (negative PPI for 3 years, rising capital output ratio). In this context “a rising debt burden” would mean more of the same – more investment in SOEs; local govt financing platforms, which I assume must be off the table, which leaves only two options.

        • Dan

          Love Adair. On to your response, while, perhaps, financial products and assets can be viewed on supply and demand curves, I wonder, if that, because they are framed in this respect, we can not clearly separate dynamics. Of course, you are talking aggregates, but maybe aggregating from Micro-economic functions, in this respect, is part of the reason why we have so much trouble in these matters.

          When I think of deflation, in China….it is of course in asset prices.
          These will have roll on effects for investment, employment, financial stability, the banking and shadow banking systems, government revenues (all levels), people, firms, the global trading system, and so forth, but these can not be captured simply in any model.

          Adair speaks of the problem of models assuming far too much.
          I have stated a theory can only be two of the following three things, taken from Weick, …………..General, Accurate or Simple

          In this case it might only be General, and Simple, but Inaccurate as relates to the topic. As might many Economic models/frameworks.

          As for deflation in the price of goods, that has been happening for a long time, formerly vaunted by Finance, as the “China Price”, where we know what goes on support of it (cheap loans, export rebates, mass over-investment in capacity, negative margins, etc).

          That leads back to the model, where you noted falling wages, unemployment in the aggregate of deflation, and leads me to the bloat of asset valuations and inequality, in the era before asset deflation.

      • Sure, deflation can be a brutal cause of a rising debt burden, but deflation isn’t always bad. During the deflationary periods in the 19th century United States (basically all of the 19th century minus wartime), consumption went up, even during the recessionary times. Deflation, when it comes because of large increases in productivity that leads to falling prices is often times a positive. Assuming households aren’t indebted or debts have been cleared, deflation as falling prices is generally positive.

        With that being said, I’m starting to think that a large part of deflationary pressures comes with the structure of a monetary system. When most people think of free banking (including economists, social scientists, etc.), they think that the impact of free banking is this highly inflationary, wild, and crazy banking system that tends towards massive speculation, bubbles everywhere, and leads to an economic system with no sense of stability at all. However, that conception is something I find to be highly flawed.

        Free banking leads to an economic system that’s highly deflationary and a financial system that’s very innovative. I also think it’s a mistake to assume innovative financial systems as the most crazy, wild, unpredictable, and unstable financial systems. I’d argue that a tightly controlled financial system or financial systems with huge government control that tend towards inflation are far more unstable than free banking. In my view, the Chinese financial system is far more unstable than the American one, even though (or more realistically, because of) the American financial system having crises regularly like clockwork almost. Crises are necessary correction mechanisms and the financial crisis was really exacerbated by government policies and not market forces. If I remember correctly, more than 50% of all securitized mortgages up until 2008 went through Fannie Mae and Freddie Mac. There were laws on the books that were specifically designed to increase borrowing among the lower classes, but somehow “deregulation” was the cause of the crisis? That really doesn’t make any sense.

        It’s interesting because Minsky says that a consumption driven economy with investment being partially socialized is the best development model (I agree), but the best example of that was the 19th century US which was extremely deflationary. For most of the 19th century, there was virtually no financial regulation in the US. Every financial crisis was basically solved by getting a bunch of elites into a room, filling the room up with cigar smoke, breaking a bunch of laws, yelling and rage for days on end, and the procedure continued until the panic was halted. By the end of the 19th century, you had some guy who was basically a financial emperor successfully blackmailing a democratically elected President who had no clue what was going on.

        The power structure of the US during the time period (especially after the fall of the Jacksonian system, into the Civil War, and until the creation of the Federal Reserve) was essentially that a winner-take-all free-for-all in the financial system decided who the most powerful people in the country were. Most of the Presidents were merely puppets of these people.

        This is why I don’t get why Minsky favors more power to the government. He talks about how the liquidity expansions of the Federal Reserve and Treasury in the 70’s were largely responsible for, and for how they exacerbated, commodity prices (particularly oil prices). This is essentially the exact same as the libertarian/Austrian argument on this regard. When you have democratically elected leaders who either make decisions or appoint people who make decisions about these things while giving lots of “power to the people” (for lack of a better word), what you usually get is some nutcase that uses the masses as a springboard to gain power and then imposes his will on independent actors to really do what he wants. I’m not a libertarian, but you can’t make the world out into something it’s not and expect good things to happen by making horribly incorrect assumptions by assuming it’s gonna operate according to the way you think it should operate. The Iraq War was supported by most of the populace. Even in the current situation, more and more of the people support combat operations in the Middle East. There’s no real understanding of what the problem is and most people don’t seem to understand that if you start blowing up stuff, you may kill a terrorist, but you actually expand terrorism.

        The worst thing we can do is to get ourselves caught up in military conflicts overseas and reacting to them by direct force. On top of this, we’ve actively been promoting dangerous ideologies while the same people in charge who support killing terrorists have these promoters of these ideologies as a large portion of their support base.

        • The problem with deflation is that it leads to people starving in the streets while food rots in the granaries.

          Basically that’s the problem with deflation. If you can get deflation without that phenomenon, then you’re doing OK, but normally that’s what happens with deflation. It’s typically a phenomenon of too little money circulating among the masses to support the desired level of real economic activities.

          • “The problem with deflation is that it leads to people starving in the streets while food rots in the granaries.”

            That’s just an assumption.

            “If you can get deflation without that phenomenon, then you’re doing OK, but normally that’s what happens with deflation.”

            Another assumption here. In the 90’s for Japanese households, was this the case? In the late 90’s for the US, was this the case? Or were households getting more bang for their buck while some bureaucrat in power thought that deflation was such a problem that we needed massive liquidity expansion to offset the real benefits by households.

            You need to be more wary of the assumptions you make. You’ve made so many assertions that involve invalid assumptions and then attack me for “not reading history” while saying that “historical examples” “prove” your assertions when examples can’t rigorously prove anything. All examples can do is DISPROVE claims and statements, and such examples are called counterexamples. Secondly, there are clear historical examples that do disprove almost every single one of your claims.

    • “Supply side deflation” means that the corporate sector produces more than there is demand. And that doens’t bode too well for employment in that same corporate sector. It can be compensated with rising corporate debtloads. But somewhere in the (near) future the corporate sector will run into a brick wall called “too much debt” and then any government policy (in e.g. China or the US) is simply powerless.

      • ““Supply side deflation” means that the corporate sector produces more than there is demand.”

        It CAN BE that this is the case, but supply-side deflation can also come because of either increased productivity or a fall in input costs, both of which increase real demand and real purchasing power for consumers.

        • – Yes, but the positive impact of increased productivity is only short lived.
          – In the long run increased productivity actually UNDERMINES demand.

          • I don’t think that is correct, Willy 2. Increased productivity simply increases wealth for any amount of labor. The amount of demand depends on how that wealth is distributed.

    • – “Supply side Deflation”, a.k.a. (the supposedly) “good” deflation is a warning sign that somewhere in the future there will be “bad deflation” (= credit contraction).

      • Like increases in productivity or firms/households paying for less in input costs? Oh no, these are such horrible things. Wait….

        • OMG. Lots of confusion.

          – Agree. lower input costs are good on a Micro level but actually are bad on a Macro level for the US economy. But lower input costs also mean shrinking sales tax revenues, a shrinking US Current Account Deficit and rising budget deficits. And the combination of a growing Budget deficit with a shrinking Current Account Deficit is actually very detrimental for us (the US).

          – Falling prices is not equal to “Deflation” (Neither Good or Bad). Falling prices doesn’t mean the amount of credit/money contracts (=Deflation). And “Deflation” is defined as a contraction of money & credit.
          – A (credit) inflation requires rising prices and conversely falling prices induce (credit) deflation (Think: Steve Keen).
          – In isolation, increased productivity actually UNDERMINES an economy because it reduces demand. But that’s a concept A LOT OF people (incl. one “Suvy”) and even a lot of (“mainstream”) economists fail to understand. Only a few economists (e.g. Gary Shilling, Steve Keen) have shown to understand this concept.

          – Since mid 2014 US consumers have had a “windfall” profit in the form of falling commodity prices & especially oil & gasoline prices. Did consumers buy (significantly) more stuff (milk, bread, gasoline, etc.) ? That would help the economy ! But US consumer saved some 85% of those “windfall” profits and spent only 15%. In that regard, the US consumer has reduced the amount of $ he/she has spent on products. So, the $ amount of household consumption actually has fallen and that’s NOT a solid base for a thriving economy.
          – I saw the amount of $ I spent on gasoline go down as well. Very nice. But I, like so many others, didn’t suddenly spend more $ to buy more (e.g. milk, bread, gasoline)

          Consumers have used about 85% of those lower “input costs” since mid 2014 to pay down debt. Although it’s good to reduce one’s debts, it’s also called “Credit Deflation” at the same time.
          – Producers also enjoyed an decrease in their “input costs”. Agree. But did those producers reward their workers/employees by increasing their wages ? That would benefit the entire US economy.
          Or did the producers keep the benefits of those lower input costs for themselves ? Perhaps competition was so fierce that producers choose to pass their lower input costs on to their costumers. Then tell me where’s the benefit of those “lower input” costs for those producers ?

          • “But US consumer saved some 85% of those “windfall” profits and spent only 15%.”

            First off, I highly doubt this is true. Secondly, God forbid people use the decrease in cash outflow to deleverage. Maybe they should just start using their houses like ATMs again. It’s very difficult to tell where the specific windfalls from a drop in

            “In isolation, increased productivity actually UNDERMINES an economy because it reduces demand. But that’s a concept A LOT OF people (incl. one “Suvy”) and even a lot of (“mainstream”) economists fail to understand. Only a few economists (e.g. Gary Shilling, Steve Keen) have shown to understand this concept.”

            Increased productivity doesn’t have to decrease demand. The relationship between productivity and demand depends on other factors.

            “I saw the amount of $ I spent on gasoline go down as well. Very nice. But I, like so many others, didn’t suddenly spend more $ to buy more (e.g. milk, bread, gasoline)”

            It’s more complex than just this, but on the net, we can make certain statements. In general, the US is one of the world’s largest commodity importer. So regardless of how the specific flows work out, the US MUST benefit on the net.

            There’s also a difference between gasoline and oil. By and large, gasoline producers have actually done quite well if I remember correctly. Gasoline requires oil as an input, so a drop in oil prices should actually help gasoline producers by both increasing demand for gasoline and by reducing the costs of the primary input required to make their product. So people can spend less on gasoline, but the net benefit can actually be more due to the complex processes underlying the production and distribution of these products.

          • By gasoline producers, I mean refiners.

          • The debate on the “windfall” from the global oil producing industry to the rest of the global economy is perfectly illustrative of how P&Ls and balance sheets interact and how financial distress ends up creating an entirely different outcome than the one expected from the simple consideration of P&Ls.

            At first, the $2.7 Tr value transfer (34bn barrels produced annually x $80 price drop from $110 to $30) from the global oil sector to the rest of the global economy seems like good news or, in the worst case, neutral since someone’s gain is someone else’s loss. All the pundits and some policymakers that should have gained some experience by now have stressed that “unequivocally” positive income transfer.

            But, once again, it’s all about the balance sheet of whichever sector has invested the most on credit during the boom based on wrong price signals distorted by excessive money creation. After Technology Media Telecom in 1996-2000, after real estate in 2003-2007, it is the global oil industry which finds itself in this unpleasant situation this time around.

            Globally, the oil and oil services industry has invested $5.2 Tr during 2005-2015 at an average oil price of $89 per barrel. The residual book value of this capex spree is $2.7 Tr. If oil remains at $30 per barrel, a significant portion of that needs to be written off. At a minimum, the $1.8 Tr residual book value of the $2.5 Tr invested during 2011-2014 at $108 per barrel needs to be written off. In the end, a realistic number could be a $2.2 Tr asset impairment. Which is slightly annoying because the aggregate shareholders equity of the global oil and oil services industry is $2.3 Tr and its current equity market capitalization is $2.2 Tr. In other words, equity is likely wiped out, leaving nearly $1 Tr of debt exposed. One way or another, most of the $2.7 Tr “windfall” from the lower oil price will have to be used to absorb the losses and recapitalize the oil sector after its QE-induced mal-investment when newly created money flooded into oil as a financial asset class and completely distorted the price, pushing it far above physical supply-demand equilibrium.

            The mining and the maritime industries are in the same (sinking) boat as oil. In total, we might be looking at a ~ $3 Tr loss.

            Same causes. Same consequences. Again and again. Only the sector changes from one cycle to the next.

            Of course, one thing never seem to change and that is the policy response, always keen to do “whatever it takes” … to initiate the next crisis and compound the problem, that is.

          • DvD,

            People also pay less at the pump, which impacts poor and middle class households the most. People are paying less for energy or any good that requires energy to be transported. There’s a multiplier effect for this that pushes up real demand.

          • Yes, of course. This is the $2.7 Tr value transfer I’ve mentioned as most likely good news, or zero sum game at worst. But, after 18 months of oil price drop, the windfall for consumers has failed to boost the global economy, which has in fact decelerated, despite the supposed multiplier effect. Instead, it is financial stress that has appeared. Why is that?

            I think that’s because, in an over-leveraged world (even more so than in 2008), balance sheet dynamics prevail over income flows and end up creating an entirely different outcome than the one generally expected.

            The fact that the oil industry has over-invested on credit at the wrong price (equity book value is around $100 / barrel) means that, at market value, the equity is severely eroded and the debt is exposed. Based on data for listed oil & gas companies from the MSCI All-Country Oil & Gas Index, I come up with $1 Tr debt at risk. The BIS, presumably based on more thorough data, comes up with $2.5 Tr debt ( That’s more than enough to trigger a global credit contraction (the total equity of the listed banking sector from the MSCI All-Country Banks Index is $5.9 Tr), thus spreading the stress to other sectors and, ultimately, to the global economy.

            Same causes. Same unaddressed imbalances in the international trade and monetary system. Same inadequate monetary policy to cover up the imbalances. Same mal-investment and generation of irrecoverable debts. Same unaddressed vulnerability of the fractional reserve credit system to losses. Same policy mistakes based on short term expedients rather than addressing the structural design flaws at the heart of the weakening economic trend and rising debt load. Same consequences. Again and again. Making the relative debt snowball ever bigger at each iteration. Only the sector changes from one cycle to the next (TMT, real estate, oil) and sometimes the main recycling country (Japan, Germany, China). One thing never seem to change, namely the mistaken policy response: “deflation, making sure it happens everywhere”. They have succeeded once again, it seems.

          • Well, a drop in oil prices won’t boost the global economy because the global economy is necessarily inclusive of all producers and consumers of natural resources. Of course the drop in oil prices globally will be zero-sum. In countries that’re net consumers of natural resources, it’ll be a positive. In countries that’re net producers of natural resources, they’ll be hit very hard.

            When people are going from spending $60-80 to fill up their gas every week and this drops to $30-40, that’s a $130-180 boost every month (the average month is ~4.5 weeks) which gets circulated back. Yes, we may have deflationary pressure, but

            Remember that with crude oil production, some types of crude are more profitable at cheaper prices than other types. For example, many shale wells are actually profitable at even $30/barrel. If the price goes to $40/barrel, more come online. When the price drops, the wells online switch off. My guess is that we’ll see major restructurings, mergers, etc. in the oil industry (certainly in the US, which is the world’s largest producer now, although it may not be so in other countries where energy is basically nationalized). I think we’re headed into a time period where oil prices are permanently <$50-60/barrel for a long while.

            Also remember that deflation is simply a transfer to consumers. Consumers get lower prices. There's the kind of deflation from falling input costs or rising productivity and there's also debt deflation. The latter is always bad, but the former is always good. Anytime consumers get gains from productivity increases, it increases real demand. We must remember that. Countries that've already deleveraged or have gone a long way to deleveraging are in relatively good shape. Countries that've not deleveraged or have been exacerbating their bubbles (most of the world) are royally screwed.

            The only country that seems to have remotely healthy private sector balance sheets seems to be the United States. Virtually every other country has had their bubbles become systematically worse.

            In the case of the US, the biggest issues are trade and inequality–which are becoming more and more important prominent as the elections become closer. I hate saying this, but Donald Trump is right. We're losing to China, Vietnam, Mexico, and a whole bunch of other places. We're doing bad deals that're gutting our manufacturing for no reason. Eventually, I think we'll either see a shift in currency movements/capital flows or some kind of a tariff. This will be good for American demand and deleveraging, by and large, but it'll be horrible for the world as a whole. Given the centrality of the United States to the global geopolitical and financial landscape, these issues in the American political system will be the critical issues to determine the global geopolitical financial system over the next 50 years.

          • DvD wrote “But, once again, it’s all about the balance sheet of whichever sector has invested the most on credit during the boom based on wrong price signals distorted by excessive money creation.”

            I’m going to make a subtle but important quibble here. I don’t think there was excessive money creation — I think the money created was being sent to *the wrong people*.

            The rich, banks, investors are awash in money. The poor, the working class are sinking under debt and have no money. If the money creation had been directed straight to the poor and working class, the price signals would have been correct and the money would have been allocated to the correct sorts of investments.

            But the money was directed to a small, rich elite. As a result the price signals were waaaaaay off, because they reflected the interests of a tiny elite, not the general economy.

          • Trade imbalances within an international foreign exchange (non-)system based on systematic wage arbitrage rather than genuine comparative advantages, the resulting global duplication of money / credit creation in both the deficit and surplus countries, the resulting global deformation of value added between labor and capital income, the resulting divergence between ballooning asset prices and stagnating income values are all related. They are different aspects of the same issue.

          • “The poor, the working class are sinking under debt and have no money. If the money creation had been directed straight to the poor and working class, the price signals would have been correct and the money would have been allocated to the correct sorts of investments.”

            This idea that money creation can be directed to the working class or poor seems nonsensical to me. When a central bank “prints” money, it finances an asset purchase by issuing liabilities with NO CHANGE in the net worth. Since central banks can only buy financial assets, there won’t be much change for the working class or poor since the poor and working class don’t hold very many financial assets.

            Of course, governments could issue bonds that’d be bought by the central bank that could then be given to citizens (it seems like you’re suggesting tax cuts), but that is just debt monetization. Buying assets by issuing new liabilities doesn’t inherently make us any more productive or wealthier. It just transfers real resources.

            In my eyes, the most productive way to transfer resources to the poor, working class, and middle class is by debt restructuring and supply-side deflation. Deflation transfers resources to consumers by reducing costs and increasing real purchasing power, but there could be an issue if there’s too much debt since deflation increases the real value of the debt. Hence, we need more debt restructuring.

            I really dislike how the Fed targets a inflation rate of 2% and that target needs to go. Central banks can’t control inflation in the way that monetary theory suggests they can. Hell, even measuring inflation effectively is a difficult think in and of itself. There’s nothing inherently wrong with deflation and the largest increases in the standard of living for the US has historically come under extremely deflationary conditions (the 1930’s were the exception for the US for several reasons including the world’s financial problems after World War I was resolved).

  18. The rebalancing towards higher household income share and lower capex share in China should have been the correct policy response to the overcapacity situation and reduced export opportunities of 2008-2009. It was easier to implement at the time since the Chinese balance sheet was still in relatively good shape.

    But the actual policy response in 2009 was the exact opposite, unleashing massive credit expansion to fund the investment-related stimulus program, under quasi unanimous applause from the “experts” who had somehow missed the fact that this strategy had consistently produced poor outcomes in all the countries that had tried it in the last 30 years, with ephemeral impact on economic growth but lasting debt overhang.

    Now that the Chinese balance sheet has materially deteriorated as a direct consequence of the 2009 policy response, the rebalancing is even more necessary – and has actually started slowly in the past few years – but the path towards an orderly completion is much more narrow and difficult, as you have shown.

    It doesn’t seem so frequent that policymakers of all countries, confronted to the consequences of their erroneous decisions, have the courage to change course. They usually find it more expedient to resort to the famous risk management rule “when in trouble, double!”. Which suggests that the cycle of lowering interest rates, initiated one year ago in China, will continue. Alternatively or in conjunction with lower interest rates, the experiment at currency realignment might also continue after the initial trial of last August. These measures would be a transfer of value from households to borrowers, the reverse of what you suggest.

    No doubt Chinese policymakers are facing a largely self-inflicted economic dilemma at the moment (in that, they are in good company). We’ll see which way they eventually find it easier to lean. It would be good news if they choose to pursue the rebalancing. But the pressure and temptation to go the other way and lower interest and exchange rates should not be underestimated.

    You say the world needs a new Bretton Woods. You are almost alone saying this. Of course, there is a generally under-appreciated difference between being alone and being wrong. Or between being in a crowd and being right. Not that it makes the smallest difference but I think you are right. Early versus the dominant opinion (sorry for the pleonasm), but probably right. That’s not the most difficult part, however. The real Herculean task is to lift the weight of “established truths”. Good luck for that and thank you for your thoughts.

    • Thanks, DvD, but much less alone than I might have been had I made the same arguments five or ten years ago. I have convinced a number of influential people that the thesis is correct, or at least that it is not wrong, which turns out to be two very different things, and there are at least four or five of us who have been using various platforms to make the same argument and to cross-check each other.

      I am certain that we will eventually win because events will make us right, but the point is to win before that happens. If events force a change in the global monetary system, it will be messy and chaotic. If the change is pre-empted under a hegemon or a coordinated power structure that can impose an orderly transformation, it needn’t be.

      Remember that the driving force behind Bretton Woods was to avoid repeating the 1920s and 1930s. We have to do the same.

      • That’s good news. But note that 10 years ago (December 2005) was already extremely late to realize the necessity of a new international monetary arrangement, probably too late to avoid the complete seizure of interbank money markets in July 2007. Now, it’s 10 years later and global relative debt is significantly higher, making the path towards a new balanced international arrangement that much more narrow. At least it’s good to know some “influential people” are finally waking up from their decades-long “benign neglect” hibernation, the economic consequences of which is a few dozens trillions $ of irrecoverable debts. I fully agree with the pressing goal to prevent an economic and social catastrophe from the collapse of an uncooperative and highly leveraged global trade and monetary system and admire and support your perseverance in this respect. But, unless it becomes an immediate priority of the next US administration and unless there is still enough goodwill and trust left globally to put something together as quickly as feasible for these type of international agreements (2 big “if”), it seems to me the odds of the orderly scenario are very low by now.

        • The primary issue for the United States is the current account deficit. Of course, there’s been major movements within both sides to see this problem fixed. The only thing is that this movement isn’t coming from the “mainstream”. The person who’s been pointing to the American current account deficit as the biggest issue has actually been Donald Trump followed by Rand Paul and even people like Bernie Sanders, albeit to a lesser degree.

          From a pure financial standpoint, Trump actually understands that one of the most important issues is the negative current account balance. The person who doesn’t know anything about these issues is Hillary Clinton, who’s really nothing more than a shill.

          • why is this a problem? Now approx. 1.8% of gdp and disappearing fast.

          • The most recent data from that link is from Q3 2013 and it can be skewed via noise. For the past few years, the current account deficit has been 2.2% of GDP according to Trading Economics. Either way, even a 2.2% deficit is too much. The US needs to be running current account surpluses, not current account deficits. We can’t do this unless we change the monetary system.

          • Let me also preface my original comment about Trump by saying that there’s things on which he scares the hell out of me about. He’s not a statesman, he’s a complete clown, and some of the things he says are neither practical nor well thought out. I’m not voting for this guy, but he is right when he says the current account balance is a major problem.

            His immigration policy of deporting all illegal immigrants and revoking birthright citizenship in the 14th Amendment are batshit insane (and completely wrong IMO). He also wants to build a wall, which is stupid. A wall isn’t gonna work. He’s previously said that he wants to use Predator drones on the Mexican border. Is he insane?! These are weapons of war that’re being used on civilians looking for opportunity at a better life. This is just ridiculous.

            Trump is correct on infrastructure and on the current account balance, but he’s not a statesman. I don’t know how long he remains in play here either.

          • First, the US current account deficit is not disappearing, neither fast nor slowly. On the contrary, it has widened since 2013 relative to GDP despite the beneficial impact from the lower oil price. In fact, excluding oil, the US deficit is the widest it’s ever been, if I’m not mistaken. Not surprisingly given the strengthening of the USD since 2013. The US deficit will not disappear at all, at least not without a big fight. Large economic zones that are already in very significant external surplus – the Eurozone and China (together ~ 30% of world GDP) – are doing “whatever it takes” to get relief from their own debt problems by forcing up their external surplus even further. Japan is desperately trying as well, almost permanently for the past 25 years. The US (~ 23% of world GDP) is the obvious counterparty on which to try to export this unwanted excess debt given the international status of the USD. Especially as the Fed has temporarily stopped “making sure it doesn’t happened here” and is even providing incentives to floating capital to rush into the US with the prospects of higher short term rates. The US current account is structural, inherent as it is to the international trade and monetary system with the USD as its unit of account and no cooperatively enforced limits on large and persistent imbalances.

            Second, the reason why it is a problem for the US is that 40 years of accumulated current account deficits have been a big factor in pushing total debt from 150% to 350% of GDP. The reason it can not go on like that is quite simply that the US can not find itself with 550% debt to GDP in 40 years time. The same is true for all deficit countries, a fortiori is they don’t have an internationally recognized currency to issue at will or if they have lost monetary sovereignty because in that case the adjustment is by way of economic recession, mass unemployment and wage deflation. Perhaps it will make the issue more tangible for the US if the country was placed under an IMF adjustment program to try to eliminate the deficit. Of course, it’s precisely to avoid such unpleasant experience that the US is obstinately refusing to give up its veto right at the IMF.

            Third, the reason why it is a problem for the rest of the world, including surplus countries, is that it makes their development model very unbalanced, hence precarious and unsustainable. Reliant on FX arbitrage rather than genuine comparative advantages. At the first sign of slowing external surplus, the default response from policymakers is to use the accumulated FX reserves from years of external surplus to expand domestic credit, eventually ending up as indebted as the deficit countries themselves, if not more. This has happened to Japan and China. The end result is that there is duplication of credit worldwide in both the deficit and surplus countries and this is the mechanism which has been inflating the global debt snowball relative to global GDP for the past 35 years. To the point where the whole world is at risk of falling into a balance sheet recession. This is the point where we are now, thanks precisely to decades of “why is this a problem?”, also known as “benign neglect”. The staggering and totally unnecessary cost of such attitude is dozens of trillions $ of irrecoverable debts and the rise of potentially serious conflicts over the assignment of the corresponding losses.

            This is why it not only matters but it is probably the single most important economic issue of our times.

          • DvD

            This, to me, is the most important, and clearly explicated, statement that you have written here.


          • DvD

            You provide just enough of the pertinent information to explain what is happening and going to happen. Getting bogged down in perspective rich, data rich, and model rich explanations, while interesting and useful, takes us away from what has happened, is happening and is going to happen.

            Now with what you have said to regions attempting to go to surplus…. add in this piece, which I am sure we discussed well before anyone else, I know that I was well concerned with the global development implications of this well before the GFC, but this piece as to Chinese attempts to export their surplus steel production


            Reminds me of Friedan/Petti/Rodrik/Zedillo, After the Fall regarding financial cooperation.

            Then look at OBOR and AIIB.

            Look at how the Europeans jumped on board.
            Look at IMF support for China in IMF SDR.

            It is obvious that the ideology of global policy makers, ideology is always the bastard step child of philosophy, the group-think, and poor sense-making of this lot in regard to where we are at, where we have come from, and where we are going.

            While vast reams of argumentation have been given to “dichotomized” around ideology as scholarship in the past half century; too many interests, interested only in the narrow values of their particular discipline,we have a state of affairs where the whole development project is being suborned by a severe lack of cooperation at the global level. this is why I repeatedly highlight Laissez Fair Liberalism and International Cosmopolitanism, against the more Realpolitick Westphalian Territorialism we see acted upon by states.

            It seems that those who would support International Institutions, that would premise markets, that would support half-measures or merely, and slyly, act upon sheer greed, or upon Malthusian principles have married their utopian, Marxist, brothers and sisters while riding out to Xanadu on their unicorns.

            It is truly amazing how information and communication technologies, both lead to an advanced potential of humans and states, while also encouraging the most ridiculous of expectations, driving the most irreal of demons, as we march to the tune of the molochs.

            Dani Rodrik is really correct on what is happening, even while new paint is applied to the system. What China has been enabled to do, stops development before the debt dynamics you describe strip the gears of the system.

            I am not sure how any could have applauded such a massive overbuild of capacity, such a structuring of growth, when global demographics trend as they do, while there seems to be little time or room to ensure the structures that can support such a capability to supply.

          • DvD,

            Be careful using gross estimates of debt/GDP because we’re not on a gold standard anymore. Much of the debt is in the financial sector, which is just because of securitization. For example, the total assets of the American banking system are ~85% of GDP. In Europe, that number is closer to 300% of GDP with little securitization. When you account for capital assets, one security often shows up as debt 2-3 times because of the procedure that goes through a firm, but when one debt gets paid off, another does simultaneously.

            Gross debt/GDP is not very useful in the current financial structure of the US. It can be useful if the primary mode of financing is bank lending, but if you use capital assets or equity as your primary mode of financing, gross debt/GDP tells us nothing.

          • The source I use for total debt to GDP is the Financial Accounts of the United States. In this document, the Fed provides gross and net balance sheet items by sector. The 350% number (346% is the most recent data point exact if my memory is correct) is the net number for the US. And the 150% number from 40 years ago is of course from the same time series, hence calculated according to the same methodology. It is the net number. As we have previously discussed on this blog in the past (with Vinezi Karim but I can’t remember in which article from the top of my head), most if not all financial debt is not double counting but double leverage on the same asset base and absolutely needs to be counted.

          • “The source I use for total debt to GDP is the Financial Accounts of the United States. In this document, the Fed provides gross and net balance sheet items by sector. ”

            I know where the data is from and I actually have the data and charts of the gross debt/GDP in my FRED account. I’m not attacking your source for the data. I’m attacking the idea that the number is even valid when considering the financial structure of the American banking system.

            “As we have previously discussed on this blog in the past (with Vinezi Karim but I can’t remember in which article from the top of my head), most if not all financial debt is not double counting but double leverage on the same asset base and absolutely needs to be counted.”

            Most of the financial debt in the US must necessarily be double counting because of the structure of the American financial system. These are capital assets that move around in trillions on a daily basis via the repo market. For that to be true, it has to be double counting. Many times the amount of money is moved via the repo market daily than via the traditional bank market in the US.

            I can’t emphasize how different the American financial system is compared to the way you’re thinking about it. It requires a completely different way of thinking about it.

            It’s funny, because people read Minsky and apply it to our financial system but don’t seem to get that much of what he said can’t really apply. In terms of understanding the structure of the financial system and the pure acumen of thinkers, Murray Rothbard has a more sophisticated and nuanced understanding of the American banking system (especially when thinking in terms of capital assets) than Hyman Minsky.

            For example, Rothbard actually cites call money data as a very important piece of information for the US in the 19th century. Rothbard understands the capital asset base of American finance and on a level that’s much more sophisticated and nuanced than Minsky. There’s issues on Rothbard’s economic views and a lot of stuff that I don’t agree with him on, but there’s no doubt of his financial acumen and the details of it as well.

          • Suvy,

            You are not being clear.

            First, you tell me the number referenced above is gross. Which it’s not, it’s net.

            Then you tell me you know it’s not gross because you have access to the gross number from the Fed but that the problem is actually not that it’s the gross number (which you initially said was the problem) but that the number is not valid. Then you say the reason the number is not valid is because debt securities are traded many times over in a given period of time. Let’s clear a confusion here: it doesn’t matter whether a debt security with a face value of $Xm is sold and repurchased 0 or 100 times during a given time period, it is still a $Xm debt outstanding. You are confusing the amount turned over during a certain period of time with the amount outstanding at a given moment in time.

            Take a few minutes to study pages 82-106 of the latest Financial Accounts of the US. It will clarify your understanding of what is and what is not “financial sector debt” in the meaning of the Financial Accounts of the US, which is the meaning in which i use the expression.

          • DvD,

            Not only must most of that debt be double counting, but in many cases (if not most), it could even be triple counting. For example, if a firm issues asset backed commercial paper (ABCP) to finance some activity, some fund (suppose this is a money market fund although it would probably be some other type of fund, I’m just gonna refer to all of these as MMFs) essentially buys the commercial paper while offering “deposits” in the fund. Then, some origination company else buys that ABCP while buying other ABCP from other places packages it into an asset backed security (ABS). In other words, that firm as ABCPs as an asset and an ABS as a liability wherein the original MMF now has essentially swapped its ABCPs for an ABS that’s backed by a combination of ABCPs with the origination company having essentially no exposure one way or the other. Now someone can take that ABS and use it as collateral to borrow in the repo market.

            This is just an example and it probably won’t work out exactly like this way, but the capital markets in the United States work out very similar to this. In other words, double-counting is probably a large understatement and I suspect most of these asset-backed securities are created something like this. When you add in other derivatives like IRS or CDS, then this thing gets even more layered.

            Of course, this is basically the way the American capital markets worked up until the creation of the Federal Reserve where stupid bureaucrats mismanaged the system, ran it into the ground, and then proceeded to blame the people who built the system rather than themselves. Using this mechanism in the 19th century, the United States had a larger rail network than the rest of the world combined by 1860, had the world’s highest wages by the mid 1870’s, and had one of the largest sustained increases in standard of living ever seen in the four decades before World War I.

            It was really the Woodrow Wilson time period where this thing got fucked up. Then, these leftists have built these narratives saying that it was this market system that’d failed while Wilson and FDR are the Americans most responsible for setting up the dominance of the United States in the 20th century. It’s such horseshit. The stabilization of the short term money market rate of interest after the creation of the Federal Reserve combined with the use of the War Finance Corporation (WFC) as a ward of the state to make loans to small farmers and the like to sustain excess production levels led to catastrophe. Instead of the debts being cleared out like clockwork from consistent and sustained shifts in short term money market rates that usually shifted along with the agricultural cycles, they never got cleared. Then, Wilson decided it’d be a good idea to continue these policies by essentially lending others money to buy our shit after the war instead of writing down inter-war debts.

            The people who were primarily responsible for the economic and financial dominance of the US in the 20th century was the structure of American finance and people like JP Morgan and others. What I’m really worried about is that since the 40’s and 50’s, the financial understanding of both the populace and the elites actually fell IMO (especially the populace). I think this has started to shift with my generation, especially considering that we’ve been looking at our financial documents since we were effectively children. Unfortunately, we’re loaded with debt, but if this debt could be cleared, a lot of wonderful things can happen. I’m currently of the opinion that we understand money as well as any generation of the United States in ~100 years and as time goes on, it seems more and more true.

          • That example isn’t quite right. So when a firm issues an ABCP, it’d be an origination company that’d buy it and other ABCP, then package it to issue the ABS as a liability to an MMF or some asset manager that’d hold this ABS. They could use this ABS, at any point, to go into the repo market to get cash for operations.

            I’m not so sure how often commercial paper is securitized, but all sorts of things are primarily securitized and almost all credit created is securitized today from mortgages to student loans to credit card loans to virtually anything. In other words, there’s probably more double-counting than what either one of us would expect. Keep in mind that much government debt that’s held as an asset by the private sector is also used as collateral to borrow in the repo market, so much of that will be double-counted as well.

          • I don’t even know if my second example is a good one either. The important thing to remember is that this is basically how all money is created today and it works something like that. As long as the balance sheets balance, you can really create any security backed by virtually anything and the procedure would look like that.

          • I’m not saying that it’s their trading that makes the gross debt/GDP invaluable. I’m saying its their very creation and design that makes that number invaluable.

            I never said anything about what is gross debt or what isn’t, but I’m pretty sure that the repo market does count in the financial sector debt. With that being said, an asset backed security is obviously a liability of someone else. When you use that capital asset as collateral in the repo market, that asset shows up twice even though the originator probably has no exposure to the performance of the asset.

            Also, when you have a loan that’s been securitized, that loan counts as a liability as does the security. Then, if the security is being used as collateral in the repo market, that debt shows up again.

            The number I referenced above (I assume you meant the 85% of GDP number) was the total assets held by the commercial banking system. It’s not net debt or anything like that. It’s just the total assets of the commercial banking system that includes some ABS along with other bonds.

            I assume this is the chart and these are the numbers you’re referring to. I’ve only provided the private sector. The gross would be public+private.

            Why is that total number not valid? According to FRED, it classifies the debts as “credit market instruments” and as a “liability”. If this is the case, then you certainly can’t take the gross debt/GDP seriously.

            The mortgages of a person would be securitized into some MBS that shows up as a liability of an origination company, but both the household and the mortgage company have their own equity capital. So how can it be double leverage if you look at debt/equity ratios? That makes no sense.

            The useful numbers aren’t the gross debt numbers, but the debt/equity numbers for households, non-financial firms, and financial firms.

          • In the American financial system, it’s not valid to just add up the liabilities and assume that it’s the total debt level of the country that has to stay within income limits. There’s no reason for this and doing so leads to inaccurate conclusions IMO.

            This is shadow banking, which means that for a capital asset to exist, it has to show up on several balance sheets as a liability for that capital asset to exist, but there’s only one loan that really impacts the real economy. You’re gonna have firms that have literally no exposure to anything that may happen to such a capital asset being counted as liabilities and then counting another liability if that asset is used on the repo market as cash.

          • Let me make my point simple. Suppose you had two economies where everything on the real side of the economy was the exact same with the same incomes and everything and suppose one used shadow banking whilst the other used traditional banking where the household sector only had mortgage debt at 70% of GDP.

            In the shadow banking economy, that 70% mortgage would be securitized into ABS worth 70% of GDP making the gross debt AT LEAST 140% of GDP (probably higher with a repo market) with the origination company having no exposure to the quality of the loan. In a “traditional” banking economy, that 70% mortgage debt would show up as a total debt of 70% of GDP. Yet one capital structure of an economy is no real different from another.

          • *That last comment should be:
            *real structure, not capital structure

          • Suvy,

            It is now clearer to me what you mean and I will try to find the time to investigate further this delicate question of to what extent is financial sector debt “double counting” or “double leverage”. In the meantime, please note that if you look at the aggregate balance sheet of the US domestic financial sector (p. 82 of the latest Financial Accounts of the US) you will see that mutual fund shares and repos are separate items, they are of course not included in financial sector debt.

          • Okay, thank you for clearing that up. Also, I’m getting much of this stuff from Perry Mehrling. Here’s a video you may be interested in (for the current topic at hand, go to 44-46.

          • BTW, I don’t think mutual fund shares have anything to do with ABS, except for the fact that they may own them. Mutual funds are run by asset managers, which is wholly separate and different from an intermediary.

          • Suvy, you’re missing the inequality problem. The wealth generation in the second half of the 19th century was being vacuumed up by a small, rich elite, which created severe inequality problems which got worse and worse and worse and worse. The inequality problems led to ever-more-severe financial crises, like clockwork. (This is because high inequality causes an unstable economy due to the masses being poor and unable to buy stuff.)

            These were only addressed by Woodrow Wilson when he established the progressive income tax. (It wasn’t his idea, but he co-opted it.) The 1920s Presidents reversed the progressive wealth-transfer policies, and brought about the Great Crash and Great Depression as a result.

            That’s the reason Wilson and FDR were responsible for the US being a pretty decent place to live during the 20th century. The 19th-century Panics were getting worse and worse. The 1870s Depression was already referred to as the “great depression”, and they just kept getting worse. The Panic of 1907 was barely short of catastrophe: it was addressed by JP Morgan implementing big-government “command and control” policies (albeit with no legal authorization and no legitimacy). And after that, the 1929 Crash was outright catastrophe.

            To create a stable economy, the inequality problem has to be permanently addressed.

          • Nathaneal,

            Wilson was the most responsible for the Great Depression. Half of the damage of the Great Depression and the scale of the debt deflation came because of the foreign assets accumulated by Americans for war debts. Those debts kept being rolled over until there was an explicit default. If it weren’t for that, there would’ve been a HUGE problem. It was Wilson and the Democrats who explicitly chose to not write down unsustainable debts. Of course, you don’t have to take my word for it. You can take Keynes’s word or Adam Tooze’s word or a whole host of others.

            BTW, race relations actually got better in the Great Depression. Woodrow Wilson ran one of the most racist campaigns in American history to get elected and stacked his entire cabinet with Social Darwinists. He attacked Andrew Carnegie for donating money to black colleges for God’s sake.

            The panics of the 19th century were a great thing for the economic and financial system. Of course there’s short term instability, but is the goal of a financial system to have perfect stability? Of course not. The goal of a financial system is to reward risk-takers and finance productive activity, not to keep wealthy savers from earning “risk-free” returns on deposits.

            BTW, I understand inequality is a problem too (I’ve written about it before).

            Another thing you may wanna note is that the US had the world’s highest wages and its standard of living became the envy of the world by the late 19th century. The US was even ahead in things like shorter work weeks or other things of that nature.

            You may wanna actually read history before acting like you know it.

            And find me one time where I attacked FDR? I don’t hate or dislike FDR. On the contrary, I think he largely did what had to be done. I dislike Wilson cuz he’s an idiotic, idealistic, two-faced bigot who couldn’t even add properly.

      • The latest boom – bust cycle is now reaching “bust” phase in an unsurprising repetition of the same causes producing the same consequences.

        In the not inconceivable scenario where policymakers have to save the world again in the next few quarters / years, and assuming that it won’t be the same ones that “broke the world”, and hoping – perhaps too optimistically – that it won’t be by repeating again the same idiocies of “deflation, making sure it happens everywhere”, are the “influential people” ready to swing into action yet?

        To have a chance to win before events force a messy change in the international monetary system, one might as well start in the not too distant future.

        Thank you for having been a (rare) lucid voice during the boom phase.

  19. Could China export its financial crisis? That is, take out loans with its SOEs on foreign soil, use them to pay of the bad debts at home, then privatize those SOEs and let them default?

    • The SOEs would need to be able to get the loans in the first place.

      But everyone knows that:
      1) China’s SOEs are not only notoriously opaque, inefficient behemoths that rely on overly-generous state funding and monopoly positions to survive (with many of them failing to make a profit last year anyway despite these unfair advantages!)
      2) The financial data they do release is difficult to verify and generally considered to be unreliable (to put it mildly).
      So no foreign bank is going to give them loans – at least nothing close to the order of magnitude of money necessary to fix China’s problems at home! And any real loans they would even consider would look incredibly unfair to the SOEs used to being fed the Chinese peoples’ money on favourable terms by the state. In fact, it seems that Mr Xi has just announced $60Bn of aid to Africa. Presumably most of this will be paid to Chinese SOEs to build infrastructure in Africa which of course can potentially benefit the locals who use it (once the Chinese workers who build it have gone home) but at the same time, this is only adding to China’s internal debt burden.

      Also, I think the “how do we screw the outsiders to solve this particular problem?” mentality well-captured in your post has been way too obvious from Chinese business for decades now. It’s almost an epidemic sickness within the modern PRC to believe that you can cheat and con your way out of any problem – even if you already have a reputation for cheating and lying and nobody trusts you! It’s a good example of the chickens coming home to roost: for decades, the PRC has been nickel-and-diming companies and partners and telling itself how clever it is to cheat their way in to small and temporary advantages… while all the time, a huge crisis builds up. And now that the regime has finally accepted there is a problem (after a decade of aggressive, politically-charged denial), it seems that the regime’s nature has too much inertia for anyone to fix it.

      One final point: Michael Pettis Wan Sui!

    • if they’re taking out dollar loans abroad does that solve the problem of rmb debt at home?

  20. Excellent. The 3 policy options as summarized have not been clear signals to markets of Beijing’s choice. This appears to be undermining its credibility in maintaining a financial structure that can protect it from a financial crisis.

    The high debt level is relative viz other major economies and China’s debt/GDP level is at the upper boundaries. Markets can pressure a financial crisis such as the considering the RMB to be overvalued. Besides reforms as you correctly pointed out are filled with inertia with dubious impact on the existing moribund financial structure.

    Can we really hope for benign markets as China totters along to have confidence in Beijing’s ability to avoid a debt crisis ? Can we underestimate exogenous pressures in today’s concentration of debt laden major economies ?

    • Dan

      His argument is that the price of oil, and the ramp up of US shale, has wiped out segments, or percentages, off the current account deficit.. The longer term view you provide is useful. Because of two reasons; swelling of the current account deficit during the commodity supercycle story, which particularly hit the US at points, and primary through oil, but also the global impact that had on balance of payment dynamics, which should have impacted the US negatively. The intereseting thing, is the swelling of foreign holdings after the GFC (some switching to US Treasury debt, from other pools of dollar capital achieved over what time frame; Japan keeping pace with Chinese Treasury debt acquisitions).

      So, DvD is implying that if it wasn’t for oil the US current account surplus would be much higher.

      This is obviously true in some respects.

      First, as to oil, the US is producing more of its own. As the price of oil sinks, the US will import more. When the price starts to rise the US will produce more domestically. Noise in the financial media about debt in the sector, etc….are over-blown. Some, misguided pundit casting their net around to hope to be able to claim victory in the future (I predicted the Oil debt bomb back in 201X). More fundamentally, OPEC points of underinvestment in the industry, may see the traditional spike in oil prices globally, but this will see a bonanza domestically in the sector, mitigating rises in US C.A. Deficits in the lower oil price term. Any Builderburger or Free-Mason theorists out there?

      Now what DvD needs to consider is this;

      what does the “double global gdp” from 1998-2008 world experience, on the back of heightened enthusiasm for global integration, the super-cycle in commodities, and stories of deep untapped potential for consumer demand globally along with the rise of the global middle class, and the vertical rise in global debt levels, along with vast asset bloat, and well too much productive capacity in East Asia, mean/imply/assure?

      Well as to the US current account deficit, it implies that rises were do to the confluence of those factors. The current global recession (shallow depression), and alterations, imply that these should be subdued, and will likely be subdued, that attempts by others to continue what is being done, by large prosperous regions, undergoing distress, assure a break to the system. Because it cannot continue to work. It is added more grease to your drain pipes.

      So, the current account deficit in the US, if it were to rise, would be nothing more than a signal of a far greater global disaster in the making. Fundamentally, and structurally, this has to do more with the role of the US and the dollar in the global system, than with the status of the US economy itself. This is the US economy as the necessary center/keyhole/switch point of a world economy that is decidedly in bad shape.

      Insofar, as current account dynamics being a harbinger of the demise of the US economy. It should be acknowledged by now, that it is far more indicative of a global trading system that has become extremely distorted.

      While OPEC may be concerned of US shale, or merely losing market share, it may have been, that US shale, played a far more important place in stabilizing the global system than many might have realized. Without Shale, could you imagine what US austerity would have assured, as political ideologues of all sorts viewed the quarterly date.

      As Michael has said repeatedly, or is it just that I have, the US just needs to attach more of its own demand.

      DvD, whaddya think about accounts placed, in all our names, in the FED, with helicopter money, that can only be spent on services (barbers, restaurants, masseuses, education, tutors, lawyers, accountants, doctors, health care, physical therapists)?

      This at least, would assure one pass through the economy, via consumption, prior to leaking out in the terms of goods purchases.

      This passign through, and around, was what was meant to happen in the global system. Not China and others, altering the development trajectory of their peers, by insuring against “financial volatility” and structuring their economies to get asset bloat (ensuring financial volatility), to get high savings, to run up investment, to achieve high growth rates, and structure, current account surpluses, and creating an enormous amount of suspect growth (doubling of global gdp in 10 years), which enables social critics far outside the realm of their expertise, to note the rise of the rest, looped back into the economic discourse, by sell-side financial analysts, while all merrily hum a tune, in their sleep.

      • “DvD, whaddya think about accounts placed, in all our names, in the FED, with helicopter money, that can only be spent on services (barbers, restaurants, masseuses, education, tutors, lawyers, accountants, doctors, health care, physical therapists)?”

        I love it, but given the state of the poor, I think it should be legal to spend the money on domestically produce food, too.

        (Not rent. Rent is a problem economically because it’s typically not a real service — though if it includes repairs, that is a service — but usually it’s more of a tax extracted by landowners.)

    • – Higher US oil production.
      – Commodity prices drifting lower since mid 2011. Assuming US import volumes remaining flat. Falling commodity prices mean that both the US trade deficit & US CA deficit shrink.

  21. How do I explain the fact that the US is in permanent current account deficit since the end of Bretton Woods? I just did it above and, more importantly, it has been done in a very articulated manner by Michael Pettis so many times that you can pick pretty much any article on this site. If pressed for time, you can simply refer to “How much longer can the global trading system last?” or “Are we starting to see why it’s really the exorbitant burden?”.

  22. DVD, to clarify a technical point, when you say that surplus countries use accumulated FX reserves to expand domestic credit, leading to an international duplication of credit, are you describing the process by which the PBOC floods the market with RMB that were originally “printed” to exchange for USD received from exporters? (With that exchange maintains the currency peg and those USD used to purchase treasuries and help inflate asset bubbles in the U.S.)

    Just wanted to make sure because I recall from previous essays that U.S. treasuries/USD can not themselves be used in China on a large scale.

    • In the current system, a national central bank can issue currency not only against claims denominated in the national currency but also against claims denominated in foreign currency, like USD for instance.

      Generically, it works like this:

      1. Chinese companies in aggregate sell more goods to the US than they buy from the US, hence they have a trade surplus for which they receive the corresponding amount of USD balances as settlement.

      2. Chinese companies convert these USD balances to national currency balances (RMB) at the Chinese commercial banks.

      3. Chinese commercial banks convert these USD reserves to RMB reserves at the central bank. Said differently, the PBoC issues domestic currency as counterpart to the USD thus acquired. The equivalent of the USD balances enters China money supply. This is how Wikipedia describes it: “Foreign exchange reserves are assets held by central banks […] used to back its liabilities, eg. the local currency issued and the various bank reserves deposited with the central bank”.

      4. The PBoC typically invests these USD balances in the US financial markets. Notice here the round trip of USD from the US to China back to the US, with the effect that the US trade deficit doesn’t result in any monetary contraction, hence doesn’t restrict purchasing power, hence doesn’t trigger any downward adjustment in internal demand to rebalance the external trade account. This is the secret of “the deficit without tears” as Jacques Rueff called it or the “exorbitant privilege” of the USD as it is sometimes referred to in the sense that the US can buy without paying or by always pushing the payment to later. In any case, the USD balances have entered China money supply without leaving the US money supply. This feedback of USD is repeated endlessly on a daily basis. It is the mechanism by which trade imbalances have been allowed to develop and grow unrestricted for so long, accompanied of course by the corresponding rise in claims, ie. debt.

      5. The new RMB reserves of the Chinese banks can support new loans for a multiple amount of those reserves, for instance a 10x larger amount of loans if reserve requirements are 10%. This is precisely how China spectacular credit expansion was made possible from 2009-2010: by multiplication of the monetary reserves accumulated after years of trade surpluses. There is duplication of credit between China and the US as the USD balances enter China credit system while at the same time being on-lent back to the US, for instance being lent to the US Treasury if China buys US Treasury bonds. This exact same mechanism was also behind Japan’s credit boom of the late 1980’s after years of Japanese trade surpluses.

      The combination of large trade imbalances with fractional reserve banking is the powerful engine that explains the staggering rise in global Debt-to-GDP for the past 35 years, ultimately pushing both debtor (US) and creditor (Japan, China) countries into excess debt situation. The fast increase in global debt relative to global production results from this double mortgaging of future production at each iteration of this duplicate credit structure. Until such time when debt is no longer serviceable from the cashflows generated by future production, even with interest rates at 0%. At that point, the global pyramid of financial claims will collapse, either nominally or in real terms.

      • DvD:

        “In the current system, a national central bank can issue currency not only against claims denominated in the national currency but also against claims denominated in foreign currency, like USD for instance.” Zimbabwe, like China, can issue any amount of currency it likes with or without “claims denominated in a foreign currency.”
        In para 3: “The equivalent of the USD balances enters China money supply.” My understanding is that because the PBoC was worried about inflation, it required the banks to return those RMB in exchange for various central bank IOUs, which paid a very low return. In exchange the PBoC set very favorable loan – deposit rates guaranteeing profits and passing costs on to households.
        Then in para. 4: “In any case, the USD balances have entered China money supply without leaving the US money supply.” In addition to US bonds, lets say PBoC also bought Fannie Mae securities or shares in Microsoft with these dollars: are these assets now part of China’s money supply?
        Finally (para. 5): there were no “new reserves;” nor were new reserves necessary for the govt to massively increase credit in 2009.

      • Thank you, DVD, for the thorough explanation. That this process will lead to consequences seems clear, at least as you’ve described it. That leaves me wondering how this process is supposed to unfold. It seems only natural that the exporter would need to convert the USD to RMB in order to pay employees, make investments, and payments as necessary. To convert, the exporter would have to go to the local bank. Would the process unfold differently if the local bank didn’t exchange its USD for RMB at the PBOC? Or is the issue that the local bank and PBOC are simply giving too many RMB for USD, thereby artificially increasing its value?

        Csteven, I’ve gone back and read every single post on this site, and bookmark insightful comments from you, DVD, and others. The big picture stuff makes sense, almost like a scientific discovery, which is why I enjoy coming here so often. Sometimes I get stuck on the technical details, I imagine because econ/finance are not my field.

        That’s one reason I always keep my eyes open for book recommendations here. Reading the Volatility Machine, I felt like I could have used a book or two as background to get the full value. Perhaps a basic finance textbook is the answer.

    • Yes, he is saying that. Read back to previous blog posts of michaels, at DvDs writing, and you will see his writing on that matter. I would skim the last three newsletter/blog posts. Worth doing.

  23. This post provides a very interesting discussion about the different scenarios for rebalancing of China’s economy. To express the progress of rebalancing as the closing of the difference between GDP per capita and household income per capita seems highly relevant. Moreover, in my opinion it is appropriate to focus on so called ”financial distress” costs instead of the risk of a debt crisis. However, the magnitude of China’s recent credit boom and the current debt service ratio have for many countries in the past lead to a recession and/or banking crisis.

    For those who would like to know more on this topic I’ve published an article about rebalancing in China on my educational website ( On pages 31-35 I discuss the problems of over-investment and debt capacity constraints caused by China’s investment-driven growth model. Finally, I’m grateful for the comments and useful information provided by Michael Pettis for this article.

  24. Is it likely BJ will introduce any major land reforms to help avoid the inevitable? One major difference between China and most of the rest of the world is the ownership of lands, and I say that as China does have a massive stock of land outside of populated cities. In your model, you argued that the cure is to transfer the state driven investment model to private household driven investment model and you rightly said it’s politically very tough. I wonder if the land privatisation is the other cure that can help boost the spending from China within. After all, this worked for the controlling party last century and it could work again maybe?

  25. The Federal Reserve has begun tightening with its most recent rate hike. On the first day, the Fed took in $105 billion in RRPs. I suspect the entire tightening will occur primarily with RRP and, from what I understand, it seems to me like the biggest monetary contraction in American history. There’s talk that the market has priced in this move, but I don’t think the market has priced in this move. It seems to me like the float in the money markets is shifting very rapidly right now and I think most people don’t fully understand how large this tightening will end up being.

  26. So, Podemos just got 69 seats. Not enough for a revolution, but for a change?

  27. Prof Pettis – you’ve written about the impact of China’s rebalancing on commodities demand in the past and I wanted to ask if you’d given any thought recently to what your analysis (which I think is brilliant, for what it’s worth) implies for Chinese oil demand growth over the coming years. The various projections change frequently but in general energy analysts ALL seem to be expecting China to account for a quarter to a third of total global oil demand growth (the EIA says 1.1mm bpd in 2016 with China accounting for 0.3 of that). They differ with respect to assumptions made about supply growth/declines but I wanted to ask if you think there is a low/medium/high risk that the assumptions they make about Chinese demand growth turn out to be inaccurate given your views on how the rebalancing is likely to unfold. If trained economists can misunderstand the relationship between GDP growth and credit growth or why too much debt hurts an economy it doesn’t seem implausible that a consensus view on oil demand growth could be inconsistent with a broader set of assumptions made about a country’s economy.

    • I’ll write about this again soon, Andrew, but I am sure you knew I was going to say that when we’ve made similar projections in the past, we always ended up heavily overestimating usage by whichever country was the latest “miracle” candidate. Until we have a time machine we won’t be able to test this, but if you could go back and say about the USSR in 1960 or Japan in 1990 that within a decade or two either country would represent less than 6-7% of global demand, I’ll bet you’d have had a hard time convincing people you weren’t an idiot. I met a very senior Russian government official on Wednesday who warned me NEVER to underestimate just how difficult the adjustment always turns out to be. He spoke from experience.

    • David Stockton had an article on his blog stating that China’s oil purchases last year included large quantities of oil to fill their strategic reserve. That without these purchases China’s oil consumption recorded zero growth over the previous year! If this is correct, this year is almost certain to show a fall in oil purchases/consumption over 2015 since their economy and mfg in particular is slowing.

  28. Topic: Harry S. Dent & Demographics.

    Today I came across a weblink (see below) in my browser’s “Favorites” list. Didn’t know I still had it. The weblink points to an article on the website of the New York Post. It provides a good overview on Dent’s view on how demographics and the economy interacts. Although I don’t agree for the full 100% with Dent’s view. I think the current GIANT US debtload (~ $ 60 trillion) could\will be much more devastating than A LOT OF people think. (See Japan after 1990).

    I din’t read the book (“the Demographic Cliff”), so I don’t know whether or not I should/can recommend it.

    (article was posted on February 8, 2014)

    • Most of that $60 trillion is just held by financial intermediaries. You can’t treat that $60 trillion in the same way as Japan’s economy in the 90’s because the financial structure of the two economies is completely different. I’m confident that most of that $60 trillion is in stuff like ETFs, MBS, ABCP, and a whole host of other stuff.

      Using the nominal level of debt in an economy without looking at the specific financial structures in place for the economic systems in place is really quite useless. If we’re concerned with the degree of deleveraging that needs to take place, it’d be much better to use debt/equity ratios.

  29. Michael … interested in your take on transparency of reporting and cost of capital for China, etc. Nevsky Capital closing letter made me think of you, as they cite opaque financials as a key reason for fund closure.

  30. Professor Pettis,
    There are some cultural and economic explanations for the Chinese housing bubble which have gone unmentioned in your article and which keep the bubble afloat.
    1. Authorities in large cities have connected home ownership to census and education registries. If a citizen wishes to maintain access to good schools and the right to live in a city, he cannot sell!
    2. The government is publicly commited to keeping this bubble intact. Their right to govern is tied to this promise.
    3. Unmarried Chinese couples will rarely tie the knot without owning a house or flat to move to.
    4. If the housing bubble collapses, the banks will collapse with them.

    Add these points to 40% minimum downpayments, and a collapse in prices is not inevitable. The government will do everything possible to keep it from becoming an avalanche….Outside of the main cities, there are many instances of building companies abandoning new constuction projects that haven’t sold. Let’s see how this develops.

    Steven Milgrom

    • I don’t think a “collapse” in the housing bubble in inevitable except over a very long period, Steven, but not really for the reasons you say. After all your points 1, 2, and 4 are true of nearly every housing bubble of the past 100 years, and longer in many cases, and yet some bubbles have collapsed and others haven’t. An asset bubble collapse is almost always a kind of “bank run” in which a severely mismatched asset-liability structure has until some point been maintained by a financial system always willing and able to keep assets liquid and to roll over the liabilities as they come due. Once it is no longer willing or able, and especially when the mismatches are highly inverted, then either a) a “sudden stop” in lending, usually because lenders become increasingly worried about insolvency, financial fragility (i.e. increasingly inverted balance sheets requires increasingly small shocks to cause them to unwind disruptively), or some kind of exogenous risk, such as political risk, that can reverse the self-reinforcing process of rising prices, or b) a “sudden stop” in buying, usually because the market has become wholly speculative, with buyers only buying because they expect that they will be able quickly to sell at a higher price, and some exogenous event or slowly growing awareness has convinced them that higher prices are no longer likely or inevitable. In either case that is when the bubble usually collapses.

      Although on paper Chinese balance sheets are extremely fragile, and prices are well above almost any fundamental measure of value, government control of the banking system means that we can treat the banking system to a large extent as a single bank in which every maturity can be rolled over because every payment creates the deposit needed to make the payment, and the regulators ensure that banks can roll over debt with impunity because any bank can raise whatever deposit or purchased money it needs under the implicit government guarantee and with the accommodation of the central bank. In addition the system can respond to a buyer’s “boycott” either because the government (especially local governments) will buy real estate directly or will direct other entities to buy real estate. For example we’ve seen financing arrangements where preferred entities are able to buy real estate and finance the full purchase prics without recourse. Under those conditions you can always find buyers — basically if prices rise, the buyer pockets the profit, and if they fall, the buyer walks away and the bank or the government pockets the loss, in which case only a fool wouldn’t buy.

      As long as the government is credible, in other words, it can prevent a housing collapse. That leaves, I think, three questions:

      1. Is the government credible enough to prevent a housing collapse and are we certain that rising debt or regulatory mismanagement will not undermine its credibility?
      2. If so, and if prices continue to rise and bank exposure increases, is there any risk that at some point the housing market itself begins to undermine credibility by creating liabilities that exceed our perceptions of government creditworthiness (political as well as financial)?
      3. Even if government credibility is impregnable, a housing bubble distorts the economy and generates negative externalities by diverting land from its most productive use, by diverting credit from producers, by concentrating wealth, by taking up otherwise-productive labor and resources and allocating them into building unnecessary and unused real estate capacity, and so on. This can create a huge and growing dead weight loss to the economy. As this happens, at some point does the government decide that the cost of a disruptive real estate adjustment is less than the cost of continuing to misallocate and waste valuable resources, and so lets prices decline? If so, it will attempt to deflate the bubble gently, but there aren’t many cases in which bubbles have deflated gently, and n one when the bubble had reached extreme levels.

      As an aside which would be humorous if our province wasn’t still suffering 30-40% unemployment, I have already mentioned on this blog a New Year’s Eve party my mother held in her home in southern Spain in 2003 in which we had about 70-90 guests for dinner, including friends she, my three brothers and I had known as far back as my high-school days. I remember at one point being suddenly struck by the thought (this often happens when you’ve had a lot of great food and even more great wine) that except for my family, and an old friend with the Mercedes Benz franchise, nearly every person at the party was involved in or had evolved towards working in the local real estate sector — investors, owners of construction companies, tractor drivers, a petty burglar (we had a diverse group of friends), electricians, time-share agents, hotel owners and managers, specialized lawyers, the family that owned the largest home appliance emporium in the province, etc. That’s when I realized Spain was headed towards a massive real estate crash. It simply wasn’t sustainable that such a large share of a region’s working population could earn livings, sometimes fabulous livings, trading half-constructed bits of land back and forth among themselves.

      • Even if the debt keeps rolling yet the RMB depreciates against the USD by 30% or 50%, and housing prices at 1st tier stay about the same, from our perspective wouldn’t that be equal to the bubble collapsing?

        “I don’t think a “collapse” in the housing bubble is inevitable except over a very long period,”

        Hopefully some other readers can correct me however I take this sentence to mean: “… if they re-balance”. But current understanding is that they won’t/can’t, thus it is inevitable.

  31. I sent your piece on Chinese housing to some friends in China. They couldn’t open it. Had to copy it into my email and resend. In case you didn’t know.

  32. Hi Michael,

    I read an exert that you realised Spain for sure was in a housing bubble when you were sitting around at dinner and everyone seemed to be involved in the property sector. In Australia we have had the same thing for a while but everyone just seems to be a property investor. My uncle has taken the plunge and bought 3 homes in the last 3 years, brother in law has bought 3 homes in the last Couple of years, other brother has 5 homes over the last 12 years, Dad is renovating for extra rooms to rent out.. You get the picture. But property prices have registered their first quarter decline in 3 years last quarter, Western Australia property prices were falling all last year and now just as Andy Xie said, we have one of the highest foreign debts in the world ( 1 trillion on 1.6 trillion GDP) the mining slowdown could cause the money to stop going to Australia and liquidity to tighten. We’re getting that now with Australia’s largest bank (Commonwealth bank) getting international finance .3% higher than its last bond sale, investor loans declining. Most people are thinking it won’t get any worse than this but it could just be the beginning..

  33. Michael, wouldn’t now be a good time to revisit your bet with the Economist? Meaning, declare victory? Seems the mainstream economists have caught on…

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