Will China’s new “supply-side” reforms help China?

It wasn’t enough that we started 2016 with one of the worst weeks in the recent history of Chinese and global markets, but the panic continued into the following weeks and wreaked a great deal of damage to confidence. A lot of the reflexive China bulls are cautioning against misinterpreting the implications of the stock market collapse, and of course they are right, but the fact that the plunging Chinese markets can easily be misinterpreted should not in any way suggest that things are fine. Two weeks ago in the FT Alphaville blog (which is the best place to read regularly about China’s vulnerabilities, in my opinion, especially in their relentless focus on the changes in the various components of the balance of payments) Peter Doyle discussed one of the standard set of responses that we’ve seen repeated regularly since 2011 and 2012. The bull refrain has been, in his words: “things really aren’t that bad or surprising, and there’s considerable willpower and ammunition left in Beijing should it be necessary.”

“This makes good copy,” Doyle suggests, and adds, more diplomatically than I might have, “but is not persuasive”. It certainly isn’t, and he discusses some of the reasons why. On the same day George Magnus published an OpEd in the Financial Times that makes a point that too many people, as he points out, are still overlooking.

China’s chief vulnerability, and the main factor driving the tendency towards the increasingly fragile balance sheets that underlie the series of interrelated financial-market disruptions that began seriously in June 2013, is the inexorable rise in debt, and any analyst that fails to come to grips with the problem of excess credit is simply wasting his time. In the article Magnus writes:

Important economic reforms to the real economy and state monopolies have stalled, or succumbed to inertia and pushback. Policies designed to develop new sectors have not been matched by those needed to tackle problems in larger ones, such as poor productivity, chronic overcapacity and now a fourth consecutive year of producer price deflation. Tellingly, China’s most serious problem — the relentless accumulation of debt — received passive attention at most.

I will return to his point about stalled reforms, but Magnus is right about the debt. China’s most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt. In fact it doesn’t really matter if China is able to report growth rates for another year or two of 7%, or 6%, or even 8%. If the only way it can do so is by allowing debt to grow two or three times as fast, there will have been no improvement at all, the economy will not have adjusted, and China’s longer-term outlook will be worse than ever.

It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted. The astonishing ability of the China bulls, both foreign and Chinese, to celebrate every unexpected decline in growth and every new surge in debt as if they somehow justified nearly a decade’s worth of denials of the urgency of China’s rebalancing has done so much damage to China that the sooner Beijing’s leaders finally turn against the bulls, as I believe they might finally have done, the better for the Chinese people and the Chinese economy.

Beggaring thy neighbors

Before I explain why I think Beijing has decided that it has been misled in recent years, I should point out that what worried me most about the events of the past weeks was not the stock markets themselves, nor even the change in how investors and businesses inside and outside China perceive Beijing’s ability to manage the economy and the markets (I have already said many times that just as most people systematically over-rated the quality of Chinese policymaking in the past, they are likely now to be overly harsh in accusing Beijing of mismanagement). I am far more worried about how other countries might misinterpret the rapid decline in the RMB, accompanied by what seems like another surge in capital outflows.

Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth. Certainly if the PBoC ever were to stop intervening, and to let the RMB depreciate to some imagined fundamental “equilibrium”, we would quickly see that there is no such equilibrium level. In a speculative market, the market does not tend towards some stable value, with self-dissipating movement in any one direction reducing pressure for further movement in that direction. Price movements instead are self-reinforcing, and can quickly overshoot fundamentals.

Beijing is more likely to believe that the economic slowdown was caused by been weakness in domestic real estate and infrastructure construction, and not because exports are weak, and the latest trade data confirms the relatively strong export performance. Although manufacturing overcapacity is certainly a problem, much of it is in areas in which global demand has simply collapsed, and isn’t coming back, and so a cheaper currency would have little impact beyond temporarily reducing excess inventory, which is not enough of a benefit to justify the many costs of a weaker currency. Production facilities would still have to be closed down.

I think the real reason for the recent RMB weakness lies elsewhere. Beijing is trying to boost domestic liquidity in the hopes that this will generate stronger domestic demand, but expanding liquidity fuels capital outflows, and these put downward pressure on the currency, while increasing PBoC concerns about the monetary impact of money leaving the economy which, as an article in last week’s FT argues, might be worse than we think. Last week’s People’s Daily reports that prominent Tsinghua professor and former member of China’s Monetary Policy Committee, Li Daokui, claimed at Davos “that at least $3 trillion foreign exchange reserves in China is required to prevent foreign debt default risk”, for reasons that elude me, but if this reflects official views, after dropping $513 billion in 2015, current PBoC reserves of $3.33 trillion might suggest that two or three more months of continued strong outflows might prompt further steps by the PBoC to limit outflows.

The biggest risk created by the weaker RMB, as I see it however, is not a Chinese risk but rather a global one. The rest of the world may view recent Chinese RMB weakness as a signal for a new round of competitive devaluations. I have already said that I expect 2016 to be another bad year for trade, and I am worried that it seems as if every major economy in the world has implicitly decided to use US demand to bail out its own faltering economy. This will very likely derail the US recovery in 2016 or 2017 unless the US, too, decides to step in and intervene in trade. If that happened, of course, the impact on Europe and China would be terrible, but it seems to me a matter purely of logic that if the hard commodity and energy exporters are nearing the limits of their absorption capacity, either the major surplus nations or the US are going to have to absorb a bigger share of the demand deficiency created in Europe, China, and Japan.

The nine-point summary

But all this is preamble. Rather than add to the mass of coverage that the recent market events in China have generated, or to continue expressing my concern about the intractable arithmetic of global demand imbalances, I plan to discuss the process of Chinese reform and adjustment in this issue of my blog. While these may at first seem unrelated, in fact financial market disruptions are tightly tied into the self-reinforcing processes of rising debt, capital flight and slowing growth that recent reforms were supposed to untangle and address – and for which they have clearly failed.

I will argue that most economists have an incoherent understanding of China’s rebalancing needs, and for this reason many if not most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant. This is going to be a long post, so for those who want the 9-point summary:

  1. China’s economic growth is not decelerating as a natural consequence of the aging of China’s growth model. It is decelerating for three reasons. The first reason is the reversal of the growth process by which China’s imbalances have reached their systemic limits.[1]
  1. The second reason is that during the phase of rapid growth, China’s balance sheets, as occurred in every similar case, evolved to become highly inverted, and just as this automatically caused growth to be higher than expected during the expansion phase, it must cause lower-than-expected growth during the contraction phase.
  1. Finally, the economy must shift, one way or another, from one of rising leverage to one of declining leverage, and with rising debt the only thing propping up growth levels, deleveraging cannot help but cause growth to drop.
  1. This means that regardless of trends in underlying productivity, growth must slow sharply, and it will, either smoothly and continuously, or in the form of higher growth early in the adjustment period and a collapse in growth later.
  1. The growth deceleration can be temporarily countered by rapid increases in debt, but ultimately this will only increase future deceleration, with a rising chance that the shift will be disruptive. Every growth miracle in history has been followed by an unexpectedly difficult adjustment, and it is unreasonable to have expected that China would be any different.
  1. The only way to minimize the costs of the adjustment is to take steps to speed up the rebalancing of demand and the repayment of debt. This must be the direction of reforms if Beijing is going to reduce the costs of adjustment and the risk of a disruption.
  1. Repaying debt simply means allocating debt-servicing costs, either directly or indirectly, to specific sectors within the economy. This will either occur in ways targeted by policymakers, or if postponed for too long, it will occur in unpredictable ways determined by circumstances. For example default allocates the costs to creditors, inflation allocates the costs to household savers, economic collapse and high unemployment allocates the costs to workers, etc.
  1. By far the most efficient ways for Beijing to minimize the adjustment costs for the economy and reduce the risk of a debt-related disruption is to allocate debt-servicing costs to local governments by forcing them to liquidate assets directly or indirectly to pay down debt, and to increase household wealth by transferring wealth directly or indirectly from local governments to the household sector. Successful reforms must be consistent with these two goals.
  1. Beijing has already tried to address its growth problems by implementing the productivity-enhancing reforms beloved of orthodox economists, but while these might be a good idea in normal times, they will have almost no effect on reducing the cost of China’s economic adjustment.

Evaluating Beijing’s policies

It might seem exceptionally contrarian to say that most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant, but I think that senior policymakers in Beijing are beginning to agree. I say this because with the end of the Central Economic Work Conference last December, Beijing has announced with some fanfare that it plans to design and implement a new reform program consisting of what are being called “supply-side” policies.

A new reform program would seem only to be necessary if the old one has failed or is failing. It does seem to have failed. Chinese businesses and investors are very obviously increasingly concerned about both Chinese and global prospects, and so it is fitting that stock markets have been so accident prone this year. Like everyone else I have often cautioned against reading too much about China’s economic fundamentals into stock market performance. To the extent that there is informational content in the price behavior of stocks, however, we are more likely to see it expressed in the volatility of the markets than in its actual price level.

While opinion is still very split about the outlook for the Chinese economy, there is clearly a growing sense of unease about progress to date on the successful management of China’s economic adjustment, and this unease is at least part of the reason for market volatility. That is why the important news for me has been the announcement of the new reforms and the form of the announcement. Analysts are still very uncertain about what this new package of supply-side reforms that we’ve been hearing about since at least November may entail, but they way in which the reform package was announced suggests, at least too me, that the leadership is no longer satisfied that the policies Beijing has been pursuing during the past three years are having the intended effect.

I will discuss why later, and in spite of the limited information available, I also plan in this blog entry to try to place the package of reforms in some sort of useful context and to evaluate whether or not in principle these reforms are likely to be consistent with the rebalancing process. This might not be as difficult a task as it may at first seem, because rather than try to guess what Beijing will or won’t do, I will instead try to specify the conditions, albeit very abstractly, under which various policies will, individually or in the aggregate, be consistent with the rebalancing process.

It helps of course that China’s development model is not unique, and that its experiences are “different” only in the sense that with its powerful and rigid institutions (most importantly the extensive government involvement in the economy and its control of the banks) it has pushed the typical imbalances associated with its growth model often to levels that are unprecedented. There have otherwise been dozens of other countries that have experienced investment-led “miracle” growth in the past century, and their histories have been remarkably consistent.

Based on these histories we should be able to make fairly reasonable predictions about some of the problems that China faces today. Indeed we should have been able to do so a decade ago, but because very few economists seem to be familiar with the history, no matter how predictable they were each new reversal or systemic shift always seemed to come as a surprise. This is an important point to stress, especially if we want to understand what kinds of policies are likely to prove useful over the next several years. China’s extremely successful growth model was always likely to generate sustainable and rapid if unbalanced growth under certain easily-specified conditions.[2] It was also always likely to cause the financial sector and the various government and business balance sheets to evolve in a specific direction and imbed certain risks.

This is why nearly a decade ago – even if none of the economists or analysts writing about the Chinese economy understood why, with the exception of a handful, mostly Chinese academics – it was clear that the Chinese growth model would have to be reformed, and that these reforms were generally fairly easy to specify. Imbalances can persist for many years if the institutional constraints preventing adjustment are very strong, but all unbalanced systems tend towards rebalancing, and eventually the institutional sources of the imbalances are reversed, and they do.

Must everything cause a crisis?

Not everyone sees things this way. In the standard economic framework the economy is always at or close to equilibrium, and when exogenous shocks or policy distortions push it away from equilibrium it is only temporary.[3] For that reason most economists seem to assume that the longer what looks like an imbalance persists, the less likely it is really to be an imbalance that must ultimately reverse itself, when in fact the opposite is true. Imbalances can persist and get deeper year after year, but that only means that the reversal is more certain and likely to be more disruptive.

For the same reason most economists also seem to assume that if anyone thought that the Chinese economy was deeply imbalanced, and that debt was growing at an unsustainable pace, he was necessarily predicting an imminent crisis. This belief is so powerfully embedded in the standard equilibrium models most economists use that, strangely enough, even those of us who described the imbalances in one paragraph and in the very next paragraph insisted that a crisis was unlikely – in China’s case because of the government’s very high credibility and its role as financial guarantor – were automatically assumed to be predicting an imminent crisis.

Earlier this year, for example, a strategist at a Chicago-based fund by the name of Brian Singer said:

“Everyone is aware of China’s horrid debt levels and [Chinese financial markets analyst] Michael Pettis has done some great work, but he is China’s ‘Chicken Little’,” Singer said, referring to his panic-style predictions. “He discovered through his research that China has built up a lot of debt and he is right. China’s debt to gross domestic product (GDP), however, is pretty close to the United States’ and Germany’s.

“If we’re all so terribly concerned about China’s debt to GDP levels, why aren’t we equally as concerned about the US?…Even if [China’s] growth is slowed from double digits down to 4 or 5 per cent, they would still be absorbing that debt a lot faster the US could.”

I have already explained many times why comparing US and Chinese debt is nonsensical, and should be very obviously so, but to the extent that Singer, who seems an intelligent person, finds it impossible to accept that countries whose already-high debt levels are rising unsustainably (which simply means that debt is rising faster than debt-servicing capacity) do not necessarily default or collapse soon afterwards, it can only be because the economic model he implicitly uses is incoherent and that he is unfamiliar with financial history. Not only can an unsustainable rise in debt persist for many years, in some cases even decades, as Japan may one day prove, but in fact most unsustainable debt burdens are not resolved by crisis or collapse.

They are always resolved by mechanisms in which debt-servicing costs are explicitly or implicitly allocated to some sector of the economy, usually unwillingly, and while default or some form of financial crisis is one of the usually-explicit ways (the losses are assigned to creditors, obviously enough), it can often take many years before it happens, and it does not even happen in the majority of cases, as I will explain later in this entry when I discuss some of the ways in these debt costs have been allocated.

So while I have never predicted a crisis, panic-style or otherwise, I certainly have pointed out very early on that Chinese growth had become dependent on an unsustainable relationship with debt. While it was always possible that after many more years this could lead to a crisis, I always noted that a crisis was unlikely and most certainly not imminent. So why would Singer (and, to be fair, most other economists who use conventional equilibrium models) have found it impossible to see the sentences in which I said crisis was unlikely, once they read sentences in which I said imbalances were deep? It is because the two statements are incompatible in their models, which exclude ordinary balance sheet dynamics. The systemic creation and reversal of imbalances are not formally captured in these models.

My point is not simply to correct any misperceptions about what I did or didn’t say – in fact I have to confess that it hasn’t been all bad: in the past year because of similar mistaken models I have received a huge amount of credit from very generous people for correctly predicting market crises that in fact I did not predict. My point is rather about the incoherence of conventional thinking about unbalanced economies. The wide-spread inability intuitively to understand disequilibrium explains at least in part the misplaced confidence so many people have in the role Chinese reforms of the past few years would have in resolving China’s economic vulnerabilities (and those of peripheral Europe, for many of the same reasons) because it made improving productivity, rather than the rebalancing process itself, the main objective of the reforms. Refocusing on the rebalancing process will allow us to see not just why many of the old reforms simply didn’t matter, but also which of the new supply-side reforms might in principle work and which cannot.

Debt isn’t irrelevant

China’s unsustainable rise in debt is part of a self-reinforcing dynamic involving the consumption imbalance, and the important point is that because imbalances necessarily must reverse themselves eventually, any useful reform must be consistent with China’s economic rebalancing. In fact it should have been obvious years ago that Chinese policymakers only ever had two choices. They could proactively implement the reforms aimed at reversing the imbalances, however costly these reforms might be (and the longer they were postponed, the more costly they would become), or they could try to postpone the necessary reforms indefinitely – as many if not most countries in similar circumstances had done unsuccessfully in their attempts to sidestep the costs of rebalancing.

In the latter case, however, they would have almost certainly discovered, as their predecessors always discovered, that as the debt burden increased, the increasing impact of the distortions caused by the imbalances – and it is important to remember that the two are self-reinforcing – would eventually break through the institutional constraints that had prevented adjustment earlier. Rising balance sheet fragility makes an economy more sensitive to imbalances and to disruptive shocks, by which I mean that and balance sheets become increasingly fragile, their disruptive unraveling can be caused by progressively weaker random shocks – i.e. “triggers” – so that in very extreme cases it takes deceptively minor shocks to trigger major disruptions.[4] The risk in that case is that the imbalances would reverse themselves disruptively and force an unwanted resolution of the excessively high debt burden – of which the most obvious, but not only or even most likely, way would be in the form of a financial crisis of some sort.

I will give concrete examples later of how this has happened in previous cases, but put in starker terms, when for structural reasons economic growth in any country depends on an unsustainable increase in the debt burden, then simply as a matter of logic policymakers have two choices. They must either move aggressively to bring debt under control before the economy reaches its debt capacity limits, in which case they will cause growth to slow sharply over a difficult adjustment period during which balance sheets are rearranged. Or if they wait too long – usually because they mistakenly believe there is a set of efficiency-improving reforms that can cause productivity to rise faster than debt – at some point, as the debt burden continues to rise, either creditors will refuse to lend, in what economists call a “sudden stop”, or debt capacity limits will otherwise be reached, after which, in either case, growth will collapse. China must prevent its debt burden from reaching these levels.

Although it would have been much better for China if policymakers had recognized the urgent need to rebalance and implemented the necessary changes a decade earlier during the administration of Hu Jintao, it seems that Xi Jinping’s administration acknowledges the risk of continued credit expansion and wants to implement the necessary reforms before the economy is forced into a disruptive rebalancing. This, in effect, was what had been recognized during the October, 2013, Third Plenum. What is less clear to me, however, is how much time policymakers believe they have in which to force through the necessary reforms, and whether their assessment is realistic.

Right and wrong reforms

However much time they have – and in my opinion they are unlikely to have much more than 2-3 years in which to get credit growth under control, but there is no science to this so I cannot know for sure – as Beijing moves forward in its struggle to rebalance the Chinese economy, we should keep three things in mind:

  1. The rebalancing process is in fact fairly straightforward and easy to understand or describe, albeit only conceptually and at a very abstract level. Both the logic of China’s existing growth model and the almost uniform experiences of the many historical precedents reveal clearly the vulnerabilities China faces, what it must do to address them, and why the necessary reforms will be difficult.
  1. But while we should know what must happen, the specifics of the rebalancing process can be extremely complex, and depend very much on institutional conditions, at both the national level and the local level, and which include very powerful vested interests created by the development model. This is why even if it is clear in principle what must be done, choosing and implementing the actual reforms will be neither easy nor straightforward, and will involve significant experimentation and political maneuvering. However if we understand the rebalancing process in principle, we can at the very least distinguish between reform policies that are consistent with the necessary rebalancing process and policies that are not.
  1. But there is a conceptual problem. The historical precedents suggest – with ample support from Chinese experience of the past 3-4 years – that like very small whales with very large blowholes the economists advising policymakers, with the agreement of outside analysts, will offer a profusion of reform proposals which confuse two very different sets of reform programs, largely because of the mistaken model used by most economists and to which I referred earlier on the section on Singer. One set consists of what I call “asset-side” policies that are designed to improve China’s economic efficiency, and these are the only reforms that are meaningful according to most consensus economic models. The other set consists of what I might call “liability-side” policies – although these involve more than the liability side – that address the rebalancing process directly, and while finance specialists, or economists who have been influenced by the balance sheet approach of people like Hyman Minsky, easily recognize these kinds of reforms, in general they are not well understood. I have discussed before, including most recently in the September 1 entry of this blog, the difference between the two kinds of policies.

This third point is important and probably explains a feature of history about which economists seem unfamiliar. There have been dozens of cases in the past couple of centuries in which sovereign debt levels were seen as being excessive. In some of these cases the debt was subsequently repudiated, but in most cases policymakers at first sought to reassure their creditors that the country was facing a short-term liquidity shortage, and promised to design and implement a package of policies that would improve the country’s economic efficiency, increase growth, and restore confidence. In some cases these promises were perhaps never credible, but in many cases they were, and the markets were prepared to give policymakers enough time for the measures to work and for the country to begin growing its way out of its debt burden.

Efficiency versus rebalancing

But of these dozens of cases, few, if any, sovereign borrowers were in fact able actually to grow their ways out of their debt burdens until, either explicitly or implicitly, the debt was substantially written down and assigned to an unwilling sector.[5] Until policymakers take on the debt burden directly, the historical precedents seem to tell us very firmly, sovereign borrowers have never been able to implement reforms that improve efficiency enough to allow them to grow out of their debt burdens.

I have explained elsewhere some of the reasons that determine whether a country’s debt is “excessively high”, and I hope formally to list these reasons more fully in my next book, but the key is the gap that is created between projected debt-servicing costs and the projected revenues earmarked to service the debt when an economic entity suffers an unexpected surge in debt or an unexpected decline in growth. When this happens and as debt levels rise relative to debt servicing capacity, at some point the major stakeholders — including businesses, creditors, household savers, workers and so on — became uncertain enough about how this gap will be allocated that they take steps to protect themselves from this uncertainty.

As this happens investors, recognizing that stakeholder actions are likely to undermine the economy further and worsen balance sheet fragility, express their worry about the risk of default in the form of high required yields. They also make it difficult for the sovereign borrower to issue new forms of debt. Finance specialists will recognize this condition as very similar to, but more general than, the trigger that sets of financial distress costs.

For most economists this seems implicitly to be a surprising statement: excessive debt is a balance sheet problem, and not an efficiency or productivity problem (although of course inefficient or unproductive economic activity is usually, along with badly-designed balance sheets, the main cause of excessive debt). That is why, because policymakers will rely on advice from economic advisors who are unlikely to understand balance sheet dynamics and who are almost completely unfamiliar with historical precedents, it was almost inevitable that at first Beijing would prioritize the wrong set of reforms aimed at raising the equilibrium growth rate of the economy, even sometimes at the expense of further balance sheet deterioration.

And they have. This process is the typical end of the expansion phase of every investment-driven growth “miracle” in history. In each case after many years of investment misallocation, both unexpectedly high debt and unexpectedly low growth create the gap between debt servicing costs and expected revenues, with each driven by and exacerbating the other (as has clearly been the case in China today).

As the gap widens, it creates rising uncertainty about how excess debt servicing costs will ultimately be allocated, and at the point at which this uncertainty is high enough to alter materially the behavior of economic agents, and so lower the net asset value of the economic entity, the borrowing country has “excessive” debt. Once it does, the process of deleveraging, like rebalancing, is inevitable, and it too can occur in many different ways, all of which involve forms of “debt forgiveness”, usually involuntary.

Some forms of debt forgiveness are explicit. The devastating LDC debt crisis of the 1980s, which began in August 1982 when the Mexican government announced that it was unable to service its obligations to foreign banks, ended only in 1990, when these loans were exchanged for a nominal amount of Brady bonds equal to only 65% of the original notional amount of outstanding loans. In the subsequent years, one after another of the indebted LDCs obtained notional debt forgiveness of 30-50% in the subsequent Brady-bond restructurings.

Partial debt forgiveness has been a formal part of nearly every sovereign default or debt restructuring in modern history, although usually not until there has been a long and painful period of angry posturing and one or more partial restructurings. During this time we often also see informal kinds of partial debt forgiveness, for example when sovereign borrowers have repurchased their obligations in the secondary market at steep discounts, often secretly, or exchanged their obligations for other assets at a discount, for example the famous debt/equity swaps in several Latin American countries in the 1980s (see footnote 3).

The ways of debt forgiveness

Most forms of “debt forgiveness”, however, are implicit, and nearly always involuntary. German’s excessive debt burden after the Great War, for example, was “forgiven”, unwillingly, mainly by middle- and upper-middle-class households and civil servants, whose fixed income portfolios withered to nothing in the hyperinflation that began in mid 1921 and ended in early 1924. China’s huge portfolio of NPLs at the end of the 1990s (perhaps as much as 40% of total loans) was resolved by a decade of severe financial repression, so that lending rates of around 7% – in an economy in which GDP grew nominally by 18-20% and the GDP deflator usually exceed 8% – implied substantial debt forgiveness.[6]

Because these loans were funded by even cheaper deposits, debt was forgiven at the expense again of household depositors in the banking system, and of course it is no coincidence that during this period the household income and household consumption shares of GDP, which began the decade at already very low levels, plunged to levels that are historically unprecedented. There are many other ways of allocating a significant portion of the debt-servicing cost to unwilling agents in the economic equivalent of debt forgiveness: to creditors when debt is repudiated, to workers when wages are suppressed in order to increase net revenues for debt servicing, to small business owners when assets are expropriated to pay down debt, and so on.

In the current global environment this problem, by the way, is not one just limited to China. For example the same thing is happening in many European countries which – for all the urgency some, like Spain under President Rajoy, have implemented efficiency-enhancing reforms – have been unable to grow their economies faster than the growth in their outstanding debt. I would argue that so far the policy advice Beijing has been receiving has also mistakenly assumed that China’s slowdown was caused mainly by various regulatory and institutional inefficiencies and rigidities, and that as these are removed by regulatory reforms, or countered by the appropriate fiscal and monetary policy, the Chinese economy will naturally move towards a stable equilibrium with much higher productivity levels. This they think will ensure sufficiently rapid growth and will give Beijing additional time in which to resolve its debt problems.

But this is not how the adjustments have ever worked and until now it does not seem to be working in China. A rapid slowdown in growth is imbedded in the adjustment process, and will inevitably occur with or without the proper reforms. For now the only way to keep growth from dropping sharply is to allow debt to rise as rapidly as is needed to meet growth targets, currently at least two to three times as fast as the growth in China’s debt-servicing capacity, but as debt rises growth will continue to decelerate more quickly than predicted.

How never to be wrong

In fact growth in China has already slowed sharply, and by far more than was permitted in most of the standard models, but bizarrely enough the rapid deceleration in growth has not caused economists to reject their models. Instead, with great nimbleness and intellectual flexibility, and often without ever missing a beat, they have simply applied the same framework to explaining lower growth. Like Kevin Keegan famously, they always know what’s around the corner but they never know where the corner is.

A typical case might be Stephen Grenville, a former Australian central banker, whose growth forecasts are regularly and quickly undermined by reported growth data with no appreciable effect on his analysis. It may be unfair to single him out, but I have become familiar with his work mainly because several of my investment and academic friends in Australia seem to delight in sending me his articles and making witty comments about how economists can take data that confounds their forecasts and use it to confirm their analysis. He has long been an optimist on Chinese growth and a little over two years ago he assured Australian investors that Chinese government debt was quite low, and that keeping it low was easily achievable. Now he accepts that it is high and poses risks, but it was apparently never likely to be otherwise.

He even cheekily wondered at the time about economists predicting a slowdown “How wrong do you have to be before you lose your expert status?”, he asked. The question is going to prove purely hypothetical, the investor from Sydney who sent me the article assured me, given that there is no amount of slowdown and no strain in credit that will do the trick for Grenville, but he was nonetheless fairly annoyed that a former Australian government official who claimed to understand what was happening in China would have done the unforgiveable and never warned that iron prices were about to drop from over $190 to test $50, even though that turned out to be a fairly easy prediction.

Perhaps he forgot. As an aside, one of my PhD students, Hao Yang, helpfully explained to me early last year that if I ever needed to write these kinds of academic papers he could do it for me because that is precisely what PhD programs train students to do. I suspected he was being a little cynical, but certainly it has been widely noted within the investment industry that while there have been profound disagreements during the past decade about the Chinese economy, and its performance seems to have thoroughly confounded the expectations and forecasts of majority opinion, so far it is hard to find economists who haven’t been proven right, and not just among Australians. Something so extraordinary almost certainly could not happen without a great deal of highly specialized training, so perhaps Hao Yang was not being cynical at all.

The most common argument used by analysts like Grenville to justify the recurrence of “unexpectedly” low growth while maintaining the validity of the conventional equilibrium models is usually that slower growth is a natural consequence of China’s rising capital intensity. As the level of investment increases, and so becomes less scarce, the return on capital naturally must drop, and it is this drop in the marginal return on capital that explains the deceleration in growth.

This explanation however verges on the nonsensical, and it is useful to consider why:

  1. While it is true that the return on capital should decline as capital intensity rises, and that the capital intensive component of growth in China should be declining precisely because Chinese investment has surged, in fact surging investment is a three-decade-old story, whereas growth only began to decelerate rapidly over the past 3-4 years, just as China began to rebalance. This cannot just be coincidence.
  1. The deceleration in Chinese growth moreover has been far too rapid to be explained by any normal decline in marginal returns on capital as investment rises, even if capital intensity were uniform throughout China, and in fact it isn’t. Capital intensity varies tremendously from province to province, so while investment saturation might conceivably explain growth deceleration in the most advanced provinces in China, it cannot do so to anywhere near the same extent in most provinces because of the tremendous variation in capital intensity across China’s 31 provinces and provincial-level entities. In fact a mathematician looking at a map of China listing provincial per capita investment rates would immediately see that such rapid deceleration, compressed over so short a time period, would require extraordinary mathematical convolutions to support an argument based on investment saturation.
  1. Most damning of all, if growth deceleration were caused only, or mainly, by declining returns on capital as capital intensity rises, the most rapid deceleration would occur in the most advanced provinces, whereas there should be no slowdown in the least advanced. In fact across provinces the opposite is true.

Andrew Batson recently posted an interesting and related entry on his blog that is worth reading in full. Aside from investment saturation and unexplained invoking of the “middle-income trap”, I am not aware of any other plausible explanation for the sharp decline in reported GDP growth (and I ignore the very active debate about whether the real decline in economic growth is fully described by the reported decline in the GDP data) that might serve as an alternative to the model which posits sharp slowdown as the inevitable consequence of the rebalancing process.

The two important points if I am right, then, are, first, that during the adjustment a sharp slowdown in growth is inevitable, and is embedded within the rebalancing process, and second, that until the debt is specifically addressed, efficiency-improving reforms will never be enough to resolve the rebalancing process. Growth in other words will continue to decline substantially no matter what Beijing does.

By how much? I have argued since 2009 that the upper limit of average growth during the rebalancing period, which was always likely to be with the advent of the new leader, during the 2013-23 period, is likely to be 3-4% and that the longer Beijing succeeds in postponing the decline the greater the risk of disruptive “catching up” of the necessary deceleration in growth. It is not clear how quickly China has been growing in recent years because of the huge discrepancies between the reported growth data, which even Premier Li has questioned as being “for reference only”, and nearly every attempt by investment banks and independent economists to calculate growth independently. While it is hard to know what numbers to trust, most independent estimates already range from 1% to under 5%, but any higher growth rate over a longer rebalancing period is extremely unlikely and can only happen if implicit transfers from the state sector to the household sector very implausibly average more than 2-3% of GDP annually.

Do we care about the amount of economic activity?

Unfortunately the locus of the debate among those who recognize that the growth slowdown is not incidental and part of a “normal” deceleration of growth has shifted primarily to the accuracy of the published data. The Economist has typically been among those publications least convinced that China was facing a very difficult adjustment – in fact the FT’s Alphaville and the Economist have tended to bracket either side of the debate during the past few years – but in an article last week they worriedly note just how uncertain things have become:

Increases in indebtedness of that magnitude have been a forerunner of financial woes in other countries. Cracks are beginning to appear in China: capital outflows have surged, bankruptcies are occurring more frequently and bad loans in the banking sector are rising. It is all but certain that more pain lies ahead, though quite how much and how it will play out are matters for debate. 

I think the cracks may have appeared a while ago, but in the same article they make reference to the debate about how accurate are the GDP growth data:

Judging by the eerie stability of key indicators recently, China’s statisticians appear to have been doing just that. In year-on-year terms, growth over the past six quarters has been 7.2%, 7.2%, 7%, 7%, 6.9% and 6.8%. Such a tight clustering is improbable. 

I am not sure this is always as fruitful a debate as many seem to think it is. Of course it matters to anyone who wants to understand the economic cost of the adjustment, but arguments about whether the reported data are overstated, and by how much, have become part of the bull vs bear debate about whether Chinese growth is merely slowing temporarily, and not as part of a major economic reversal of the growth model. If you agree you are meant to accept the accuracy of the reported data. Otherwise you would question the data and assert that real GDP growth is substantially lower.

I don’t think this part of the discussion is especially useful. I have long argued that as long as China – or indeed any other country – has the debt capacity, it can get pretty much generate any amount of economic activity it wants. What is important is not how much growth there has been in economic activity, which is what the GDP numbers measure, but rather how much growth there has been in economic wealth, or in debt-servicing capacity, which is much the same thing, and how that compares with the growth in debt. In fact there probably hasn’t been much growth in the former, whatever the reported GDP data tell us, and there has been a lot in the latter.

Only two things matter

So what kinds of reforms are consistent with China’s rebalancing? Improvements in efficiency matter in the long term because as long as the economy does not suffer a major disruption they will tend to close the gap between the growth in economic activity and the growth in debt-servicing capacity, but they will have little effect on rebalancing. If the new set of reforms are to be truly effective, in other words, they must be designed directly to eliminate the balance sheet constraints on the economy. They must, in other words, accomplish the following:

  1. One of the two goals must be to rebalance demand. The distribution of resources must be rebalanced in a way that it can generate debt-free demand for the economy. In principle one way to do so is to reform the financial sector so that it is able to identify productive investment opportunities and channel credit in that direction. This has been one of the most regularly proposed “solutions” available to Beijing.

In practice this almost certainly cannot happen. As I have discussed elsewhere, if we understand the political and institutional constraints that drive the evolution of a country’s banking system we would see why the necessary reforms are likely to be impossible to implement, and for those who are interested, my former Columbia University colleague, Charles Calomiris has written excellently on the subject. “A country does not choose its banking system,” he and his co-author Stephen Haber point out, “rather it gets a banking system consistent with the institutions that govern its distribution of political power.”

The historical lesson here is fairly unambiguous, although as always it is disappointing that economists who do propose such a solution for China evince so little curiosity about the historical precedents. It should be no surprise that many countries in the late stages of their own investment-growth “miracles” have tried this kind of transformation, but none has ever managed so radical a change within its financial sector quickly enough, at least in part because the capital allocation decision is at the heart of distributional politics. Because China begins the process with the highest investment level in history, the extent of the transformation must exceed that of any other case, and it must occur at a time when weak Chinese demand is compounded by weak global demand, thereby reducing productive investment opportunities for the private sector.

Another source of additional debt-free demand is, in principle, the external sector. China, however, is already challenging Europe as running the highest current account surplus in history, and in a world in which demand is likely to remain weak for many years, the external sector is unlikely to provide sufficient additional demand. Of course China can generate more demand by exporting more capital to the developing world, as it proposes to do with OBOR and the New Silk Road projects. It can also exploit its technology lead in high-speed rail, as a recent People’s Daily article on potential contracts for the high-speed Moscow-Kazan, Las Vegas-Los Angeles, Malaysia-Singapore, and Tanzania-Zambia lines. The total amount of development finance or rail exports it can provide, however, is tiny compared to domestic demand requirements, and if the recipients find themselves unable to repay the debt, as history suggests could easily be the case, this becomes a worse alternative to misallocating investment at home.[7]

The only certain and politically feasible source of debt-free demand is domestic household consumption, but Chinese households suffer from the same problem Marriner Eccles identified in the US in the 1930s: those who want to spend do not have the resources, and those who have the resources do not want to spend – or in this case are not able to spend productively. The solution is as obvious as it is politically challenging: China must redistribute resources from the latter, i.e. the state sector, to the former, i.e. Chinese households.

  1. The other of the two goals must be to repair the balance sheet. Growth will not revive until the debt burden is sharply reduced. Debt can be reduced by partial debt forgiveness as part of a restructuring process following a default. It can be reduced as part of a pre-emptive restructuring. It can be reduced in the form of implicit debt forgiveness through monetization or financial repression. Or it can be paid down with funds generated from implicit or explicit taxes or from asset sales, including privatization. There are no other realistic ways to reduce debt.

Because most of China’s debt is internal debt, and directly or indirectly owed to the banks, debt restructuring with partial forgiveness is not an option at the macroeconomic level because ultimately it is a contingent liability of the government either way. But Beijing must resolve its debt burden at the national level or it risks repeating the mistakes of Japan –and Japan’s experience merely confirms what we already know: growth will not revive until the debt burden is sharply reduced.

China is also constrained from reducing the debt burden though monetization, financial repression, or taxes on households because in each case the cost is indirectly allocated to the household sector, which simply exacerbates the original imbalance. This leaves only two alternatives. First, Beijing can expropriate the wealth of small and medium enterprises directly or indirectly (in the latter case by raising taxes), although this means undermining the most productive part of the Chinese economy. Second, Beijing can liquidate government assets and use the proceeds to pay down debt. There are no other plausible options.

Multiple paths to the same outcome

One way or another China will adjust, and both of these objectives will be met. This will happen if for no other reason than because if something cannot go on forever, as Nixon’s CEA chairman Herbert Stein helpfully reminded us, it will stop.

The logic of rebalancing is overwhelmingly corroborated, if it needed to be, by historical precedents. Every relevant country that has experienced Chinese-style growth has suffered in a similar way, and in every country the resolution has turned out to be the same, whether the resolution occurred automatically as a consequence of a financial crisis or occurred because of specific policies. But just because we can predict with total confidence that China will eventually rebalance and deleverage, it doesn’t mean that we can just as easily predict how this will occur.

There are several paths a country can follow once systemic distortions and imbalances have become deep enough. The path that China actually takes depends, of course, on the policies implemented by the government, the behavior and confidence of Chinese households, investors and businesses, and external conditions. For this reason the whole point of the reform process should be, first, to identify the distortions and imbalances that have become, or threaten to become, wealth destroying; second, to list the various plausible paths by which these distortions and imbalances will be reversed; third, to select the optimal path consistent with the country’s political, social and economic institutions; and finally, to design and implement the policies that move the economy along the least painful of the many paths.

I list what I think are only six plausible paths China can follow in Chapter 5 of my 2013 book, Avoiding the Fall, along with the associated conditions for each of these paths. Each of the various paths will take the economic system back into some kind of balance from which policymakers can expect further sustainable growth, but these various paths have very different impacts on wealth and stability.

Take rebalancing. I have already listed above some of the many ways deleveraging can take place, from default to buy backs to financial repression to the sale of assets to pay down debt, and likewise there are several ways the rebalancing of demand can take place.

Both the US in the late 1920s and Japan in the late 1980s had deeply unbalanced economies and excessively high savings rates, the consequence of which were huge current account surpluses, along with what may have been the highest and the third highest hoard of foreign currency reserves, respectively, in history (China today probably ranks second), and highly inflated domestic asset markets. The causes of their imbalances were, at least in part, high levels of income inequality and relatively low household income shares of GDP.

Both countries rebalanced in the subsequent decade, as they inevitably had to, and in both cases the savings share of GDP declined (or the consumption share increased, which is the same thing), but it declined for very different reasons. In the US, the rebalancing occurred mainly in the form of a collapse in GDP relative to household income, with the former dropping by around 35% between 1930 and 1933 and the latter dropping by “only” half that rate. This was accompanied by substantial income redistribution, much of it occurring partly because of redistributive policies under Roosevelt and mostly because of a wave of sovereign and domestic bond defaults whose losses were borne mainly by the high-saving wealthy. Japan’s rebalancing, on the other hand, occurred in the form of two decades in which GDP growth barely exceeded 0%, while the growth in household income and consumption averaged more than 1%.

The state must pay

It is worth noting, as we think about China’s options, that historically a sharp, economically disruptive rebalancing with negative consumption growth and even more negative GDP growth, as experienced by the US, and a long period of stagnation with low consumption growth and even lower GDP growth, as happened in Japan, represent the two main ways that significant savings imbalances have tended in the past to adjust. In principle you can also have moderate GDP growth and high consumption growth, but this has never happened in history, probably for obvious reasons, and the extraordinary faith many analysts have that this is the most likely outcome unless Beijing seriously mismanages the process is almost certainly wholly misplaced.

There seem to be four main mechanisms responsible for major incidences of income redistribution. The first is a politically-driven redistribution of wealth from rich to poor (sometimes disruptively, in politically unstable states, and sometimes not). The second is very high inflation or financial repression that erodes bond and bank-deposit values. The third is a wave of sovereign and domestic bond defaults. The fourth is war, although perhaps this occurs mainly because war is often inflationary.

However they occur, the many historical precedents, reinforced by logic, suggest very strongly that no reform program will be viable in China unless it is consistent with a rebalancing of demand from investment to consumption and with a reining in of credit expansion and eventual reduction in the country’s debt burden. Because the only plausible way of rebalancing demand requires that Beijing directly or indirectly redistributes resources from the state sector to the household sector, while the most efficient way to reduce the debt burden involves liquidating state assets and using the proceeds to pay down debt, it turns out that by far the most efficient and sustainable program of reform requires the wholesale liquidation of state assets to fund transfers of wealth.

And there’s the rub. While a reform program that liquidates state assets to pay down debt and to rebalance the household income share is economically the least disruptive kind of reform program, and is the one most likely to leave the economy in a position to resume rapid growth over the long term, it is unfortunately likely to be fiercely resisted by the many powerful vested interest who benefit from state ownership and control of assets. This is the big challenge faced by the Xi administration, and it has been the challenge faced by nearly every country that has undergone a similar type of growth “miracle”.

Why do we need a new program?

I have taken a very long digression before actually beginning my discussion of successful and unsuccessful reforms, among both the previous set of reform proposals and the newly proposed “supply side” reforms, because once we understand what has worked in the past, and what has never worked, it becomes much easier to evaluate the specific reforms that might work for China and those reforms that are clearly irrelevant. In fact they become almost obvious.

There are two main criteria by which to judge the usefulness of specific reforms. First, because the consumption share of GDP will rise no matter which of the rebalancing paths China takes, policies that maintain or even increase the growth rate in household consumption, mainly by maintaining or increasing the growth rate of household income, will push China along a “better” adjustment path of more rapid growth.

Second, because China will deleverage one way or the other, and because financial distress costs create a powerful inverted relationship between the size of the debt burden and the pace of economic growth, policies that reduce financial distress costs, by far the most important being those that pay down debt, will push China along a “better” adjustment path of more rapid growth. These should be the two main considerations when evaluating reform proposals, and while policies that accomplish neither may in fact benefit China’s economic efficiency in the long run, they will not protect China from a brutal and potentially disruptive adjustment.

Beijing formally promised to begin rebalancing the economy in a famous speech by Wen Jiaobao in March, 2007, although it was only in 2012 that the consumption share of GDP stopped declining and began to rise. Since then, the consumption share of GDP has expanded by perhaps one-fifth of the amount by which its GDP share would eventually have had to expand, and debt continues to rise at least twice as quickly as debt-servicing capacity, perhaps much more. Clearly Beijing plans to design and put into place what are being called “supply-side” policies mainly in response to the difficulties it has encountered so far.

I think it is safe to say that implicit in the new set of policies is the recognition that in recent years Beijing has failed to rebalance the economy by nearly as much as it should have, and that it has not made enough progress in implementing the Third Plenum reform proposals. These reforms, if implemented robustly, would have restructured the country’s economic institutions so as to consolidate the progress of the past three decades and make long-term growth sustainable, but this has turned out to be extremely difficult, largely, I suspect, because of what to many was an unexpectedly strong political opposition. And yet this opposition was very much one of the characteristic outcomes of the rebalancing process.

There are only three choices

I have explained many times before why every fiscal, monetary, or regulatory policy decision Beijing takes ultimately forces it to choose among three outcomes, and to understand the supply-side reforms, we must keep these three outcomes in mind. China faces a tradeoff in which Beijing must continually choose among these three:

  • Higher unemployment, the limit of which is largely a political issue involving social instability, with the added wrinkle that certain types of unemployment are likely to be perceived as more politically costly than others – e.g. because returning to the family farms acts as a kind of safety valve, even with a significant fall in living standards, unemployment among migrant workers is likely to be less costly politically, or because university graduates are presumably more communicative and have higher expectations, their unemployment might be more costly.
  • Higher debt, by which I really mean a higher debt burden, or an increase in debt relative to debt-servicing capacity, and this can rise until credit growth can no longer be forced up to the point where it can be used to roll over existing debt with enough margin to fund as much new economic activity that Beijing targets.
  • Higher wealth transfers, in which governments – and because the Xi administration is seeking to centralize power this is most likely to involve local governments rather than central government entities – must liquidate assets and use the proceeds directly or indirectly either to increase household wealth or to pay down debt. The main constraint on Beijing’s ability to direct this process is likely to be the tremendous political opposition of the so-called “vested interests”, for whom government control of these assets is an important source of power, patronage, and wealth.

Beijing’s range of policies, in other words, is quite limited and in every case either economically painful (higher unemployment or higher debt) or politically difficult (higher wealth transfers). This new program of “supply-side” reforms is probably expected to provide Beijing with an alternative path from which perhaps it can sidestep this difficult trio of outcomes, but it will also be limited by the fact that these are Beijing’s only options, so that the best Beijing can expect might be simply that the supply-side reforms will give it more time.

Announcing the supply side policies

A widely-read primer published last month by Xinhua, the country’s official news agency, explained what Beijing might mean by supply-side reforms. What I found to be especially interesting was its explanation of why Beijing had shifted from what it called demand-side reforms to supply-side reforms:

The Chinese economy is no longer galloping ahead on the back of investment, exports and consumption. Adjusting banking regulations and interest rates has not been very successful in boosting investment or consumption.

With growth falling below 7 percent, China’s economy is in dire need of a makeover. Instead of working on the demand side, attention has turned to stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity resulting from the previous stimulus. Such measures are intended to increase the supply of goods and services, consequently lowering prices and boosting consumption.

I think it is especially noteworthy that Xinhua says that the adjusting of banking regulations and interest rates liberalization, among the most important parts of the existing reform program, have not been successful, and that China is “in dire need of a makeover”. This fact alone, if true, should be a very powerful indicator of just how misguided the economic models are that implicitly underlie the optimistic consensus about the management of China’s adjustment process during the past few years. Because I have long argued that these reforms would at best reverse the process by which the imbalances were created (especially the elimination of the financial distress “tax”) if the balance sheet approach to rebalancing were the appropriate model, and are implicit in the trade-off among three outcomes I list above, they are at least consistent with what I believe is the correct analysis.

The day after the Xinhua piece, an article in the People’s Daily made the same point:

China used to rely on stimulating the demand side, including investment, consumption and exports, to support growth. However, the effectiveness of such a strategy has lessened.

The economy experienced acute volatility in the mainland equity market, disappointing economic indicators and a currency devaluation this year. The government appeared to have done everything it could, including five interest rate cuts and massive investment in infrastructure, but that was not enough to spur the slowing economy. (“That’s because it [the demand-side support policy] is no longer the remedy for the disease,” said Li Zuojun, a researcher with the State Council Development Research Center (DRC), a government think tank.

The sense that “supply-side” reforms are a response to failures in the current reform program permeates reports in the official and non-official Chinese press, to the point where it should resolve the long running argument between bulls and bears. Economists at various Chinese think-tanks have made the same point, many affiliated with government ministries, including at the independent Winbro Economic Research Institute and at China Academy of New Supply-side Economics, the latter set up by former government official, according to an article published two weeks ago in the South China Morning Post. Their goal is to explore new ways to create a better framework for reforms.

The same SCMP article provides a fairly good summary of the new thinking, and suggests more specifically the perceived failings of current policies:

Economist Teng Tai, founder of Winbro Economic Research Institute, a private think tank in Beijing, is one of the most vocal proponents of supply-side reform. The country’s previous strategies for boosting economic growth were quickly losing effectiveness.

“The effects of demand-side measures in driving economic growth are getting weaker and weaker,” said Teng, who in 2012 sparked debate with the publication of his Declaration on New Supply-side Economics. “Take fixed-asset investment for instance. The government can increase infrastructure investment for sure, but the effects can be easily offset by sluggish capital spending by property developers and manufacturers,” Teng said.

However, through “supply-side” measures, such as reducing government red-tape, cutting taxes, and freeing up the labour, land and capital markets, China could prevent economic growth from slowing even more, while creating new sources of growth, said Teng, who attended a recent advisory meeting chaired by Premier Li Keqiang.

Keeping growth high

It goes on to list similar doubts by another proponent of the supply-side measures:

“A breakthrough in economic theories is needed since the approaches found in old textbooks can no longer solve today’s problems,” said Jia Kang, a government researcher and a member of the Chinese People’s Political Consultative Conference. After retiring from his research position at the Ministry of Finance, Jia founded the China Academy of New Supply-side Economics in 2013, pulling together a group of economists from both public and private sectors to study the approach.

“The leadership’s emphasis on supply-side reform is a new approach for connecting theory with reality.”But China’s supply-side economics would be different from its Western version to reflect China’s reality. In essence, Jia said, it was a systematic summary of what the country needed to do to restart its economic engine.

The official press has also suggested that the new reform program is in response to the ineffectiveness of the existing reform program, although they appear careful not to suggest too bluntly that the policies of the past 3-4 years were not the right policies at the time. “While the effectiveness of traditional demand-side policy support lessens,” the People’s Daily tells us, “the country is now turning to the other side for new growth vitality.” Or as Li Yiping, People University professor and one of the sharper economists in China, writes in China Daily:

Since the 2008 subprime crisis in the US, China has taken a series of demand-management measures to stabilize growth, including a 4 trillion yuan ($616.8 billion) stimulus package in 2008. These measures were taken on the assumption that the government could solve microcosmic problems through macro policies.

But the government intervention distorted factor prices and created further overproduction pressure. In other words, the structural adjustment didn’t work. The marginal utility of the stimulus package declined sharply the 4-trillion-yuan investment was not enough to maintain 7 percent growth today.

While from what I can understand there are very realistic appraisals of some of the problems China faces, unfortunately rather than acknowledge that it will be impossible to maintain current growth rates for more than a few years, and that the longer they are maintained the greater the risk that China is forced into a disruptive adjustment, at least some of the policy advisors have drawn a different conclusion. China can maintain high growth rates if it switches to a new basket of “supply-side” reforms.

What are Beijing’s “supply-side” policies?

What are these reforms? Here is how the People’s Daily describes them, in an article that calls them the “top priority” of this month’s annual Central Economic Work Conference:

The supply-side reform will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system. Public service is set to be improved and new demand created to spur growth.

The country’s top leaders are likely to introduce all-round “supply-side reform” at the annual Central Economic Work Conference, which began on Friday in Beijing. “All signs are pointing in the same direction, that supply-side reform will command center stage next year,” according to a policy review of the conference by China Minsheng Bank, one of the largest non-State banks.

The article goes on to give a little more detail further along, of which perhaps the most important and encouraging comment, at least in my opinion, is the suggestion that the GDP growth target will be de-emphasized:

A Web commentary by People’s Daily called the supply-side reform “a profound change”. It will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system, it said.

In the most immediate move, the commentary said, the government will have to reduce housing inventories, and one way is to subsidize rural migrant workers so they can settle down in the cities where they work. It should also shed excessive industrial capacity, especially in industries with low technology and poor market prospects, it said.

A third thing to do is to deepen reform of the financial system, so as to build a nationwide system of financial service, taxation and multiple layers of insurance, the commentary added. Wang Yiming, vice-president of the State Council Development Research Center, said reform will definitely be the priority at the meeting.

GDP growth will be assigned secondary importance, economists said. Some suggested that next year’s GDP growth target should be lowered from “around 7 percent” this year to between 6.5 and 6.8 percent. GDP growth in the first three quarters reached 6.9 percent year-on-year, down from the 7.3 percent last year. The growth target won’t be published until the National People’s Congress in March.

In its December 22 primer, Xinhua explained what Beijing might mean by supply-side reforms:

Supply-side economics holds that the best way to stimulate economic growth is to lower barriers to production, particularly through tax cuts. The wealth-owners, rather than spending on direct “demand” purchases, will then be more enticed to invest in things that increase supply, such as new businesses, innovative goods and services.

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. …Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

The return of Say’s Law

My understanding of the proposed reforms is that they are only partially described by use of the phrase “supply-side”, whose overuse is already causing some off us the same confusion felt by Inigo Montoya, the vengeful swordsman from The Princess Bride: “You keep using that word. I do not think it means what you think it means.”

The phrase itself was first used in 1976 by Herbert Stein, of the University of Virginia, to discuss a body of policies that had evolved in opposition to demand-side policies, often mistakenly attributed to Keynes, that could not explain or address the stagflation of the 1970s. These policies later became more widely known as “Reagonomics”, the heart of which is usually assumed to be tax cuts as part of a strategy to reduce government involvement in the economy on the grounds that government involvement creates incentives that systematically distort economic behavior and reduce productivity.

The heart of supply-side economics is Say’s Law, sometimes summarized as “supply creates its own demand”, based on the work of Jean-Baptiste Say, a French economist who lived from 1767 to 1832 and whose main work is A Treatise on Political Economy. In that book Say claimed that “a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” Because the full value of any commodity produced is dispersed into the economy in the form of production costs, wages, and profits, insufficient demand for goods can never be a fundamental condition of any free market because the payments involved in creating the supply of goods and services also create purchasing power which will either be used for consumption or will be saved and directed to investment, creating demand that is equal to the value of those goods.

This doesn’t mean that Say and his followers deny that there can be supply and demand mismatches, of course, but that they happen only for two reasons. First, as long as perfect information is impossible, the economy will be subject to bad information, poor judgment or exogenous shocks that can cause these mismatches. These tend to be fairly small in effect and are always temporary. Second, and far more powerfully, institutional distortions can force agents into systematic misalignments of supply and demand (mainly by changing incentives for political reasons) that can get very deep and can persist for very long periods. The main source of these distortions, according to supply-siders, is the government. In that case the best way to increase productivity permanently is to remove the source of these distortions.

According to Say and his followers, policymakers should never worry about inadequate demand as the source of depressions. They should only worry about policy distortions that cause the market to create the wrong mix of goods and services. In what is perhaps the most quoted of all of Say’s passages, he says:

The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

But we have to be careful about how we interpret that last clause. At first glance Say and the supply-siders seem to suggest that the whole rebalancing thesis is wrong for China, and that there is no reason to worry about the low consumption share of GDP. If this were true, however we would immediately have to dismiss supply-siders because it only takes a little arithmetic to show that China’s soaring debt burden is a direct consequence of its demand imbalance, and to dismiss the consequences implies both that the country’s debt capacity must be infinite and that there will never be uncertainty about the allocation of debt-servicing costs, neither of which can possibly be true.

A more sophisticated reading, however, would recognize that China’s demand imbalance could never have existed except for very powerful political incentives that created in the past two decades deep institutional distortions. In that case the point of supply side reforms would be to eliminate these distortions so that the imbalances can reverse, and it seems to me that the only possible disagreement among supply-siders must be whether the purpose of reforms is to eliminate institutional distortions as quickly as possible or whether Beijing should take active steps to speed up wealth transfers to the household sector. Which side you support depends, clearly, on how urgent you believe it is to begin to deleverage the Chinese economy and how quickly rebalancing can occur as you eliminate distortions.

The main tenets of China’s supply-side reforms

It is pretty easy to see why this economic theory might appeal to Beijing. China produces far more than it is able to consume or demand domestically, but even with one of the highest current account surpluses in history and with explosive credit expansion to generate demand, inventories are rising and growth rates dropping sharply. Reforms during the past three years have done too little to resolve the problem, and whether China can rely on these reforms depends on how much longer Beijing can afford to allow excessive credit expansion before China runs into debt capacity limits, and on whether Beijing is strong enough to overcome domestic political opposition and speed up the pace of the rebalancing.

Is this new set of supply-side reforms the solution? At least some of the policies that are being bandied about are actually contradictory or mutually exclusive, and clearly there is not nearly enough certainty about what exactly the reforms entail nor, just as importantly, whether they can be implemented, but already analysts have been wrestling with the implications, trying to clarify the reform proposals, and providing their initial evaluations. According to last month’s Economist:

Those who first pushed supply-side reform onto China’s political agenda want a clean break with the credit-driven past. Jia Kang, an outspoken researcher in the finance ministry who co-founded the new supply-side academy, defines the term in opposition to the short-term demand management that has often characterised China’s economic policy—the boosting of consumption and investment with the help of cheap money and dollops of government spending.

Whatever the supply-side reforms imply about earlier reform proposals, I do not think we can easily declare yet either that the new policies will be successful as predicted or that they won’t – with one exception: I am very confident in saying that unless implicit wealth transfers to the household sector rise to 2-3% of GDP annually, which I recognize will be politically very difficult to manage, there is almost no chance that growth over the rest of this decade can remain at 7% or even at 6% or 5%.

Because we are still in the very early stages of this new set of policies, it is hard to discuss them except in very abstract terms, and already so much ink has been spilled describing them that contradictions and confusions have emerged. An article in China Daily seems to set the stage at least as well as any other:

China used to rely on three major forces to drive economic growth – investment, exports and consumption, which are classified as the demand side. As the effectiveness of boosting growth in the demand side wanes, the government has started to reform the supply side, or the supply and effective use of production factors, including funds, resources, skilled workers, equipment and technologies. The reform aims to accelerate economic growth by freeing up productivity and raising supply-side competitiveness. Measures will include cutting excess industrial capacity, reducing housing inventories and cutting production costs with policy support.

The focus on freeing up productivity and raising competitiveness is of course no different than the promises made by the earlier set of reforms, but supply-side doctrine proposes that rather than raising productivity by improving the distribution of demand and letting producers respond, Beijing will take steps to boost production efficiencies, confident that more efficient and profitable producers will trickle down into stronger consumption. Credit Suisse, in its December 21 report, specifies more concretely how Beijing plans to raise productivity:

The central committee of China’s communist party held the annual Economic Working Conference between 18 and 21 December. The conference listed five major tasks for 2016: (1) Reduce over-capacity. (2) De-stocking. (3) De-leveraging. (4) Lower corporate costs. (5) Improve weak links in the economy.

The meeting pointed out that supply-side policy should be given more attention in order to stabilize growth. The conference highlighted that promoting the supply-side structural reform is an innovation to help China to adapt to, as well as to lead, the new norm of the economy. In the coming years starting from 2016, China will promote the supply-side structural reforms on top of appropriate expansion of aggregate demand. China will maintain macro policy stability in order to create a stable macro environment for structural reform. China will enhance the strength of active fiscal policy through tax cuts and the periodic increase of the budget deficit. Steady monetary policy should be adapted with flexibility. China will maintain adequate liquidity and appropriate growth of total social financing. China will increase the degree of direct financing, lower funding costs and further develop the exchange rate mechanism.

An article in Xinhua proposes, similarly, the following policies that are consistent with Credit Suisse’s understanding:

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

Finally, another article, this time in the South China Morning Post, describes the intentions of President Xi for the proposed supply-side policies in the following way and in nearly identical terms:

Xi has listed the four big battles of the coming year as addressing overcapacity, cutting financing costs, reducing property inventory and preventing financial risks, China Business News reported.

The key objectives

As far as I understand these reforms, then, I would list the main objectives very broadly as consisting of the following:

  1. Reducing over-capacity. This will include encouraging mergers and acquisitions, as well as preventing bankruptcy. Because of very strong incentives that favor gross production over productivity, including pressure, mainly from local governments, not to fire workers, Chinese companies have been very reluctant to close down capacity even as demand has plunged globally. Because companies that maintain capacity at the behest of local officials can have them pressure banks to finance rising inventories, the obvious consequence is rising debt collateralized by permanently rising inventory, and with no formal mechanism to write down either, wealth will be overstated. It is not clear to me exactly what policies will be implemented to address over-capacity, but policymakers at the Economic Working Conference stressed that the balance between social stability and structural reform should be dealt with carefully. Overcapacity must be reduced, in other words, but not by firing workers to the extent that the resulting unemployment is destabilizing. It will not be easy to do one however without risking the other.
  1. Reducing real estate inventory. Xu Lin, director of the Department of Development Planning at the country’s top economic planner, the Central Leading Group for Financial and Economic Affairs, explains in an interview with Caixin in November that “the key step [in reducing the inventory of property] is to help migrant workers in cities to settle down through household registration reforms, thus creating more demand for housing and reducing excess inventory of property. The mega cities of Beijing, Shanghai and Guangzhou are suffering from population pressure, so they have strengthened controls on population growth. But there are many other big and medium-sized cities with little population pressure that should enhance efforts on household registration reforms. But those efforts have been inadequate.” We have already seen tentative “experimental” policies aimed at liberalizing the hukou regime, which determines the residency status of all Chinese, but the biggest problem, as is well recognized, is that the supply of hukous is for lower-tier cities whereas most demand is for the top tier cities.
  1. De-leveraging and otherwise strengthening balance sheets. Much of the focus here seems to be on making debt-servicing costs more manageable for heavily indebted entities, especially provincial and municipal borrowers, many of which are struggling. According to an article last week in the People’s Daily, Zheng Gongcheng, a member of the National People’s Congress Standing Committee, said there are a great many zombie companies among State-owned enterprises. “Their existence can only increase financial loss and the pressure to repay debt.” What makes this especially difficult is the highly politicized nature of lending, which the supply side reforms will try to address. As Caixin explained in another article: “Banks were sometimes strong-armed by local government officials to extend loans to these [zombie] companies because they feared letting them go under would cause social instability, a risk-management executive at one bank said. ‘But these companies are doomed,’ he said, adding that forcing banks to lend to them ‘amounts to dragging down the quality of the loans to non-performing.'”
  1. Fiscal expansion, including tax cuts. Fiscal expansion is usually seen as a demand side policy, but in this case tax cuts will be designed and implemented as much to improve business efficiency as to boost demand.
  1. Lowering corporate costs directly and by reducing government bureaucracy. Again, according to Xu Lin, “I think the core idea is to reduce transaction costs created by institutional arrangements. Businesses are paying quite high costs in transactions, taxation, financing and social security. High transaction costs in China are mainly created by institutional hurdles. Reforming the supply side will reduce costs and make it easier for enterprises to do business. It will encourage business innovation, boost quality and efficiency of the supply system, and improve the supply structure. Eventually, supply side reform will lead to higher productivity of the economy and improve enterprises’ competitiveness.” There has been a great deal of complaining in the past about the cost of bureaucracy and most of the reformers seem to stress the need for streamlining bureaucracy.

The goals, then, seem to be to take advantage of the urgency generated by recent events to force through a series of difficult reforms that will improve China’s economic efficiency over the longer term, but that must at the same time address the vulnerabilities that China faces in the shorter term that can easily overwhelm any larger reform program. These reforms clearly will not be easy and just as clearly face significant political constraints.

How will the reforms proceed?

I won’t pretend that I can lay out with any subtlety the specific reforms that Beijing must implement in order to improve the long term functioning of its economy, and can only wish the reformers the best of luck in what promises to be an immense task, but I do want to address, perhaps a little abstractly, the kinds of policies that will directly move China towards or away from the optimal adjustment path. Again, I want to make the distinction between the two types of reforms to which I earlier referred:

  1. China, like every other economy, has institutional constraints that prevent it from achieving the sort of frictionless system in which incentives, including the design and implementation of economic laws, reward economic behavior that increases social wealth, and in which land, labor and capital resources are exploited as productively as possible. These reforms, which I sometimes refer to as “asset-side” reforms, are not always clear-cut among economists and are no less subject to fashion than men’s hair-styles, but it is pretty normal that at any point in time there is a widely accepted consensus about what constitutes an appropriate set of reforms. The goal of these reforms is to identify institutional or investment constraints that reduce efficiency and eliminate them, with the goal of increasing productivity.
  1. In highly unbalanced and heavily leveraged economies in the late stages of a particular growth model, another set of reforms are designed specifically to speed up the rebalancing process and to reduce leverage.

I have already pointed out that historical precedents had always made it easy to predict the sequence of events:

  • During the later stages of the period of rapid expansion in economic activity, and in spite of ample evidence that included an overwhelmingly consistent collection of historical precedents, the economic advisors to the Beijing government, along with most of the research analysts covering China, would fail to recognize the relationship between growing imbalances, capital misallocation, and deteriorating balance sheets. Nor would they recognize the symmetrical role of balance sheet inversion, in which what had caused them to confuse speculative profits in a period of expansion with higher-than-expected productivity would necessarily cause the contractionary phase to slow even further because the symmetry of speculation meant that losses would be magnified just as profits were. Just as inverted balance sheets made growth unexpectedly high in the expansion phase, in other words, they would necessarily make growth unexpectedly low during the contraction.
  • At some point, however, debt levels would become so high that these same economic advisors would recognize the need for economic rebalancing, and for reforms that would accommodate the rebalancing in a way that lessened the chance of disruption.
  • However because of a continued failure to understand the balance sheet component, the proposed reforms were always likely to be the asset-side reforms described above. For that reason it was also fairly easy to predict that the reforms would have very little impact in improving the underlying imbalances in the Chinese economy or in reducing the country’s reliance on surging debt to stabilize growth rates. It was inevitable that barring some major positive shock, debt would rise far more quickly than the economic policy advisors had predicted, and China’s vulnerability would rise to dangerous levels.

So to repeat myself

So far China has followed the same unfortunate path as all its predecessors. The recent announcement of supply-side reforms is no more than an explicit recognition that this is exactly what has happened. Beijing clearly now faces two options. One option is to recognize that productivity growth will not pull China out of its rising debt burden and to focus on liquidating assets to pay down debt and to fund wealth transfers to the household sector.

The second option is to embrace “supply-side” reforms which design improvements in economic efficiency in the elimination of institutional constraints that are dramatic enough to lead to a surge in productivity powerful enough to allow China to grow its way out of its debt burden. China, in this case, will not have to allocate losses directly or indirectly to households, businesses or governments, nor will the PBoC have to monetize the debt, which of course is simply another way of allocating the losses to the household sector. At the same time the household share of GDP will rise so rapidly that investment can quickly decline with no impact on growth or unemployment.

No country in history as ever managed to pull off this second option. This doesn’t make it impossible for China to do so, but it is all the more worrying that no country has suffered from economic imbalances or from debt burdens as deep as those of China today. Frankly I find it difficult to work out arithmetically any such outcome with numbers that are consistent systemically except under assumptions of near frictionless transitions and many years of implausibly high levels of wealth transfer from the state to ordinary households, on the order of at least 3-4% of GDP.

If I am right, the best way for China to avoid a very painful and possibly disruptive adjustment is for the supply-side reforms to be designed and implemented to accommodate rebalancing. Each important reform must be designed either to accommodate or boost a rapid increase in household income or wealth or it must be structured to pay down debt. As I will show it is important to understand that wealth transfers are fully compatible with supply-side reforms, depending on how the reforms are formulated.

How the evaluate the reforms

To return to the main objectives of the supply-side reform plan I listed above:

  1. Reducing over-capacity. The purpose of reducing over-capacity must be to reduce the growing gap between the rise in debt that is required by companies to maintain unnecessary production facilities and the declining economic value to Chinese households of what is produced. Inevitably there will be lots of other considerations invoked by the relevant stakeholders and regulators involved in the problem of over-capacity, but they are barely relevant. If the reformers understand that the measures they take should be valued primarily in terms of their impact on reducing China’s debt burden, these reforms will be consistent with a smoother and ultimately less costly economic adjustment.

The difficulty in closing capacity of course is that it also usually means increasing unemployment. This is simply yet additional confirmation that all policy choices for Beijing boil down to choosing among higher debt, higher unemployment, and higher wealth transfers. But closing down unnecessary capacity can pay for itself, even if unemployed workers are temporarily put on the government payroll (causing debt to rise, but usually by less than it had before), but only temporarily as Beijing takes other measures to boost household income through wealth transfers from the state and so to boost consumption, a form of demand which is likely to be more labor intensive than the demand created in the process of over-capacity.

There seems to be a very clear consensus about at lleast some of the targets of the over-capacity drive. On Friday People’s Daily reported a statement released a day earlier by Premier Li Keqiang: “Steel and coal sectors should take the lead in cutting overcapacity, digest unreasonable inventories, reduce costs and improve efficiency.”

Steel and coal have been so universally recognized as problem sectors that it is pretty clear that they will not be able to escape significant cuts, but after a decade or two of extremely cheap credit (often negative in real terms), widespread moral hazard, and corporate governance incentives that prioritized production and employment above all other measures, it would be astonishing if over-capacity and bloated inventories were not a blight on most industrial sectors dominated by the state or by large companies with access to state patronage. Because these are likely to be the key causes of misallocated credit, and because measures that cut back on overcapacity are likely to be painful, and so politically resisted, if the measures do not extend well beyond steel and coal their impacts are not likely to be sufficient.

  1. Reducing real estate inventory. Conceptually there is no easier reform to explain than this one, and while I recognize that there may be innumerable legal and political implications, in fact the economics are brutally simple and incontrovertible.

The economic value of an empty apartment to the Chinese economy is exactly zero, minus running costs and depreciation, which are only partially mitigated by the positive economic impact of their role as a secure form of savings. The moment an empty apartment is occupied by a Chinese family, Chinese wealth and income are immediately increased by the value that family attaches to the change in its living standards. China is notorious for the sheer quantity of its empty apartments, and these empty apartments represent an enormous expenditure of labor and resources by the Chinese people of which a large amount of wealth is destroyed every day that the apartments remain empty.

To get a sense of the magnitude of the cost to China of residential vacancies, we would need to begin with an estimate of the number of vacant apartments. I have seen estimates of the number of empty apartments in urban China range from 64 million to as much as 89 million. I have read elsewhere that roughly between one in four and one in five urban apartments in China is empty. I assume these two sets of numbers are consistent. For comparison sake I understand that urban vacancies in China are roughly ten times the global norm – i.e. in the rest of the world one in forty to one in fifty urban apartments are typically empty.

If we assume that there are in fact 60-70 million empty apartments in China, and further assume that the average size of these apartments is 50-60 square meters and the average square meter costs roughly $1,500, then the market value of empty apartments in China is between $4.5 trillion and $6.3 trillion. The real economic value of an apartment is not necessarily the same as its market price, especially if a speculative real estate bubble has artificially boosted prices, so let us assume that the fundamental value of these apartments to Chinese households is actually between one-third and one-half of the market value. If these apartments were actually occupied, in other words, Chinese households would feel wealthier by between $1.5 to $3 trillion dollars, or roughly 12-25% of GDP.

If somehow vacancies in China were immediately to adjust to global norms, these back-of-the-envelope calculations suggest that the annual impact on household wealth would be the equivalent of an annual increase in household income of 2-3 percentage points – which increases the income of households by 4-6%, assuming that the income of ordinary Chinese households is roughly 50% of GDP.

This is not a negligible number. If the supply-side reforms Beijing is contemplating include measures that reverse the institutional distortions responsible for the very high vacancy rate in China, household income would be the equivalent of a 4-6% higher every year, and the household income share of GDP would be raised by 2-3 percentage points, which isn’t much less than has been accomplished over four very difficult years.

Reforms that fill up empty apartments, in other words, are clearly consistent with rebalancing, and are the kinds of reforms that will lower the adjustment costs for China. What kind of reforms can fill empty apartments? That I leave to smarter people than me, but if the carrying cost of an apartment, which is currently very low, were to increase significantly, most obviously by instituting an annual property tax, apartment owners would have very strong incentives either to sell or to rent out their apartments to generate enough income to cover the cost of holding apartments. The risk of course is that by forcing some owners to sell, this could cause the market to drop sharply, and while I would argue that lower housing prices represent, paradoxically, an increase in Chinese wealth, along with a redistribution of wealth from the richer to the poorer (and, not incidentally, might help President Xi flush out additional corruption), it might have a destabilizing impact on the banking system which would have to be addressed.

The point is that by placing real-estate-related reforms in the context of rebalancing, we can quickly tell which reforms are helpful and which are not. We can also see that houkou reforms aimed at diverting population flows to empty apartments in secondary cities, and away from the highly prized Beijing-Shanghai tier of cities, avoids addressing a big chunk of potential rebalancing value – empty apartments in those cities – and so these must be addressed by other policies. Finally building new low cost apartments for the poor represents an increase in debt, unless it is funded by the sale of state assets, and an increase in economic activity, but an increase in debt would only be justified by labor shortages in the relevant lower-tier cities – shortages that constrained the productivity of existing investment facilities, which is unlikely to be the case.

  1. De-leveraging and otherwise strengthening balance sheets. The purpose of this set of reforms and its consistency with the appropriate goals of rebalancing is pretty self-explanatory. There is one important point, however, that is often missed.

Debt exchanges that lower debt-servicing costs for provinces, provincial borrowing vehicles, or large corporate borrowers do not advance the rebalancing process or lower China’s adjustment costs in the least, contrary to expectations. All they do is reduce unbearably high debt-servicing costs for insolvent or nearly-insolvent borrowers by transferring part of the debt-servicing costs elsewhere. If a provincial borrower is able to swap out of an expensive loan into a bond with a much lower coupon, its debt-servicing costs will of course have plummeted, and it might finally have additional breathing space which it can put to good reforming use (although it can just as easily abuse the benefit), but every RMB it saves represents an equivalent reduction in the profitability of the bank or of some other lender, and so also a reduction in its retained earnings, and it will increase the contingent liabilities of the central government by the same amount.

The provincial debt swaps, in other words, do not reduce debt and do not reduce debt-servicing costs. They simply transfer debt from China’s provincial balance sheet to Beijing’s central balance sheet. Some economists are sophisticated enough to argue that because of the convexity of financial distress costs, this debt transfer will lower slightly overall financial distress costs for China, but this is only true if the resulting increase in central government debt – in the form of contingent liabilities, in this case – has no impact at all on the perception of central government creditworthiness. It would be extraordinary, however, if it had no impact.

  1. Fiscal expansion, including tax cuts. The optimal role of fiscal policy in lowering China’s adjustment costs is another case of reforms whose purpose should be fairly straightforward. If fiscal policy is designed to reduce income inequality, or to raise household wealth and fund this increase in wealth by the liquidation of state assets (and not by increasing debt), it will advance the rebalancing process, lower adjustment costs, and reduce the risk of disruption. Because there are a near-infinite number of ways fiscal policies can accomplish or not accomplish these objectives, it isn’t meaningful to try to list them, but the optimal set of policies involving changes in fiscal expenditures and perhaps a reallocation of tax collection, in which revenues of RMB 11.1 trillion were accumulated in 2015, according to People’s Daily, is quite clear: faster growth in after-tax, disposable household income, in which the lower the income, the faster the growth, and a reduction of outstanding debt.
  1. Lowering corporate costs directly and by reducing government bureaucracy. These may seem like the most obviously useful set of reforms, but this is only because economists mis-conceptualize the value of improvements in asset-side efficiency. These kinds of reforms, if done correctly, will benefit China in the long-term by raising productivity growth, but as in the case of the reforms implemented by Mariano Rajoy in Spain, they do not address the rebalancing process, and their net impact on reducing the country’s debt burden takes far too long to matter to China’s adjustment process. The historical precedents indicate that however effectively the reforms are designed and implemented, if China’s economic adjustment is excessively costly or economically or socially disruptive, they won’t even matter in the long term.

A new beginning, or more of the same?

My description of the kinds of supply-side reforms that Beijing may be contemplating may seem overly abstract, but the purpose of my very long essay is not to propose specific reforms that will help resolve China’s rebalancing. It is to warn against falling into the trap of economic orthodoxy. China’s problem is not that a spate of recent exogenous shocks has perturbed the economy from its path of high growth, and so it does not require efficiency-enhancing improvements to the way it manages the asset side of the economy in order to return to that high growth equilibrium.

China’s problem is a systems problem, and it is the same problem every country that has experienced a similar investment-led growth miracle has experienced. China must switch from the current growth model to a completely different growth model as smoothly as possible, and the more debt it has, and the more distorted the structure of that debt, the more difficult it will be to manage this switch smoothly. This new growth model requires that household income comprises a much greater share of GDP than it currently does, and one way or another this new model will be imposed upon the Chinese economy. The first of the only two important questions is whether the higher household income share of GDP is a consequence of a rise in household income or a drop in GDP.

Because the quality and structure of Chinese debt severely limits the options available to Beijing and significantly increases the risk of a shock causing a disruption or a crisis, one way or another debt will eventually become a lower share of China’s GDP. The second of the only two important questions is about the manner and speed with which debt is reduced. Put differently, the only way to reduce debt is to allocate the cost to some sector of the economy, and broadly speaking these sectors are the household sector, the private sector, the state sector, and the various more specialized subsectors within these three – for example households can consist of rich households versus the rest, the state sector can be divided among the central government and the provincial governments, the private sector can consist of SMEs, large corporations, labor-intensive industries, capital-intensive industries, the export sector, etc.

China can choose to avoid reducing debt for as long as possible, as Japan has done, but the cost is a near permanent state of economic stagnation and the risk is that a poor, volatile economy like that of China is unable to last as long as Japan, in which case it’s debt burden will be reduced in the form of a debt crisis or in the form of monetization by the PBoC, which is simply another way of saying that the cost of the debt will be implicitly allocated to household savers, as was the case in the Chinese debt crisis of the late 1990s.

But this would make rapid growth in consumption impossible. Without the ability to boost GDP with explosive growth in investment, as China did following the debt crisis of the late 1990s, this also means that GDP growth must collapse, and could even become negative.

Alternatively China can choose to reduce debt explicitly by allocating the costs to some sector of the economy. As I have discussed many times, including in my 2013 book, Avoiding the Fall, arithmetically and logically the only appropriate sector is the government sector, and given the need for President Xi to further centralize power if Beijing is to implement reforms successfully, it is obvious that debt costs must be allocated to provincial governments.

Of course this is politically easier said than done, but nonetheless these are the options open to China. It must rebalance and it will. It must reduce its debt burden and it will. It can do what many other countries have done in similar circumstances and waste time and resources by implementing the kinds of reforms beloved of academic economists that do not directly address the rebalancing or the debt directly, and so significantly raise its ultimate adjustment cost while running an increasing risk of crisis. Or it can take steps aggressively to direct the rebalancing and reduce the debt.

China has done the former during the past several years but Beijing’s recent announcements about supply-side reforms suggest that its leaders are frustrated by the ineffectiveness of the proposed reforms and are determined to set out on a very different path. Whether or not this very different path ends up being more of the same we will learn only over the next two or three years.

But whatever happens, this year will clearly be an important one for China, apropos of which, happy Year of the Monkey, which begins in two weeks. They say if you’re very smart you’re likely to do well this year, otherwise it’ll be a very tough year.

 

Footnotes

[1] The Chinese growth model is simply a variation on what I call a “Gershenkron” growth model, which has three main characteristics:

  1. Rapid economic growth is driven by rapid growth in investment. To achieve this rapid growth in investment, the financial system is structured so as to maximize credit expansion, and credit is directed primarily into infrastructure investment and investment in manufacturing capacity.
  2. In order to force up the savings rate so that savings can easily be directed into investment, direct and indirect taxes are used to constrain the growth in consumption by constraining the growth in the household income share of GDP. As households retain a smaller and smaller share of GDP, their consumption also becomes a smaller and smaller share of GDP. Because household consumption comprises most consumption in any economy, total consumption also declines as a share of GDP, and its obverse, savings, rises. Ideally the result is such rapid growth in GDP that even as the household share contracts, household income overall grows rapidly.
  3. The institutional settings that maximize credit growth and that constrain the growth in household income are further linked because the direct and indirect taxes on the household sector that constrain growth in household income also subsidize investment. In China’s case these taxes have mostly been indirect and include low wage growth relative to productivity growth, an undervalued currency, environmental degradation, the rights of eminent domain, moral hazard and, most importantly, financial repression.

Many countries have employed variations on the Gershenkron model and have achieves spectacular growth. All of them, however, have ended up with very difficult adjustments and significant debt problems. The sequence is usually the following:

  1. At first it is easy to identify productive investments and the system pours credit into these areas, achieving very and unbalanced rapid growth that is both wealth-creating and sustainable.
  2. At some point however the economy begins to reach investment saturation, and this is especially a problem in poor countries because most poor countries are poor because they do not have the institutional ability to absorb and exploit resources productively. When they reach this point continued rapid credit expansion results in credit growth that exceeds the growth in debt-servicing capacity, and the country’s debt burden begins to grow unsustainably.
  3. At this point the economy must switch to a new growth model that focuses not on continued expansion in investment but rather on implementing the institutional reforms that will allow businesses and citizens to exploit resource more efficiently. These reforms are usually described as a kind of “opening up” or “liberalization”, and require substantial changes in the educational, financial, and legal systems as well as an elimination of the direct and indirect taxes that had constrained the growth in household income and the subsidizing of investment.
  4. Because these reforms are always strongly opposed by the elite that grew up around and had benefitted from the Gershenkron model, the reforms are strongly resisted and in every case in history the result has been a dangerously excessive build-up of debt.
  5. Ultimately either the reforms are implemented against strong political opposition or, if they are not, the economy suffers from a crisis, usually a debt crisis, in which it rebalances disruptively. Whether or not the rebalancing occurs disruptively, the longer the debt burden is allowed to grow the more painful the adjustment.

[2] And as Albert Hirschman reminded us, all rapid growth is necessarily unbalanced.

[3] The orthodox world seems to be one that approaches that described by Adam Smith, in which we can assume a near-infinite number of economic entities, none large enough to have an impact on input or output prices, and in which there do not seem to be significant institutional constraints. In fact the only variables that operate as institutional constraints, and so the only variables that can prevent rapid adjustment towards equilibrium, are wage stickiness, along perhaps with certain kinds of price stickiness.

I suspect that in many orthodox models household savings preferences are also implicitly a kind of constraint that can occasionally change independently for reasons that are not specified (i.e. if there is a change in the household savings rate that cannot be modeled by demographics, income levels, unemployment, or various kinds of economic uncertainty, we simply assume that households have decided to become more or less thrifty). Efficiency in this world is usually maximized when the economy achieves some idealized equilibrium. Exogenous shocks can move the economy away from this equilibrium, and wage and price stickiness, along perhaps with rigidities in savings preferences, will slow the adjustment process by which the economy returns to equilibrium, but in the long run if left to its own devices the orthodox world always returns to equilibrium, rendering economic policy-making largely useless.

In the short run however the orthodox world accepts that fiscal and monetary policies can speed up the adjustment towards equilibrium, largely it seems by countering these constraints, or by setting interest rates in order to manage investment and consumption. There is a great deal of disagreement between those who seem to think that monetary policy is largely ineffective and those, known as monetarists, who followed Keynes in attaching importance to changes in the demand for money while berating him for not stressing the inflationary impact of money creation. Whether the disagreement between the two is a trivial one or is of major theoretical and practical significance seems mainly to depend on how seriously you take the neo-classical synthesis, but I think both the orthodox and the unorthodox would agree that it isn’t a good idea to confuse anything Keynes might have actually said or believed with any of the various “Keynesian” schools.

I try to describe this “orthodox” world because even though I suspect most mainstream economists would agree that the Chinese economy in no way resembles one that is comprised of a very large number of agents too small to affect output or input prices, in which there no major institutional constraints, in which unsustainable credit expansion cannot persist except over a very brief period, and imbalances return automatically and fairly quickly towards efficient equilibrium. As I have discussed many times, however, this world is very rigidly embedded into most of their models and analyses.

For those who are interested, Hyman Minsky lists the conditions implicit in the world of orthodox economists, with tremendous sensitivity, in the 5th chapter of his book, Stabilizing an Unstable Economy. In my September 1 blog entry I argued that economists typically focus on managing the asset side of the balance sheet, and almost never on the liability side, because they implicitly understand both the extent and the nature of economic growth to be almost wholly a function of the ways in which assets are managed. If you want to increase the growth rate of an economic entity, in other words, you must do so by improving the efficiency with which its assets are managed.

But this is only true under certain specific circumstances. In any economic entity in which either debt levels are high enough to introduce uncertainty into the debt-servicing process or the balance sheet is sufficiently distorted or inverted to transform the incentive structure or exacerbate or otherwise affect the impact of exogenous changes, the relationship between the value of assets and the value of liabilities can in itself increase growth, reduce it, or cause it to collapse.

[4] This very important but surprisingly poorly understood feature of balance sheet fragility was something that Irving Fisher often discussed when he insisted on the distinction between the events that trigger a crisis and the underlying “cause” of the crisis. In the early stages of the GFC, for example, optimists often pointed out that the total outstanding amount of US sub-prime mortgages was too small to matter much to the US economy, but the fact that something so “small” triggered so large a disruption simply means that balance sheets were extremely fragile and increasingly susceptible to smaller and smaller shocks. That is why while it is true that the Chinese stock market is too small to matter in any “fundamental” sense, that doesn’t mean we can completely rule out in the future its impact on a larger disruptive process.

[5] The only clear historical exception I can find in the past 200 years is the case of Romania in the 1980s. Nicolae Ceausescu, worried by political instability in Poland after it had been forced to restructure its debt (Poland was one of the 32 sovereign creditors participating in the “LDC Debt Crisis” of the 1980s), and concerned perhaps about the implications of a debt restructuring for his domestic reputation as a policymaker, chose to repay in full the $13 billion the country owed, which it did ahead of schedule in 1989 by imposing brutal austerity. Few think it is a coincidence that shortly thereafter, when he and his wife were captured quickly executed, there was general jubilation among Romanians.

Colombia and the USSR were technically not among the restructuring countries, although they traded as such (their loans were “voluntarily” rolled over by banks unwilling to add to the pool of formally restructured sovereign debt) and engaged in direct and indirect discounted buybacks. Chile was among the restructuring “LDCs” and was one of the only major restructuring countries, I believe, that did not request or receive a Brady restructuring with a formal discount. It was however among the most active participants in direct and indirect discounted buybacks, especially through its famous “Chapter 18” and “Chapter 19” debt-equity swaps.

A well-known economists suggested to me that the only exception he could think of was England after the Napoleonic wars, and although I am not sure whether it indeed is an exception, it is noteworthy that except for the case of Romania, which is not really an exception because it did not grow its way out of the debt but rather imposed brutal austerity, we would have to go back 200 years to find an exception. It is surprising that this very consistent and remarkable history has not at least been acknowledged by economists who have recommended with great confidence programs aimed at allowing overly-indebted sovereign entities to grow their ways out of their debt burdens.

[6] There is a great deal of confusion about this. In a January 13 panel discussion organized in Moscow at the Gaidar Institute Conference at which both Peking University colleague Lin Yifu and I participated, Dr. Lin proposed China’s experience during the past decade as precisely one case in which a country with an excessive debt burden was able to grow its way out of the debt with no partial forgiveness and no allocating to some other sector a substantial portion of debt servicing costs.

But it turns out that China was not an exception. China during this time had nominal GDP growth ranging typically from 16% to 20% and its GDP deflator was typically 8-10%. Interest rates however were extraordinarily low by any standard. The lending rate was around 7% and the deposit rate around 3.5%. While the standard explanation is that bad loans were resolved by transferring them to the AMCs and liquidating them efficiently, in fact the AMCs purchased most of the loans in two tranches, one at full face value and one at 50% of face value. I believe that they were able to liquidate only a portion of this portfolio, and at less than 25% of face value.

The AMCs received the full funding for these purchases from the banks that sold them the bad debt in the form of 10-year bonds, many or most of which were subsequently rolled over for a second ten-year period. Clearly this did not involve any transfer of value.

However under the nominal GDP growth and GDP deflator conditions described, a lending rate of 7% was clearly concessionary by any standard, and by at least 5-7 percentage points. In that case it is easy to calculate that the amount of debt forgiveness for just the first 10-year period ranges from 28% to 36% on all loans. The costs were borne, of course, by household depositors, who bore an additional cost to recapitalize banks equal to approximately 9% of their savings, in the form of a spread between the lending rate and the deposit rate that was roughly double the standard spread.

China did not simply grow its way out of its loan problem of the late 1990s, in other words. It implicitly passed onto households between an amount equal to between a third and a half of the value of the loans in order to recapitalize the banks and grant debt forgiveness to insolvent borrowers. It was no coincidence, of course, that during this time the household income and consumption shares of GDP plummeted, from already low levels. The impact of lagging consumption growth on GDP growth was countered, obviously, by soaring investment.

While this was a very successful way of repairing the damage caused by bad lending in the 1990s, China of course cannot use the same mechanism again. Rebalancing requires that consumption growth exceed GDP growth, and Beijing fully understands that it cannot use a surge in investment to counter the impact of such a huge transfer of wealth from the household sector.

[7] A recent editorial in Caixin makes the point a little bluntly: “Some officials have recently placed their hopes of avoiding painful reforms on the “belt and road” initiatives, arguing that they will export their way out of excess. But new markets opened by these programs will not be big enough to absorb all of China’s excess capacity. We have already witnessed backlashes in some developing countries against China’s steel exports. Such resistance will become stouter.”

 

186 Comments

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  1. Maybe it’s just the exhilaration after my second read-through of fully understanding how radical your vision for rethinking economics, but I think when you finally get the Nobel Prize (which you will when the committee realizes that the purpose of the prize is not to protect academics from being charged with making economics irrelevant) this is one of the pieces they will cite, Mr Pettis. The combination of your mathematical intuition and your mastery of the history gives your explanation of why the reforms have gone wrong an authority that takes your essay from being mainly about China to being mainly about economics.

    While I’ve winced a little from the criticism of our discipline ( I am one of those academic economists) I am honest enough that I will most assuredly make my PhD students read this and think it through. Your point about the failure of any overly indebted country in history to have reformed and grown its way out of its morass of debt without partial debt forgiveness is a profound criticism of our entire conception of reform if true, and I know enough history to know your charge will take an awful lot of work to dismiss. Why hasn’t it been obvious before?

    Congratulations Mr. Pettis, and don’t mind the brickbats.

    • You’re much too kind, John, as are most others because the only brickbats have been from some of the China experts who were around several years ago. I do think we have to look at the track record of overly indebted countries and try to understand who, if any, resolved their debt problems without hidden or explicit debt relief. This should be a serious question whose answer should be part of any reform proposals.

  2. Whew, that was a long read but easier to follow than it seems. I’m not an economist, I’m more what Pettis calls a finance guy (options), so maybe I’m wrong, but is this as brilliant as an economics piece as I think it is? I think I get why they’ve been reforming like mad and nothing’s happened. I think I also get the Rajoy references.

    • I would say you are not wrong, it is a brilliant as you think, and I almost feel there is the cusp of something new here in analysis. The reader above who mentions prizes is not exaggerating that much!

      • As to something new, it seems to me at least, that Michael is moving more into the camp of economics as a complex adaptive system. As opposed to a static, in the vacuum, system, with fewer elements that need be considered, as changes in debt, in the inversion of balance sheets, creates emergent properties not able to be considered in general models.

        And, like everyone, who has read for awhile, we all know how powerful an impact Michael’s perspective has had on clearing away the noise, we no longer even consider.

  3. Another fabulous post – thank you, Prof Pettis, for sharing your insights and logic with all of us. It is a major public service you are providing.

    I would love to know what form China reaching its debt constraint would take in your opinion?

    Given the vast majority of its debt is domestically funded and that Chinese banks are controlled by the government who can provide the banks liquidity at will (possibly to the detriment of households), the China bull argument I guess goes that any debt constraint is far away.

    In my opinion, the massive capital outflows that we’ve been seeing over the past year is in fact the first sign that the debt constraint is already becoming binding. Chinese owners of assets are increasingly seeing the writing on the wall, they recognise that there are a vast amount of unrecognised bad debts whose costs are yet to be allocated to stakeholders. Given the strong possibility of a significant portion of these costs being imposed on households, to the extent holders of domestic wealth are able to remove their assets from China, it seems to be an asymmetrically positive trade form them to do just that and protect their assets.

    • Capital flight should be one of the typical sources of financial distress, DRJ, but I would define the debt constraint as being the limit at which credit cannot grow fast enough to roll over debts that cannot be repaid out of the productivity increases presumably generated by the debt-funded spending, which should be according to Minsky (and to logic) growing at an accelerated pace, with enough left over to fund whatever is the desired level of economic activity.

      • mathematically why “credit cannot grow fast enough” when it is domestic credit? Isn’t monetizing a form of credit, in a way (pardon if I understand it wrong but inflation would move the debt cost to households from debtors, which in a sense is credit?)

        or is it due to the pressure on foreign currency reserves?

        Would appreciate it if someone could sort it out for me. Thanks!

        • My understanding is that productivity gains generate the income that is necessary to pay down the debts.

          The limits of the system rest with the creditor’s stubborn refusal to be willing to write a loan amortization schedule that demands no interest, no principal payments and no due date. If a creditor could be found that would agree to these terms there would be no limits on the amount of credit in the system could sustain,

          Of course, it would be difficult from an outsiders perspective to differentiate a creditor who accepted those terms from debt forgiveness.

        • My understanding is that productivity gains generate the income that is necessary to pay down the debts.

          The limits of the system rest with the creditor’s stubborn refusal to be willing to write a loan amortization schedule that demands no interest, no principal payments and no due date. If a creditor could be found that would accept these constraints there would be no limits on the amount of credit a system could sustain.

          Of course, it would be difficult from an outsiders perspective to differentiate a creditor who accepted those terms from one who forgave the debt.

      • Example in my town;
        400K dollar beautiful buses driving around central California buying farm land and house by the dozens.
        i have seen to many buses to count.
        realtors that i know well say that they are purchasing all cash at the asking prices or more.
        it is at the point that even our wealthy farmers have difficulty competing in the market, but ultimately it is a relative safe haven for cash i guess.
        Thank you Dr. Pettis
        i will continue to study your writings and invest accordingly.

  4. “A well-known economists suggested to me that the only exception he could think of was England after the Napoleonic wars, ”

    England then had the *Industrial Revolution* happen, which is sui generis levels of growth never seen before or since. The stage of “all the investment is worthwhile” lasted a long time.

    …and England did so with “risk-free interest rates” (government bonds) at rates from 1% to 3%. If you think China’s interest rates are low, look at Victorian England’s. The debt total was very high, but the debt service costs were another matter — they were rock-bottom low.

    The class who was forced to pay for the bad debts was clearly the fairly-wealthy investor class. (One of the tranches of Consols was refinancing the South Sea Bubble — investors lost money in the bubble and then surviving investors lost money to very low interest rates.) And this seemed to work out quite well for the UK. Maybe other countries should try it.

    (As an investor perhaps I shouldn’t be quite so eager to see this happen, but I am a humanitarian first.)

    • If I remember correctly, the share of national income held by capital in the Napoleonic Wars shot up dramatically. It was also a different monetary system as well. As for 1-3% interest rates, in a deflationary world with massive productivity gains and a hard currency backing, 1-3% on the long end of the curve is a lot. If we have 3% long end rates with 2% deflation, that’s a 5% real rate of return that means a doubling time of ~14 years. That’s a lot.

      Also, I don’t think GDP growth in the UK during this period was spectacularly high. In fact, I think most of it was pretty moderated. Usually, you see that surge in GDP growth during industrialization in countries that’re backward. If a country is not behind, those kinds of “rapid growth” won’t happen unless it happened like it did in the 19th century US: with massive short term instability and a financial system heavily geared towards risk-taking.

  5. I have one question, but before that I would like to add to the praise of the two previous posts. I am an economist by training, but I have only once before read an Economics textbook (as this almost is) straight through without dozing off, that was “Economics in one Lesson” by Hazlitt.

    My question concerns the empty apartments and the transfer of wealth to the household sector. Are you saying that only if these apartments are sold at a fraction of their construction cost to households will the wealth of those households increase and that of the state decrease – and that a transfer at full cost would have no benefit to the Chinese economy?

    • No, just that their market value and their economic value to households are not the same. I don’t refer to their construction costs at all.

      • As to your tax of real estate, is it not likely, that incomes for the general population can not rise quickly enough to see bloated real estate values rationalized, at even par of former level, and that rental is unlikely, due to notion that once lived in, the value will plummet while those who might buy, might not have the ability to service the initial costs of the asset acquired at bloated valuations.

        your tax, would see a drop in values, but, even with that, are Chinese incomes, of those who have yet to purchase able to even service a 50% drop. I doubt it.

        • Csteven. You refer to an oddity, a fault line in financial thinking, that is common to Chinese people inside China and elsewhere in the Far East. That is the idea that a property loses value as soon as it is lived in, rather like a new car loses value he moment you dive it out of the showroom. Therefore the value of a property is preserved if the owners buy it and keep it empty. Unless the building and fitments are of very poor quality so that they rapidly dilapidate with use – this is not true. In fact some mechanical units will actually decay with lack of use more than with use.

          • Perhaps, it maintains value, at some level of volume, relative to some practice as described, which is an ascription of recency, of observation under conditions of much lessor exacerbation.

            90 million vacant units
            land values pumped up for revenues to local gov’t, with formula of lending based on land price
            nature of ownership
            location of housing (tier of city) and desirability

            then need of underutilized resources for a market and an efficient use of resources for the development of an economy

            As to fitments, many of these properties, if not most are shells, to be fitted.

            And both fitted or unfitted degrade, especially with non-use

      • Before coming here, it never occurred to me that logical and “smart” people could so often fall into separate camps. It’s probably because I come here so often that I made a goofy framework for analyzing how people think about issues – the framework divides thinkers into a Hamilton group and Jefferson group.

        In my framework, analysts like those you mentioned above fall into the Jefferson group. This is probably totally unfair, as I haven’t read much on Jefferson. That aside, simple models with clearly stated assumptions are more useful, or so I hear.

        Thank you for sharing another brilliant piece with your motley crew of readers.

  6. Thank you for the most outstanding post on China (and economics in general) I have come across. I am not an economist and was confused with regard to this part:-

    “Because most of China’s debt is internal debt, and directly or indirectly owed to the banks, debt restructuring with partial forgiveness is not an option at the macroeconomic level because ultimately it is a contingent liability of the government either way. ”

    Can you help me understand why the government can’t write-off debt from State owned lenders? -what is the difference between a “macro-economic” level as opposed to a “national” level? And in what way are the liabilities contingent if its known a loan is non performing?

  7. Moscow-Kazan Railway:
    Chinese bid €6 billion
    German bid €2 billion

    Good luck with that

  8. This is a wonderful piece.

    I found it very interesting how you cited financial history to show that countries don’t select their financial systems. That’s quite accurate and this really puts a hole in the basics of modern political economy. It’s not about the intersection between politics and economics that drives the development of banking systems. It’s about the geopolitical constraints that financial systems must meet for the system itself to survive. No one understood this better than the great Alexander Hamilton, who seems to be so ignored by everyone. I find it appalling how we teach Karl Marx’s theories in classrooms, but barely lift a finger to read Hamilton’s ideas.

    In the case of the American adjustment, it was largely due to foreign loans that went bust because of the unwillingness to write down war debts either after Versailles or at later periods though not for a lack of trying (the Republicans in Congress were citing Keynes ad verbatim and Harding tried to get authorization from Congress to write down war debts). Of course, I don’t think China can handle an adjustment of that kind very well.

    In my eyes, the willingness and ability of the United States to absorb current account deficits is dwindling. From the American POV, we’re doing bad deals with countries interfering in currency markets that end up with American manufacturing getting crushed while the net capital inflows get swashed through the banking system and fuel asset bubbles. Basically, Donald Trump is correct. This will not be sustainable and this will be resolved. China would be hit very hard by this.

    The rise of American protection would signal a significant shift in the geopolitical financial system that would be very hard on most of Asia in general and China in particular. It’d mean that no one in the world would have the ability to push their surpluses on the United States.

    • Suvy,

      Would you kindly point to a source where Hamilton writes about this specific issue? Thank you.

      • Read his reports to Congress for a central bank and The Federalist Papers. A history of American cemtral banking is a history of war finance, which Hamilton understood well. The most obvious place to look is Hamilton’s financing proposals during the Revolutionary War.

  9. If I’m correct in saying that the geopolitical financial system will shift fundamentally as we will begin to see the Americans placing restrictions on the ability to run current account deficits, then the entire Gershenkron model will completely break down as we know it. As of right now, the only person really talking about this issue is Donald Trump.

    Yet again, the entire 2016 election in the United States is gonna be the focal point of the world’s geopolitical financial system. If Trump gets elected, we will see a reversal in the trade deficit in 4-8 years tops. If Sanders gets elected, I suspect we’ll see the government absorb the net current account deficits of the surpluses of the world, which isn’t sustainable or good. The reason why I’m saying this about Sanders is because I think the MMTers are essentially his economic advisers (I know Stephanie Kelton did a lot of stuff with him). Having an institution with the world’s most guns being the world’s largest net creditor and accepting it IS NOT a stable situation. That scares me more than the Greenspan methodology for resolving current account deficits.

    If someone like Cruz wins, I have no clue what’ll happen, but he says he wants some sort of a hard currency backing which would remove the ability of the US to run current account deficits. Of course, I don’t know if he’s just saying that or he actually has ideas of doing this. If he actually knows what he’s doing, this may not be such a bad idea after all because it’d fix the flaws in the global geopolitical financial system.

    In the case of Hillary Clinton, I suppose it’s just more of the same.

    The thing about Fed policy is that it is under the executive and may be even able to be removed or changed via executive order. This is certainly true for something like a hard currency backing. These are the four people most likely of winning the Presidency as of right now. I don’t really see much changing here.

    What I could see is that if Hillary Clinton runs against Trump, I’m not so sure Trump couldn’t win. Everyone in Congress hates Ted Cruz, and with good reason (this was a guy who shutdown the most powerful institution in the world with unrivaled military, financial, and economic power with nothing more than his sheer willpower and determination for 17 days). There’s also talk about what happens if Bloomberg runs as an independent. I’m starting to think the most likely situation could end up being a situation where 3-4 people run for President and no one gets to 270.

    The most critical factor in this entire system could be who is able to get to 270. If no one does get to 270 and it goes into the House of Representatives where every state gets exactly one vote, it’ll be anyone’s guess. I highly doubt it’ll be Cruz that gets the bid because everyone in Congress hates him. It sure as hell won’t be Sanders or Clinton cuz the Republicans control more state legislatures and thus more states in Congress due to gerrymandering. If Trump is the Republican nominee and no one gets to 270, I think it’ll be Trump as President. If the nominee isn’t Trump, I don’t see it being anyone other than Cruz who has no chance so it may be Trump again if Trump runs as an independent.

    If Bloomberg runs as an independent, I think he’ll take New York state because the New York City metro area, State Island, Long Island, and that entire area contains most of New York’s population. If New York is taken away from the Democrats, it’ll be difficult for the Democrats to get to 270. If Bloomberg or Trump as independents can influence a few other states, no one will get to 270.

    • Suvy,

      If trade deficits reverse, wouldn’t that assist with adjustment in Europe?

      • Yea prolly, but I bet it’d be socially and politically destabillizing.

      • how? Europe is running massive trade surpluses to counteract high unemployment/low AD, if the US refuses to run a deficit that’s just one less source of demand. unless you mean it might force Germany to confront reality n accept club med debt write downs, but I wouldn’t bet on it

        • It would still force Europe to adjust and help them with the adjustment since Europe is running surpluses, but it’d be socially and politically destabilizing. Honestly, it could be the trigger that blows Europe up.

    • Suvy,

      Apparently, one of the only candidates Congress hates more than Cruz is Trump, who does not have the endorsement of a single representative, senator, or governor (Cruz has a number of endorsements from the House). You think Trump is in the top 4? You’re a math guy, right? What do you think of Nate Silver/538? I’m not following as closely this time around, but think I recall a few articles pointing out the poor value of certain types of polling (e.g., so early out and getting a biased sample), how we often overhype the possibility of the establishment not mattering, and Trump’s high unfavorability numbers.

      Also, if I recall correctly, many of the unpolished, hyper-partisan, less serious candidates in the Republican party were at the top of the pack around this time four years ago, with concerns by many that a fringe candidate would make it to the general election.

      I just Googled around and saw that Kerry wasn’t considered a threat around the time of Iowa. He may have even seemed comparably less of a threat than Mr. 9.9.9, Michelle ‘let’s sacrifice ourselves in opposition to Obamacare B., and so on in their primary.

      Anyway, after reading Professor Pettis it’s really interesting to hear the candidates talk about econ and China. I’m pretty sure Hillary Clinton has mentioned in the past that we’re in trouble if China pulls the plug on lending (as if its purchases of U.S. Treasuries were a discretionary decision to lend). This would seem to qualify as a big misunderstanding. It was interesting to see the Rs coalesce on the disadvantages of a more aggressive approach to undoing the U.S. current account deficit.

    • This is a correction to what I said earlier because my initial comment wasn’t entirely correct (and partially wrong). The Democrats certainly have been talking about trade as an issue. However, Clinton and Sanders haven’t really discussed any solutions except for renegotiating TPP, which isn’t a problem at all.

      The problem isn’t even free trade per se. The problem is that you have a few specific parts of the world like Europe or China pushing their surpluses on the US. There’s no real problem with a country that genuinely wants to use the American free trade order. I think something like NAFTA makes sense considering that the US gets all of its energy now from within the North American trade network.

      Either way, the trade deficit will be resolved within the next 8 years. I think we have to seriously consider either putting up tariffs or placing some sort of tax. I like the idea of a “business flat tax” the best since exporters wouldn’t be paying the tax and importers would. I also think you have to seriously consider taxing the accumulation of American assets abroad in accounts of larger than, say $10 million. There’s no way central banks should be able to pile up $3-4 trillion of Treasuries or we should have empty apartments in San Francisco that’re driving up rent and cost of living for no reason.

      I’d also like to talk about financial reform. I used to think that it’s a good idea to break up large banks, but I’m not so sure any more. The problem is cybersecurity. The largest spenders of cybersecurity are banks, which makes sense, and I wanna say it’s 5% of what they spend in total. Well, if cybersecurity is that large of a portion of their total expenditure, then breaking up large banks could be VERY costly. It’s just hard to mobilize and direct resources on that scale with small and decentralized banks. Quite frankly, I think breaking up the big banks could result in a serious national security threat. I could be very wrong here and am open to changing my mind, but we have to keep in mind that the 2010’s aren’t the 1950’s. The threats that we face are very different and no one wants their bank accounts or private information hacked.

      • The only real problem in using the US free trade order – the one with the US dollar as its reserve instrument upon the insistence of the US at Bretton Woods and no obligation for participating countries to keep their external account close to balance by unilateral decision of the US in 1971 – is for the US itself.

        What do you think of those who complain about the consequences of which they cherish the causes?

        • Well, let me begin by clarifying my comment. What I meant is that there’s no problem with the free trade order provided countries operate on level terms and don’t use tactics like trade diversion or blatantly accumulate USD-backed assets in ways to turbocharge growth by pushing the US to run current account deficits.

          If a country wants to use the free trade order for genuine development, that’s fine. But trade diversion shouldn’t be a strategy that should be used.

          • Yes, but achieving this is incompatible with having the USD as international reserve instrument. It is a built-in contradiction. The US wants one thing and its opposite at the same time.

            Given the weight of the the US in international organizations (not too mention unjustifiable veto rights in some cases), the key to get things going at the international level is that the US recognizes this contradiction and comes out of it, clarifying that we need a neutral international reserve instrument and that each participating member is responsible for keeping its external account close to balance.

          • It’s not incompatible if you either have some sort of hard currency backing or if you place a tax on those holding American assets abroad. If necessary, I have no problem using tariffs. Warren Buffett suggested a maximum cap on our current account deficit that could never exceed 3% of GDP.

            There’s plenty of easy and simple ways to resolve this problem, but we just need a leadership that understand these ways. We DO NOT want a radical change of the global financial system because of the can of worms that’d open up. Some of these methods may even allow for a President to circumvent the will of Congress with an executive order.

          • It is incompatible to have the domestic currency of a participating country also used as the anchor of the global monetary system.

            You say it is not incompatible if there exists some sort of hard currency backing. But this existed pre-1971 and was deemed too restrictive by the US because, precisely, it only applied to its domestic currency.

            You say it is not incompatible if you put in place an administrative cap on the US current account deficit but, if I remember correctly, that was already tried by the Kennedy administration in the early 1960’s and didn’t work, leading precisely to the 1971 decision.

            You say it is not incompatible if you tax foreign holdings of USD-assets and thus give up the “exorbitant privilege”. Perhaps, but that won’t remove the need for an international currency to settle international trade.

            I don’t need to stress the contradiction between “there is no real problem with a country that genuinely wants to use the American free trade area order” and “I have no problem using [American] tariffs”.

            It is incompatible to have the USD as the unit of account of a balanced world trade and monetary system. The first step towards a solution is to recognize this fundamental contradiction.

          • This is the real issue:

            All coalesced around a ramp up in integration.
            Financial deregulation was the progenitor of financial globalization (most recent incarnation).
            The UN had its Millennium Development Goals.
            The development community, along with a longer line of professionalization and business-like approached, came out of its Marxian doldrums, of much criticized waste and began to support market based approaches.
            Technology was all afoot, a frenzy like atmosphere, deregulation in telecommunication aided to approaches to development, business, cross-border trade rising, GATT gave birth to the WTO, but bilateral treaties dominated the field as they do to this day.
            Governments, Global Institutions, INGO’s, and Global Businesses (under morally guided SCR) dictum, marched toe to toe. Academics, Experts, Investment Banks, even day traders noted the chorus of the day; had the cleared the thought-based path, before.
            Warsaw Pact countries, non-Aligned recalcitrants, even, anti-Capitalist ideological stalwarts engaged the system. To grow rich is glorious. China enters WTO. Wow what a potential to make a great dent in global poverty, what a potential source of global demand that could (have) altered the trajectory of global development, and fostered heights of prosperity to put a twinkle in the eyes of both Ebeneezer Scrooge and Amartya Sen.

            The European Union is forming a Currency zone. The global investment community and Central Banks starts buying the consolidated currency, Euro rising, dollar declining. The great mass of doomsday thought for US, re-enters the fray.

            Perpetual current accounts required, and justified, and encouraged. IMF recommends three months of FOREX for import cover (since raised to 6 months, due to excess in some quarters).

            Rising trade, rising growth, reform in countries along institutional efficiency, greater ownership of development aid, reform of public processes (PubAdminRef), development aid into national plans, advances along toward the millenium development goals, tales of poverty reduction, great nominal rises across the board.

            Well, oh, well, the supercycle of commodities has arrived, the great growth of the global middle class descends like a shadow. Quick, to the boats, ready the investments for emerging markets to bring on supply, …time and tales, tales and time.

            EM investment explodes, much of this on the back of this confluence of factors, this ethos and spirit based merging of multiple rationales from Diamonds impact of the influence of Middle Class growth dynamics on societies toward more rules and rights based configurations, to growing market based approaches in development, to a spike in FDI, Portfolio Flows, FOREX trading, and inevitably to the Rise of the Rest, South and East.

            But GATT and WTO, had brought more into a system that had reduced tariffs, a concern of a previous era. Such has brought many benefits. Yet, it saw the rise of non-tariff barriers to trade and along critical theorist, Marxian Sociological, anti-colonial lines, oddly enough, rationalizations on the grounds of Westphalian Territorialists frames; market intervention on National Interest, Cultural Preference, and simialr terms. But NTB’s rose. As did any number of market intervention that saw some nations with heft, directly attempt to draw up multiple national supply chains into its areas, co-locating, by establishment of SEZ’s, firms to foster the establishment of Industrial Clusters to be centers of industry and innovation for, of the heft, dominance, but also to walk along the technological frontier, gain learning advantages and similar (creeate path dependencies where possible).

            Now this led to responses in other EM to negotiate treaties that weren’t necessarily in their interest. But to access potential to grow of anothers great growth, but as a tactic, of near space locational effects, to stymy the movement of MNC factors to the latest center of excessive global growth.

            Also, it led to approaches, along Krugmans Strategic Rivalry Theory, for other countries to support policies, and develop supports for industries as the new center. For example, Audi, borrowing a billion from Citibank last year, to invest in China Automotive Sector, to secure market Share, because other international brands were International encroaching on their market share, not because they thought it was useful in terms of profit. (not Dissimilar to OPEC methods today).

            So along a national strategy impetus, to be likened to the the terms of Strategic Rivalry, what occured, oh, your gonna support, so are we, oh your gonna invest so are we.

            Returning to the developed world. Can’t portfolio into China, portfolio and FDI around sectors rising. More and more investment. China….hmmmm….old before rich, or rich before old, old before rich, compress the timeframe. Supercycle, goes hypercycle.

            So, current account dynamics, surpluses, rising, nominal figures across statistics, and indices are going vertical, capital flooding into advanced markets, and rebounding around, has Bernanke lost the ability to set interest rates. What are these new innovations I keep hearing about to take this thing into the stratosphere, to handle more of this great growth (asset bloat on money printing globally) we are seeing across the world. Wait what was that pop, fizzle. Uh oh, what do we do now, austerity, austerity, easing, easing, hey, let’s just do more of the same, what just happened, was because over there they are lviing beyond their means anyway, and everyone already knows we are rising, there is a shift of economic power. So, why don’t we do just more of the same.

            Perhaps one of Micahels fans, will say, ahem, ahhh….well, your ivnestment has gone too far, you have no domestic drivers of demands. And it is obvious that the whole system, yes, even or recent decade of growth, is complicit in the structure of what is occurring today.

            So, DvD, please, you are way to competent, to state, the US just needs this and that.

            In many ways, peer developers, have to do a lot more of ensuring they are not beggar each other, as we all hope global trade to deliver global development and not seek a situation of ending in a dilemma as one big group of losers.

          • You’re making assumptions between things I said and implying them to make statements about things I didn’t say.

            You can still be the reserve currency while taxing the accumulation of American assets abroad. Most of the accumulation of American assets over the past 40 years by foreigners wasn’t to actually use the “free trade order” for development. It was just used by countries to turbocharge growth and sustain massive investment and asset bubbles. There’s a FUNDAMENTAL DIFFERENCE between GDP growth and development/real wealth creation.

            The reason the free trade order is unsustainable is because, instead of countries using the system to develop, elites in developing countries are using it to essentially pad their own wallets and protect their own power structure. That is why I support tariffs. The free trade order is being abused and American leadership needs to take strong action against countries abusing the system. Tariffs would be a way to go about doing this.

            You can also still have the USD being a reserve currency while taxing the accumulation of American asset abroad for all accounts larger than, say, $100 million or so. People could still transact in dollars, but there would be a cost to hold them. Honestly, I just want to end the piling up of Treasuries by foreign central banks.

            “You say it is not incompatible if you put in place an administrative cap on the US current account deficit but, if I remember correctly, that was already tried by the Kennedy administration in the early 1960’s and didn’t work, leading precisely to the 1971 decision.”

            Yea, but that peg fell apart for lots of other reasons including horrible financial decisions by various administrations (ex. LBJ). The reason the peg fell apart was because Nixon had no choice but to drop the peg. I think much of this was related to the policies of the Fed and Treasury in the 60’s including the horrible policies of LBJ including both the Vietnam War and the Great Society. This was completely reckless behavior that forced the US off the peg.

          • Cool down, this is not against the prestige of the US, no need to get defensive.

            Let’s just keep a few simple ideas in mind:

            1. For 30 years, the Bretton Woods global monetary system was associated with strong real economic growth and sustained deleveraging from a starting point of elevated debt loads post WWII. In that sense, it was a good system which was incorporating the lessons learned the hard way during the Great Depression. This system might yield useful lessons again for the current period of fading real growth trend, rising debt loads and widespread speculation.

            2. The Bretton Woods system eventually collapsed because of a built-in imbalance, namely the use of the domestic currency of a participating country as the anchor of the system. This congenital imbalance allowed other countries to “game the system” and speed up their development by accumulating dollar balances. It also allowed the US to accommodate the perceived “dollar shortage” by issuing new dollars at will to fund dubious policies at home and abroad. In other words, this built-in imbalance – wanted by the US at Bretton Woods against the alternative represented by Keynes – gave the wrong incentives to all countries. The incentives were not aligned with the stated goal of maintaining cross current accounts close to balance so that free trade could be mutually beneficial to all participating countries.

            3. The system broke down de facto in 1971 and de jure in 1976. The trend of global relative debt, which had been consistently declining since the end of WWII, turned exactly around that time and has been consistently rising since, to the point that we are back to post WWII debt loads. This is not a coincidence, but the result of growing and persistent current account imbalances and the resulting duplication of credit in both deficit and surplus countries.

            4. The most important question, therefore, is how to keep the advantages of the global trade and monetary system (of which, free trade) while correcting the problems that led to the collapse of BW and to the rising debt loads post BW?

            5. Keeping the USD as the international reserve instrument and taxing its foreign accumulation (so that it is not used as international reserve instrument to a too great extent) and / or imposing tariffs at US borders (but not at other borders?) is a set of idea. Keeping the USD as the domestic currency of the US and using a neutral supranational unit of account for settling international trade is another set of idea. To my mind, your idea doesn’t deal effectively with the problem and could in fact introduce a contractionist bias into the system. I add that the fundamental contradiction between the USD as domestic currency of the US and international reserve currency is plainly in sight at this very moment when, after a period of easy monetary policy which led to a great increase of $ borrowings abroad, the Fed is trying to normalize interest rates for domestic purposes while its (limited) actions are squeezing over-extended foreign $ borrowers elsewhere. There you have the incompatibility in plain sight.

            5. Let’s turn the question around: What are the advantages for the US and for other participating countries of using the USD as international reserve instrument? What makes this the best possible international monetary system?

          • DvD,

            I don’t care about the prestige of the US at all. I’m just saying that if entire countries and “development models” (primarily the rise of neo-mercantilism in Asia) weren’t abusing the system that developed after Bretton Woods, the current account deficits of the US would be pretty insignificant. The problem isn’t even the USD as the reserve currency. The problem is trying to reconcile the USD as the reserve currency with the rise of neo-mercantilism “growth”/”development” models. If there weren’t countries looking to abuse the system as they currently do, largely via trade diversion, the system wouldn’t inherently be flawed. If the US is running a .5% or 1% of GDP current account deficit, there is no flaw in the system. If we’re running 6% current account deficits–as in 2006–there’s a serious problem.

            And when you talk about debt loads, debt/GDP tells us nothing, due to the structure of our current financial system. In A Financial History of Western Europe, Kindleberger discusses how debt/GDP can actually increase and it be perfectly sustainable with certain shifts in the financial system that actually allow for a better allocation of risk along with the rise of capital assets. There’s been fundamental shifts in our financial system and using some number with a chart that doesn’t look at the underlying financial structure really has A LOT of problems. Simply put, there’s implicit assumptions in statements like that and the logical implications of such statements that aren’t really warranted. When we talk about these issues, we MUST understand the financial history, which goes back much longer than 40 (or even 80) years.

            The net capital flows and the current account balance must necessarily net out, so there’s a couple of ways to deal with the problem. You can either shift incentives for the adjustments of capital flows or you can fix the balance of trade and let the pieces of paper being sent across borders adjust as they please. It has to work out on the other side because it must balance.

            What is the best international financial system? How the hell can anyone actually know this answer? It requires knowing the future, how it’s gonna look like, and how to design a system to adapt to that–all of which is impossible. What we can do, is to take up simple steps to avoid catastrophic outcomes. The most important part is by preventing radical change, which never works because you don’t actually know the impacts of what you do before you actually do it.

            The biggest reasons for the rise in the unsustainble debt loads of countries, post-Bretton Woods, has been the rise of neo-mercantilism. There’s several ways to deal with that. The first would be to shift our entire global financial system away from debt and towards equity, but this would require an active suppression of nationalism and probably democracy, which I have no problem with but I’d imagine most people would. Another way would be to impose some sort of a hard currency backing which would force financial systems to break sooner than through a fiat standard.

            As for tariffs that’d be imposed by the US, but not by others, other countries instead use their currency. What do you think negative interest rates are for or why we have entire countries relying on large-scale currency devaluation? Other countries (including Europe, China, Japan, and almost ever single major country) do this, but when the Americans talk about putting up tariffs, we’re automatically nonsensical bad guys who’re hypocrites. This is bullshit. If you don’t want us to put up tariffs, then China, Europe, Japan, and a whole host of countries need to change their monetary policies.

          • Yes, yes, if all parties resisted the incentives to misbehave and behaved, the current system would be just fine. Let’s agree on that. It’s not advancing us much at all.

            Yes, yes, it’s not easy to untangle the part of financial debt that is double counting due the specific capital structure of such and such country and the part of financial debt that is double leverage on the same asset base and therefore should be counted in the overall debt load. That may be the reason why the various estimates of global debt vary from one source to the other. But, let’s be conservative and only take global non-financial debt to GDP to completely remove (and beyond) this impact. We still have a consistently rising global relative debt. It is still reaching levels that are becoming burdensome.

            Yes, yes, we don’t know what’s the best system should look like exactly. All we can do is learn from history. Why did the Bretton Woods system – which was associated with good outcomes – collapsed? Why has the new system that emerged in the 1970’s been associated with a significant and spreading debt snowball?

            I’m surprised that dropping the USD as international reserve currency apparently sounds inconceivable to you but that you have no problem “to shift our entire global financial system away from debt and towards equity via an active suppression of nationalism and probably democracy”. I thought we had to “prevent radical change, which never works because you don’t know the impacts of what you do before you actually do it”.

            I’m also surprised that, of “the couple of ways to deal with the problem”, you are not considering the replacement of the USD by a neutral unit of account. Why is that? I’m excluding of course any attachment to US prestige.

          • I would love to see the USD replaced as the reserve currency. I’m just saying it’s not the ONLY way to go about doing things.

  10. Wow!

    Really great piece Professor. I was getting withdrawal given the last one was in November, but it was worth the wait for my hit! Alphaville have quite rightly flagged this up more than once, and I would expect Martin Wolf to maybe be stimulated into writing a piece when he has read this.

    I also suspect that maybe this was the basis for another book, but maybe one that you ended up giving to the blog due to being too busy?

    I was especially interested by the “orthodox model explanation” for some of the bull charges against you for predicting an imminent crisis, – which i have not seen you do despite having been reading your blogs and posts and books for more than 7 years. I know your main aim here was to tackle the supply side reforms, but for me the biggest impression undoubtedly comes from the explanations here on this area.

    Thank you again! I need to re-read it before i can formulate any questions that might actually be interesting for you, but for now, just thank you!

  11. Very good..!

  12. Moscow- Kazan high speed railway
    Chinese consortium bid €6 billion
    German consortium €2 billion

    Good luck with that

  13. Excellent. As a trader, I am less optimistic that China has 2/3 years to show the green shoots of a rebalanced economy. Global markets less benign and more skeptical now of US, Japan, EC & China concurrently not able to rebalance with the challenges of their debts. Their woes reinforce in a much deeper global economy. Unlike Japan when it was challenged with rebalancing needs, it faced a more benign global market and Japan’s economy was structurally far more transparent to see through their muddles.

    It appears that China’s past reform rhetoric and now acknowledged subtly to be failures is undermining its credibility. A new set of asset side/supply side reforms reminds you of Japan’s various struggles in their lost decades (eg 3 arrows) that culminate into few global traders takes any cue from its CB on the value of its currency. It is just priced for short term carry trades. In other words, the currency regime can deteriorate further into having lost control on the pricing of its currency.

    Will you be expanding on the potent exogenous market force in derailing reforms in your next book ? Inverted balance sheets have also ceded even more power to global markets to dictate terms ?

    • Hedgie

      I suspect as you, until the last sentence on global markets dictating terms if you are speaking of global investors.
      I suspect the great experiment of the last couple of decades to lead to a slew of new national policy orientations where “understanding” of parochial domestic needs, which created policies that impacted peer developers, and the viability of an open system more generally by perennial demand providers, leas to new orientation’s, new underlying philosophical assumptions, to which policy is always beholden.

      Do you follow Rodrik? As, at least a “risk mitigator”, on the terms of frame-bending, and sense-making, it is useful, that his perspectives have a place in your thought.

  14. Arjen van der Woerdt

    1. So, debt-forgiveness… Won’t it be easiest to simply use most FX reserves to recapitalize the SOE-banks, so they can deal with the extreme debt(inverted balance-sheets) -debt forgiveness- instead of burning through all reserves on an attempt to stop the ECB/BoJ currency-depreciating effects, levered-up by money fleeing the country?
    2. The -in my eyes- complete failure of reforms that matter, is not new and in fact are described by the 1895-1912 period in which after the defeat by the Japanese military the Chinese finally decided to start reforms, economic reforms, too which didn’t effectuate because of resistance from the vested interests, the civil servants(sorry, forgot the proper term) what now maybe is the local governments and heads of SOE’s:

    “In the 100-days reform period,…, those who responded to the call for reform were few in number. The Guangxu emperor tried to accelerate the rate of refroms only to aggravate the tense atmosphere of society. people took a pessimistic view of the propspects of these crash reforms, dispelling the faith of reforms.”[the reforms were in the education system but also prominently in economics] (“China, state sponsored reforms etc 1895-1912” Zhongguo/Reynolds,)

    • 1. How could you use foreign currency to directly recapitalize local banks with NPLs in RMB? You can’t. You can increase RMB liquidity, which has been done and the outcome as noted however as also noted in the macroeconomic aspect the debtor is the creditor as well in this case (correct me if I’m wrong.

    • Debt forgiveness would cause the collapse of the regime and the system IMO. China links its many provinces, regions, and autonomous states together via its financial system by basically bribing local elites to hit GDP growth targets. If you forgave all the debt tomorrow, Chinese political stability is a given and there’s a real risk of China collapsing into warlordism.

      Approaching China like a Western nation-state will lead to real errors in our way of thinking.

  15. Hi Professor Pettis,
    How much debt relief capacity does China have? Would a debt to equity conversion of a large pool of NPL prevent a painful rebalancing?
    Latigus

  16. Hi Michael,

    I was checking this site for updates repeatedly through January, and this post was well worth the wait. However, I’ve got an only tangentially related question, if you don’t mind:

    You mentioned before that like China, most of Europe (“Spain”) could not get out of its current predicament until much of its debt was written off, and that this debt cannot get written off because the banking system couldn’t yet handle it. Now that Deutsche Bank is starting to take large write-downs (I think this is the second quarter in a row that it has done so (?)), is this an indication that Europe will soon be able to turn the corner?

    Perhaps better phrased, are the Deutsche Bank writedowns a necessary and sufficient condition for Europe’s recovery, a necessary but insufficient condition, or neither necessary nor sufficient condition (or, I suppose, a sufficient but not necessary condition)?

    Thanks again for your posts,

  17. Another great read Michael – I always come away from our discussions, your presentations or your articles feeling better informed on the challenges, risks and opportunities confronting the Chinese leadership.

  18. On paper at least the household sector and the central government in China are not highly leveraged. The deleveraging when it occurs is likely to be managed by the shock absorption capacity of these two sectors. The household sector by financial repression and unemployment which can be absorbed by a return to the farm. The central government by a return to the old days of authoritarianism and mechanisms by which the emperor always appears to wear new clothes. Maintaining credibility at the centre and relying on the capacity of the Chinese masses to absorb the necessary adjustments. This has always been the way which in the modern era can be sustained more readily by the enhanced capacities of the central state. The emperor is no longer far away over the distant mountains. The repeat of the Taiping experience of the 1860’s is unlikely. After the necessary losses have been absorbed perhaps in about 20 years the fresh buds of a new spring will emerge and optimism will again prevail. The hard lessons of the current experiment will not be completely forgotten. The blame in the interim will fall on an emerging category of ‘miscreants’ who by abusing their positions and other shenanigans have betrayed the people and otherwise broken the law. The extent to which losses can be absorbed by this class will be rigorously reviewed by creative minds attuned to the political realities. This class is attempting to exit the stage while the door is still open. Time would appear to be running out. Some of the blame will be assigned to foreigners who will have to manage the new realities with care and patience.

    Thank you for a very compelling and interesting expose not only of the realities in this country far to big to ignore but also of the limitations of the economics profession whose shortcomings may have engineered policy errors not necessarily limited to this one scenario.

  19. A brilliantly argued piece as always from Dr. Pettis. Although I feel that in the real world of living, breathing humans none of the ways Dr. Pettis suggested for China to re-balance relatively smoothly, can be implemented. For it will require the Communist Party to liquidate itself which, if history is any guide, has never happened peacefully before. No wonder China’s elite are rushing towards the exit and taking capital out with them. They and I expect very violent times ahead.

    One more point. I don’t think that when economists suggest structural reforms and the bitter austerity pill, they really expect countries to grow their out of a debt trap. But they still recommend that path, because that is the only way productivity enhancing reforms can be forced on unwilling participants. Tell me, if Germany grants debt forgiveness to Greece NOW, will Greece ever reform ? So this relentless suffocating pressure is necessary.

  20. ‘It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction’

    Why? China’s debt-to-GDP ratio, at 209% is excellent. The best in the world when we consider its remarkable growth rate.

    Why should credit growth decelerate when the economy is accelerating?

    • I think 209% is actually not accurate, firstly, GDP has undoubtedly been over-counted for many years meaning the denominator is too high. Secondly, your figure is normally at the low range of estimates, which go up as much as 250%.

      Another problem is that 209 – 250% is very high for a poor country like China. Also, it has been a very rapid build up. Also At the moment, debt is increasing at nearly twice the rate of even officially reported GDP. Also, the majority of the debt is sitting on sectors that have been the main growth drivers for a long time. Also a lot of the debt is sitting on the corporate balance sheets of entities that have not been able to generate profits for a very long time (SOEs), meaning that it is government debt implicitly. Also the higher interest rates necessary to allow households to get a good return on their savings and thus increase consumption (a government policy) is going to force a lot of this debt into even more distress than it is now – with banks being very generous in their loan classification even when interest + principal are not being paid.

  21. I echo the sentiments of other commenters in that this is truly a thought-provoking piece. I surely hope Chinese officials take heed of the analysis presented.

    As someone who focuses on individual businesses as opposed to macroeconomics, I see distinct parallels, as Michael mentions, in the corporate world compared to what appears to be happening in China.

    The issues of debt-funded topline growth and the instability of additional leverage (financial and operational) are ones that many investors have seen. Topline growth that is funded by debt at rates above the marginal return leads to diminishing value for the firm in the long-term. Moreover although leverage is boon for a business in good times, higher fixed costs (here in the form of debt-servicing costs) elevate the risks of insolvency and decrease the “wiggle” room a business has to weather a disruption.

    Again, fantastic piece. Living in the U.S., my sense, and it could be wrong and curious what others think, is that people here are generally not fearful enough about what is happening in China. There is little analysis I have seen about the cascading effects China has on our domestic economy. The U.S.’s largest trading partners may be Mexico and Canada, but each directly is tied to China, Canada directly through commodities and Mexico through its trading partners in Latin America.

    • Yes, no, in America, we are frightfully unaware, as elsewhere, on the planet, of the grave excesses, that have occurred, around the path that China has taken. Too often, viewed as a play for investors in industries around the China growth story (commodities, EM), as a potential geopolitical adversary, or in terms of class welfare (wage arbitrage).

      But of course, the globally relevant, global systemic dysfunction that China is, as we continue to hear how China represents X% of global growth, is barely on the radar of many. I am increasingly convinced that niche specialization in education, of utility from the globalization story, has assisted group-think and blindness across the analytical and journalistic spheres; let alone among lay people.

      That the China play, for inability to invest in China, has been (globally) around areas of their growth, may be why so much of the dialogue is hopeful that they can maintain their growth rates; or that failure to meet them, need be seen as surprising, mismanagement, or similar. This is why, besides the effect of what will occur within China, and how problematic that is, that why China, rather than a driver of global growth, has been a great driver of global dysfunction, mal-investment and strategic miscalculation creating irreal expectations.

  22. Dear Michael,
    Thank your for your interesting insight. I would be interested in your assessment how the following issues influence the analysis:
    1. I know a number of successful Chinese enterpreneurs who have left the country or have moved substantial parts of their money and family abroad. I sense a growing feeling of insecurity among the real entrepreneurs. That is bad news for the growth prospects. I feel this factor is not given enough weight.
    2. Xi Jinping emphasizes Marxist thinking to keep the CPC relevant: He is aware of a massive new working class that has emerged in China, the biggest working class in numbers in the world. This is a novelty in China. Trying to gain acceptance among this massive new working class seems the clear goal of the CPC using tools like the minimum wage increases, overstaffing in soes, poor protection of private property and focus on job growth at any cost in the urban economy. The Marxist rhetoric has clearly moved from lip service to the attempt to a tool of legitimacy. Entrepreneurs do not like this.
    3. Debt of the state and of state- or party-owned enterprises has to be seen in light of the net assets of these entities. By all means, the CPC and the Chinese State are the most asset rich in the world. So debt seems somewhat less of an issue – there is real collateral. Remember the asset rich Japanese state and compare it with the asset poor Swiss state. Moreover the debt/equity divide in a system with state or collecitvized “ownership” is somewhat different than in a western country with the rule of law. Debt may confer more influence than equity in such a socialist system. I feel that the Chinese system tended to keep equity constrained, as bank had lavish savings to be deployed and low equity kept and keeps capital cost low. The socialist model does not favour high equity returns – party rule and social calm are more important yardsticks to the rulers.

    These are only a few thoughts demonstrating that many Western economist tend to see the Chinese model through their distorted lenses. We should take Xi Jinxing more seriously regarding the reinvigorated socialist model propagated and draw the economic conclusions. We should better understand the ideology taught at the Central Party School. The recipe applied is definitely exacerbating the economic problems you so aptly analyse. In essence only a functioning market economy with property rights, a slimmed sown state and a vibrant democracy controlling the penchant to corruption will bring China to the next level of wealth and vibrance. Time for a real reform! Time for courage to talk about fundamentals.

  23. Dear Michael,
    Thank your for your interesting insight. I would be interested in your assessment how the following issues influence the analysis:
    1. I know a number of successful Chinese enterpreneurs who have left the country or have moved substantial parts of their money and family abroad. I sense a growing feeling of insecurity among the real entrepreneurs. That is bad news for the growth prospects. I feel this factor is not given enough weight.
    2. Xi Jinping emphasizes Marxist thinking to keep the CPC relevant: He is aware of a massive new working class that has emerged in China, the biggest working class in numbers in the world. This is a novelty in China. Trying to gain acceptance among this massive new working class seems the clear goal of the CPC using tools like the minimum wage increases, overstaffing in soes, poor protection of private property and focus on job growth at any cost in the urban economy. The Marxist rhetoric has clearly moved from lip service to the attempt to a tool of legitimacy. Entrepreneurs do not like this.
    3. Debt of the state and of state- or party-owned enterprises has to be seen in light of the net assets of these entities. By all means, the CPC and the Chinese State are the most asset rich in the world. So debt seems somewhat less of an issue – there is real collateral. Remember the asset rich Japanese state and compare it with the asset poor Swiss state. Moreover the debt/equity divide in a system with state or collecitvized “ownership” is somewhat different than in a western country with the rule of law. Debt may confer more influence than equity in such a socialist system. I feel that the Chinese system tended to keep equity constrained, as bank had lavish savings to be deployed and low equity kept and keeps capital cost low. The socialist model does not favour high equity returns – party rule and social calm are more important yardsticks to the rulers.

    These are only a few thoughts demonstrating that many Western economist tend to see the Chinese model through their distorted lenses. We should take Xi Jinxing more seriously regarding the reinvigorated socialist model propagated and draw the economic conclusions. We should better understand the ideology taught at the Central Party School. The recipe applied is definitely exacerbating the economic problems you so aptly analyse. In essence only a functioning market economy with property rights, a slimmed sown state and a vibrant democracy controlling the penchant to corruption will bring China to the next level of wealth and vibrance. Time for a real reform!

    • “. . .he CPC and the Chinese State are the most asset rich in the world. So debt seems somewhat less of an issue – there is real collateral.” Every state that has ever had debt difficulties has had “real collateral.”

  24. For those interested this is the panel discussion Michael referenced from Jan 12th

  25. Fantastic post, as always. I hope you have the ears and eyes of those in this world making economic policy decisions.

    [Many comments above have asked why the provincial debt can’t just be forgiven. If the debt is owned by the banks, then the write-off would create a hole in the bank balance sheet. The central government would likely have to recapitalize the banks, because the private market would probably not be willing. As stated in MP’s post, the debt finds its way to the central government one way or another.]

    On a different note. I recently saw a graph of Household Debt Service Coverage Ratios (DSCR) for emerging market countries that showed China’s ratio rising from around 14% in 2009 to 20% in mid-2015. Unfortunately, I cannot link to the source and I don’t know how accurate the numbers are. In any event, 20% is a pretty lofty level. For context, the U.S. peaked at around 14% in 2008 and has decline to 10% thanks to defaults and low interest rates. This reinforces your point that Beijing needs to make sure that household income continues to grow. Is there a way in which the PBOC can lower interest rates to reduce the DSCR for households without incentivizing wasteful investment? Was this a big contributor to Japan’s ability to muddle through or maybe just delay its adjustment?

    I look forward to seeing you tomorrow in Minneapolis. My office is across the street from the event. If you have any free time I would be thrilled to have a chance to entertain you.

  26. Albeit your logic is not, the tone of your writing can be somewhat alarmist. Hence, I think Singer’s interpretation is attributable to your (frequent) use of the words ‘shock’, ‘trigger’ and ‘disruption’.

    Since the field of economics/finance is by no means rational and free from emotional sentiments (which you surely know) I assume a bit of alarmist tone helps getting the attention your work deserves, but alarmists dont win the nobel prize (I think).

  27. I nead to reread, and perhaps I am missing something, but what are you saying that is in any way new or controversial?

    – China debt is growing faster than nominal GDP
    – This can’t continue forever (since among other things, interest expense eventually exceeds 100% of GDP)
    – Therefore debt growth / GDP growth needs to decline
    – This can only happen in a few ways (inflation which boosts nominal GDP; default which reduces debt; debt paydown via asset sales/higher taxes; higher real GDP growth etc.)
    – Acceleration in real GDP growth without debt acceleration would be nice, but is very rare historically/unlikely
    – If China wants less debt-intensive economic growth, they should focus on boosting consumption
    – The most likely alternatives (inflation, default, debt paydown) are unpleasant for a time
    – A crisis could result if adjustment is delayed for too long
    – We have limited visibility re. timing on any of this

    Summarized even more simply: unpleasant things happen if you borrow lots of money and invest it in low return projects…at some point.

    • Boy that would have saved a lot of time! In my line of work (sell-side know nothing), I also gets a lot of mileage for pointing out the obvious in “interesting and intelligent” ways.

      Bravo Dr. Pettis!

    • It’s new and exciting to economists who rarely think about the Balance Sheet of economics agents and normally just consider their Income Statements.

      That is really the crux of Michael’s argument: most advisors/academics are focused on trying to increase the economy’s output in order to out-grow the debt (the comercial equivalent being to grow company revenues), but if you are not dealing with the source of that debt (unproductive investment) or if, even worse, the persuit of growth amplifies that problem (think of M&A driven earnings growth) then you aren’t getting any close to a solution.

  28. Michael,

    Thanks for another interesting article. I truly wish I had the time to reconstruct all the relevant equations backing your argument. Hopefully one of this days!

    Please forgive me for asking a somewhat tangential matter, what are your thoughts about universal basic income? I find it extremely elegant and intriguing but sadly I lack the theoretical tools to judge it.

    I will look forward to whatever you have to share,
    John

  29. Mesquiteice (@mesquiteice)

    I respectfully differ on the rebalancing part. The idea of rebalance is utopian and impossible to achieve in reality. The reason is that when this equilibrium is reached in the unified economy of the world, economic activity will become NIL. If everyone had no debt and didnt need to borrow there would be no economy. Equally incredible is the ability of a few chinese leaders to change a billion people from being borrowers to investors or from producers to consumers. The labourer lives on debt and borrows on the belief that tommorow exists and he will have a job to pay back. He keeps borrowing to satisfy his unending needs. In my view any understand of economy in absolute terms of time, quantity or quality is futule. growth is relative and the ups and downs keeps the economic activity alive.

    Coming to china, i think it is the debt that has got them here. It is the steroid that has helped them grow. without it they would anyway collapse. Their only hope is to use it as long as it is available. How can they now get out of it. They cannot and need not. They just have to find people who can lend them. As long as there are people willing to lend, the system will work. If they have to consume the goods they produce, then the whole world has to be china and they will never be able to change the system. Instead the system will collapse instantly. If ever china has be become a consuming nation, they will need even more debt to finance the consumers. In any event they cannot live off the steroid of debt.

    That is not to say debt is bad. It is to say that once you have decided to use debt as a basis of your growth, then you cannot get out of it half way and expect not to collapse.

  30. Excellent article. When you suggest the government sector sell assets would that include reforms to allow leaseholders to buy freehold, and create a Torrens Land Title system like most British Commonwealth countries? The reform could be done so that freeholder owners would pay property tax thereby making it voluntary choice to start paying the tax. For the property tax system I would suggest the Danish Land Value tax system based on the writings of Henry George which some argue boosts growth rates by 2% GDP per year compared to a system which also taxes improvements. (Most governments elsewhere should also switch to that system to improve land utilization and thereby boost growth.) The local governments could be given this power on the condition they use the proceeds to pay down debt. A second supply side reform you did not suggest is to realize the industrial age is rapidly changing into the knowledge age then promote the change. Policies which increase the creativity of the population are required. The Frankfurt education model or Confucian model were effective in the industrial age but are counter-productive in the knowledge age as they fail to sufficiently promote critical thinking and creativilty. Many Chinese citizens recognize this problem and send their children to my home town in Vancouver, British Columbia to take advantage of our school system which is better at promoting critical thinking and creativity (although more can be done to rid us of the harmful Frankfurt school methods while we would benefit from adopting some of the Confucian methods aside from the rote learning). The knowledge age sector requires far less capital so promoting it is a good way to keep growth rates high while the economy deleverages. As the knowledge sector expands demand for capital diminishes so promoting it also will help keep the interest rates low to better speed deleveraging. Finally a policy of technological easing always help speed adjustments. The Chinese government could announce what technologies are allowed, and thereby attract technologies that are informally restricted in the West such as solar cells over 20% efficiency.

  31. Brilliant Article but how easy do you think that China’s move to a service economy is going to be given that the majority of workers have been trained to be in a manufacturing economy. Apart from the cultural changes necessary to adapt, how do envisage they may address the training and educational issues of a displaced workforce? Won’t reversing the move from the cities to the countryside have a detrimental affect on the economy in the same way that movement to the cities create a positive improvement. Who will pay for all those empty apartments and who will support those unemployed production workers, as not just the structure of the economy changes but the application of robotics becomes more pervasive? Who will manage the dissent that may occur during the transition?

    • The People’s Daily published an article criticizing the policies of Xi’s predecessors. It is the top state controlled newspaper. The article implies the government is likely to do something radical to narrow the income (wealth) gap between the rich and the poor. The extreme case is like rich people were forced to hand out their property.

    • Dave

      It is not merely a move to a service economy, this is a notion common on the common media, it is a move to a domestic demand driven (Consumption) economy, of which a switch to services comprising a higher percentage of GDP, itself, and also, will be a necessary movement.

      You will structural reform, rebalancing, services, and rising retail numbers.

      These have to be juxtaposed against growth in investment, growth in Total social financing, and growth in M2; with movement in reserve requirements, interest rates and currency values.

      The Urbanization Myth, of migrants, the Ant Tribes, was a long-term muddled issue, hukou limits actual migration, while allowing socially costly temporary stays.
      Further urbanization has been in lower tiered cities, and this is where much of the wastage in units sits. There is a reason why the coasts of the world are far more developed than the interior spaces of continents.

      Lower skilled service or lower skilled manufacturing will find an easy switching. Many are confused of this because of the stories in the Advanced world about education, manufacturing, “skills gap” etc…..Which, is quite ridiculous. More often than not the trade diversionary tactics of some national planners has seen movement from the Noth to the South do to provisions related to lowcost loans, tax abatement, export rebates, support for services to workers (food housing) and locational reasons as countries follow strategic rivalry theory, where they will follow their competitors into markets, others strategies, merely to assure market share (choosing suboptimal policies because of market share, as we see playing out in oil, now)

      It is not the transition that is a concern, as it implies that such occurs.
      It is a harder scenario where excess leads to descent rather more quickly.
      Of course who pays is what Michael talks about more generally, in terms of what rebalancing will look like…

      transfer of assets to households from state
      etc….

      look back into the blog

      • You will structural reform, rebalancing, services, and rising retail numbers.

        Or, perhaps, higher emmigration rates? I’m not an economist, but I think that if the rich leave and take their savings with them, the savings rate drops. Consumption wouldn’t rise, of course, but net emmigration would have the same effect on the Investment/consumption imbalance as would a rising savings rate, I think.

        As an aside, Gerschenkron talked about poor countries doing things to increase investment (at least if I understood Michael correctly–I haven’t read anything that Gerschenkron actually wrote). If we are truly moving to a world in which every first world country is trying to drive interest rates negative, I’m wondering if a third world country could grow without resorting to all of the standard financial repression techniques by simply liberalizing its own markets and allowing for reasonable rates of return. In effect, there is no competition for the money from the traditional first-world competitors.

        • Gershenkron wrote about the model in his magnum opus: Economic Backwardness in Historical Perspective. He just goes through the historical cases of how poor countries deal with the need for the centralization of the investment process (required for geopolitical, political, economic, and financial purposes).

          In the case of the 19th United States, foreign financing was used to finance investment. The problem with foreign financing is that the flow can stop and if you’re using debt, you can run into financing issues. However, the flow of financing came into the US primarily in the form of equity. If I remember correctly, many of the shareholders of the Bank of the United States (definitely the First, but I think the Second as well) were foreigners. There were land sales and purchases of American companies, but there was debt buildup within states. The important part is that the defaults of the US were DECENTRALIZED. Of course, if the US government took up more debt at the time, it would be able to pay it off because it can collect on the resources of all of its members while individual states have difficulty accessing financing and maintaining market liquidity.

          But yes, third world countries can grow without resorting to financial repression. The classic case would be India. India followed a democratic socialist model for development from 1947-1991. The result was population increasing by 200-300%, economic growth per capita at <.8%, and a ransacking of the country by the impacts of centrally planned industrialization combined with useless bureaucracy. In 1991, India liberalized and today most states in India have lower fertility rates than the United States, economic growth is very high, and markets have actually shown to work.

        • This is the book. It’s pretty expensive on Amazon, but it’s a book that I actually did shell out the money for. It’s actually really good.

          One thing I don’t get about Gershenkron is that he always talks about Marx being intelligent and insightful while proceeding to decimate many of Marx’s core ideas in that book. I just don’t get it. I don’t know how people think Marx was intelligent. It seems pretty clear to me that Marx is an idiot.

  32. A lot to digest. This piece got me thinking a lot about the vacant flats and migrant workers. Using the latter to solve the former seems intuitively appealing. However, if serious efforts are made to reduce overcapacity, jobs those workers might commute to may become less and less available. Based on what you say, the service sector will not take off in the absence of a serious effort to rebalance (again, less jobs). A liberalized hukou regime may make it easier to live in the city, but if they are cutting taxes and not liquidating state assets to pay for social benefits, it may be even more difficult to stay in the city. Then there are the social tensions as well, which I think you referred to when mentioning Beijing, Shanghai, Guangzhou.

  33. In many countries around the world, it is becoming very visible that the dominant ideas implemented by policymakers have not delivered. In many countries, after political alternances have led to try variations on the supply-side and demand-side themes with equal unsuccess judging from the consistently declining growth trend and consistently rising debt load, established political parties are apparently unable to formulate new ideas. They keep repeating their old ideas, again and again, with less and less people listening, so low has their credibility fallen. In an increasing number of countries, mainstream politicians are therefore disappearing into irrelevance and “anti-establishment” or “extremist” candidates are on the rise, often with no clear ideas themselves about what needs to be done, as we clearly saw in Greece for instance.

    It looks like the Chinese leadership is going through the same motions, trying variations on the same themes without addressing explicitly the root causes of internal imbalances driving the domestic relative debt snowball. Together with leaders of other large economies, they have also not been able so far to address in international forums the root causes of external imbalances driving the global relative debt snowball.

    Correct policymaking comes from correct diagnostic. Without the correct diagnostic, “the courage to act” is not only vain but more importantly counter-productive. It ends up making things worse.

    It seems to me that what needs to be done to achieve sustainable, mutually-beneficial growth with no excessive debt burden nor excessive income distortions for countries participating to the global economic system is indeed not so difficult to understand. You are saying it for years. Others before you have said it for decades. Factual developments have been fully consistent with your framework. It’s not that it is difficult to understand, it is simply difficult to admit for policymakers who have consistently acted in the opposite direction and benefit directly or indirectly from the imbalances.

  34. Michael

    This man seems to think he has irritated you, or that you are irritated at him

    http://www.lowyinterpreter.org/post/2016/01/28/Chinas-economic-transformation-Is-the-glass-half-full.aspx

  35. It’s a cash flow problem!

  36. Estimado profesor Pettis.
    Esto no es exactamente un comentario, puesto que no se expresa en el lenguaje inglés de este blog. Por esa razón, si ahora lo tira directamente a la papelera, entenderé que es un problema mío y no me sentiré molesto.
    Desde que Andy Robinson lo entrevistó en Málaga en junio de 2013, venciendo mi dificultad con la ayuda de Google, tengo traducidas con bastante precisión todas sus entradas de Blog que he seguido con gran interés y provecho. Creo que sus escritos me han resultado especialmente interesantes por dos razones: el paralelismo que se puede apreciar entre la trayectoria de la economía de China y la de España (paralelismo entre los desequilibrios ahorro-inversión dentro de China y dentro de la zona euro) en esta crisis –que usted ha tenido el acierto de mostrar en repetidas ocasiones-, y mi experiencia como empresario, que más que mi formación como economista, me permite compartir ese “enfoque Minsky” que es tan estimable en sus análisis.
    Hecha esta presentación, creo que puede tener interés hacerle algunas observaciones al punto 8 del resumen general de su largo y denso artículo, cuando dice que con mucho, la forma más eficiente en que Pekín puede reducir los costes de ajuste y el riesgo de disrupción, es asignar los costes de servicio de la deuda a los gobiernos locales, obligándoles a transferir riqueza a los hogares.
    Estoy de acuerdo en que debe ser el gobierno el que haga el esfuerzo más significativo en la aportación de riqueza al proceso de reequilibrio, aunque creo que eso debe hacerlo, a la vez transfiriendo riqueza y dejando de extraerla, lo que como usted ya señala, requiere una auténtica revolución política, que es muy difícil de hacer para cualquier país y es posiblemente de una especial dificultad en el caso de China.
    No obstante, lo que me parece realmente importante destacar de esta propuesta es que la posibilidad de que Pekín haga recaer el grueso de esa transferencia de riqueza sobre las administraciones provinciales y locales, recuerda de alguna forma a las “desamortizaciones” que se promovieron en España (y en México) en el siglo XIX, con similares objetivos y esperanzas. Conviene no olvidar que estas iniciativas, aunque lograron en parte el objetivo central de pagar una significativa parte de la deuda del país, en cuanto a su otro objetivo de servir de revulsivo político y económico, en realidad sólo acabaron por reforzar la estructura de poder y dominio preexistente.
    También quiero llamar su atención sobre el hecho de que es más que probable que las elites locales, aprovechen el malestar creado por el reparto espacial de los costes del ajuste para, avivando los nacionalismos de diversos niveles contra las reformas, aumentar su poder (o cubrir sus vergüenzas) como, en todo caso, estamos viendo que ocurre tanto en Europa como en España en este momento. (Tal vez le interese en este sentido leer mi artículo sobre el nacionalismo… en http://www.rebelion.org/noticia.php?id=207977, en el que además destaco la valiosa aportación hecha por usted en Can Pedro Sánchez save the PSOE?).
    En caso de que haya llegado hasta aquí, le doy las gracias y quedo a su entera disposición.

  37. Mr. Pettis, you wrote “I have already explained many times why comparing US and Chinese debt is nonsensical…” Could you point me to some of those writings? I need to understand this better.
    Thanks so much,

    • Structure of the consumption of GDP…..Investment as opposed to Consumption…think about it….relatively few focused investments (although very many)….against Many Points in the Economy (100’s of billions of service and consumer actions)

      But primarily over-reliance on Investment, for what, where is demand growing, if in China, at some point it must be by the billion chinese who consume, no, can’t keep investing forever,

      if externally, where is growing…in Manufacturing EM, who have been put at a disadvantage of Chinese State control and HEft in their own economies….

      In Commodity EM….commodities, very large investments, relatively few workers to to tech, heavy expenditures on capital goods to extract etc, then chinese economy needing to slow forward investment, because can not be rationalized domestically by consumption due to low wage share of workers in economy, relative to GDP, or externally due to declining global demand, baby boomer retirement, coupled to stagnating wages, coupled to diminishing prospects for gains made in global middle class, due to skewed nature of investment led growth, much of which is due to China’s compressed timeframe, focusing so much investment, in such a short period of time.

      So, investments, are of loans, loans are out of thin air, they create assets, debts and deposits, but ultimately, these have to be rationalized by income and revenues, which of course, are actually constrained, because so much of the economy is focused large investments, rather than hundreds of billions of consumer purchases.

      So, all this

      Michael, might then point to (or not)

      institutional constraints (vested interests)
      legacy, diversity & maturity of financial markets
      diversity of market based participants operating in market (from dealers to investors to institutions)

      You should go back to main page, and find yourself down the blog listings, then strike a title close to you interest and read

      or watch his youtube video’s (there should be more of these)

  38. Assets sales by provincial governments to delever is one of the key proposed solutions but that I can tell the post never explains which assets are to be sold. Is it supposed to be obvious to everybody?

    If it’s land, haven’t provincial governments already been selling it faster than it can be productively developed and absorbed? Hence all the empty residential and commercial space. Hasn’t rapid sale of land and debt funded development been a large the source of the problem? And even after a decade of breakneck land sales the provinces are now more indebted, not less.

    Or is it that provincial governments technically still own the land they have leased out for development? The currrent occupiers of this land feel that they paid for it and are the defacto owners and any attempt to “re-sell” it would cause a revolution.

    Or are the assets to be sold province owned enterprises (“POE”)? But given that these are in overcapacity industries, how much are they worth?
    Or are the assets infrastructure? Again how much is it worth? Hard to sell city streets and subway systems but freeways and airports perhaps.
    You can’t argue creditbly that asset sales are an important part of the soutlion without giving some idea of what assets are to be sold and for how much. These things aren’t solved in the abstract but with tangible policies that need to be evaluated in the real world. Even policies to increase household wealth and consumption need to be laid out. Everyone knows (and endlessly repeats) that consumption needs to grow much faster than investment going forward. That’s simply restating the problem. What specific measures do you propose to make this happen? What is both effective and politically feasible?

  39. ‘Li Daokui, claimed at Davos “that at least $3 trillion foreign exchange reserves in China is required to prevent foreign debt default risk”, for reasons that elude me’
    http://www.baldingsworld.com has just posted a reasonable looking breakdown

  40. I don’t understand how if the internal provinces are poor and can still benefit from state credit and infrastructure building this cannot be underwritten by the state. The Chinese state issues it’s own debt in it’s own currency and controls all the methods and materials needed for the required construction. If there are bad debts on the books of local govts in those provinces then the govt can buy the debt, put it in a ‘bad bank’ and issue new lines of credit to those govts with instructions to loan to construction firms to undertake the building.

    It looks to me as Seramteo says above that there are parallels with Europe here. It seems to me that elites within China are using the slowdown in the coastal provinces as an excuse to take control of assets from other elites in the same way that European elites have made the ‘periphery’ states sell state controlled assets to creditors from Northern Europe instead of doing a fairer write down of debt that is no longer repayable. This is a recipe for political problems.

    If the actual problem is that the coastal provinces are no longer to grow at the same rate as they used to due to saturation of their export markets and/or lack of global aggregate demand then the solution is similar in some respects to Europe – a sustainable build-up in the wealth and long term spending power of a greater proportion of the local population is necessary.

    From memory in Japan there was a small elite wealthy class that in pre-industrial times owned most of the land. The govt forced the sale of the land to smaller farmers increasing the wealth of the peasants and directed the elites families to put the capital from the sale of land into industrial enterprise. Then in the aftermath of WWII the Americans forced, or put in place the conditions for another redistribution in favour of smaller family commercial enterprises. The elite industrial enterprises were then directed to become export houses and the vanguard of Japan’s export development thrust

    So we are talking about redistribution as part of redirection. This shouldn’t have to be constrained by debt in a country with it’s own currency.

    Perhaps debt is not only a constraint, it is an excuse or a method to delay the redistribution of factors of production necessary to build a bigger middle class.

    If a person in China gets sick and has to pay large hospital bills they and their family immediately fall out of the middle class. Education costs money. State housing is obviously needed in the top tier cities. Elderly people don’t get much of a pension. In other countries the state pays a proportion of the costs of these expenses so that people can continue to earn and spend. Until the Chinese state starts to do this Chinese people will continue to save every last yuan.

    I remember a Malaysian minister saying about New Zealand’s welfare system (pathetic as it is) – at least we don’t pay people to do nothing. That is the nub of it. Until the Chinese understand that welfare payments provide the safety net that expands their middle class they will have to rely on the income tax paid by a small elite proportion of the population as well as any indirect taxes they can get away with levying on the poor.

    Why have increased consumption/VAT/GST taxes become so popular with govts these days? Because they aren’t getting the income tax revenue from the middles classes that they used to.

  41. I love this. One of my critiques, as a historian, against classical equilibrium economics for the past several years, is “history matters.” So does politics and power. Math and equilibrium models do not account for what actually occurs in the real world. Yet economists who rely on math have enormous political power to try and enforce the laws of equilibrium on humanity, often with dramatic and horrifying costs.

  42. Thankyou for this excellent article!

    I am curious; has something like the following blueprint has been tried before in a modern economy?:

    1: Start raising interest rates on debts (but not deposits). Do this very slowly but relentlessly, projecting clear language to the market that rises will not stop.

    2: The impact will trigger debt-repayment, the cessation of asset price rises being maintained by debt (Ponzi borrowing) and eventually trigger deflation as debt-repayment starts to exceed debt-creation, causing the amount of endogenous (credit-money) in the system to shrink relative to available goods and services.

    3: The extent of deflation can be quantified easily enough in today’s digital age. Create an exactly matching sum of exogenous money (created directly by the government with no liability associated).

    4: Assuming that the most productive and honest agents within the nation are those that are most likely to make sound spending decisions that will benefit the future economy, assign the new exogenous money to the accounts of these agents (both individuals and companies).

    5: Identify such recipients by looking at past taxes paid. If necessary, with the help of a modern top-tier informatics firm (such as Google or Amazon), collate bank details and tax payment details for all citizens and businesses into a single, dynamically updating database. The assumption is that productivity provides something to tax and that honest people are more likely to have paid.

    6: Inject exogenously created funds directly into the accounts of said individuals in direct proportion to past taxes paid. A delayed tax rebate in other words.

    7: Revise flows as necessary to maintain exogenous creation in proportion to endogenous destruction. The amount of money in circulation will stay the same (maintain prices), but the quality will be rotated from endogenous to exogenous until a preferred ratio is found. The process is reversed by lower interest rates to boost the endogenous supply, while increasing taxes or decreasing government spending relative to taxes (and destroying the government surplus) to reduce the exogenous money in the system.

    (8: In actual fact, the scheme I would propose is a little more complicated. It would do the allocation in two parts, first as a citizen dividend (largely to replace welfare), and second as a weighted allocation using what remains, based on past taxes paid as suggested above).

    In light of your listed objective of supply-side reforms:

    1: Reducing over-capacity.

    Where over-capacity is being funded by rising debt, this will cease as the cost of debt rises. Such facilities will either be forced to reform or shutdown. The fact that they have been relying on debt to maintain production infers that they are not efficient or profitable and are not likely to have been paying tax. Therefore they are unlikely to be recipients under the rotation scheme.

    Meanwhile, the amount of money required to absorb the deflationary loss of these firms will have been injected into the economy into the accounts of other individuals and firms with a proven track record of being profitable (offering something to tax). These agents, having been boosted by funds, will be in a strong position to acquire the defaulting agents, should there be any benefit in doing so.

    No individuals are better to make this decision than the productive ones themselves (no need for a central authority). Hence, productive reforms will be a natural consequence of market forces and the rotation from endo to exo money.

    One could imagine a situation where tax-paying workers, boosted by exo money, could acquire a facility from incompetent loss-making management, and try to turn it around. Or where tax-paying workers would happily walk away from what they know is a lost cause, safe in the knowledge that they are boosted by exo-money.

    2: Reducing real estate inventory.

    This is the same as #1. Unproductive, tax-avoiding, over-leveraged speculators will implode. The productive, cashed up with exo-money, will have the choice to acquire housing stock or not. Their choice.

    Allow the productive agents of the economy to make the allocation decisions and get out of the way. As with #1, housing that cannot be put to productive use, will simply not be put to productive use. In some cases, the most sensible thing to do, will be to demolish the over-supply, recycle the materials and put the land to a better use.

    3: De-leveraging and otherwise strengthening balance sheets.

    Raising rates will cause deleveraging. Assigning exogenous money to tax-paying agents will strengthen the balance sheets of the most productive and honest recipients. Forcing deleveraging via increased rates will challenge the balance sheets of the non-productive and/or the non-tax-paying.

    Reform is not achieved by bailing out unproductive enterprises. Reform is achieved by redirecting resources from the wasteful to the productive.

    4: Fiscal expansion, including tax cuts.

    The suggested scheme has the exact same effect as a tax cut but the sums involved are much larger. Because the wealthy are more likely to avoid tax and to employ leverage, the effect of this policy will be a lessening of inequality and, particularly, a strengthening of the all-important middle class.

    The lower end of society also pays little in the way of tax so will not benefit so much from tax-based allocations, hence the (#8) of the blueprint. In the short term, existing welfare programs could be maintained out of the new exo-money stock, prior to allocating the residual based on past taxes paid.

    5: Lowering corporate costs directly and by reducing government bureaucracy.

    The scheme directly lowers costs for corporations that actually pay tax but does nothing to help those that avoid it. This qualitative bias is likely to be beneficial to the future economy by selecting for firms with more honest management, inferring that they are less likely to commit costly fraud in the future.

    Government bureaucracy is a separate matter and indeed requires great reform. To the extent that bureaucracy is involved in this scheme, it extends no further than selecting a rate at which to raise interest rates, monitoring inflation, and managing the information of tax-paying agents. No other decision making is required, so bureaucracy is minimal.

  43. On a side issue here, there’s serious issues across various financial systems worldwide. By and large, the American financial institutions have adjusted, have high capital requirements, and are basically fine. However, virtually every other financial system across the world has serious issues. We saw a lot of talk in the international community about how the “deregulation” and “recklessness” of American banks was what caused 2008, which then became a talking point for various aspects of the left in the US which are still being repeated. The irony is that, as will become apparent in a few years, the American financial system was under the most sound footing and has shown (repeatedly) to be the most flexible. I wonder what the dialogues in both the international financial community and in the American political discourse will change. My guess is that because most people view their feelings to be absolutely correct regardless of the facts, the dialogues will not change.

    We will see, over the next 5-10 years for sure, that more regulated financial systems will not only underperform, but will be shown to run larger risks than “deregulated” financial systems and many of these “regulated” financial systems will go bust. It has come to my realization that none of the people my age or younger ever actually saw the USSR fell nor did they ever see the repeated failures of financial systems not in line with the “Anglo-Saxon” model. These people will see reality slam them straight in the face.

    People are starting to look at Deutsche Bank as having issues with the German finance minister Schauble saying that he has no concerns over Deutsche Bank. What this probably means is something I’ve been thinking all along: Deutsche Bank has real issues. I suspect many of its assets are junk while the entire German banking system doesn’t really have enough capital to take the possible hit from a debt restructuring.

    The financial systems across the entire world in places like Australia, Canada, Germany, France, Scandinavia, and a whole host of places are in real trouble. The banking systems of these countries are, for the most part, much larger than in the US while their banks and financial institutions hold far less capital. Instead of the quick and rapid adjustment of the US in 2008 where asset prices corrected and the economic system adjusted, most of these countries didn’t adjust.

    We will eventually realize something that we should’ve known from the beginning: American finance is the most robust and financial “regulation” doesn’t really work well in helping adjustments.

    • Yes, the American financial system does have enormous strengths that are not always recognized, but I think significant bank concentration undermines many of those strengths and seriously reduces incentives for activity that had supported the enormous creativity of the US business sector. For example the greater tendency historically for American banks to go bankrupt was part of a system in which the capital allocation process was much more tolerant of risk and of projects that lacked tangible backing and relied more on future earnings. Bank concentration means that any activity that risks bankruptcy must be more sharply curtailed, because the cost of a bankruptcy that might bring down the nation’s financial system is intolerable.

      Maybe it doesn’t matter, because the importance of the banking sector in the financing of business is declining, but I think if we are going to tolerate the kind of banking concentration that must force us to reduce our tolerance for risky and perhaps even foolhardy lending (and you cannot design rules that systematically prevent banks from behaving foolishly without also preventing them from taking risk on things like new technology), we should simultaneously impose regulations that systematically narrow the scope of their activities to transactions within parts of the economy in which we don’t put much value in innovation. If our brightest minds are not able to come up with new ways to facilitate consumer credit, or to postpone the cost of mortgages, for example, I am not sure the cost to the United States or to the world of losing our competitive edge in those areas will be too much to bear.

      • In a video by Prof. Mehrling, he was talking about how almost all consumer credit (usually in the form of credit card debt, student debt, etc.) was all securitized and exists largely outside of the domain of regular banks. Also remember that many people use things like credit unions for financing, which are much less stingy and slimy than banks.

        In my case, I have a bank account that I HATE using, but I do use nonetheless. Most of my savings are in my brokerage account where I use it to do whatever I want.

        We should really focus on getting away from banks all together. We need a government, and policymakers, who can use financial innovation to finance productive activity.

        Also, I’m sure you’re well aware of the advantages brought by larger financial institutions in general. This kind of “oligopolization” of the financial system is nothing new in American finance. This is what basically always happens when you have a market based financial system where your response is to let it run. When the banking system is heavily decentralized and geared towards risk-taking, small banks get wiped out while the larger, more diversified banks survive. These cycles keep going which means the bigger, more diverse, and better run banks/financial institutions absorb all of the little guys. In the end, you end up getting a cartel.

        I find it funny when many of the “progressives” (I know you consider yourself to be a progressive Democrat, but you’re someone that understands financial structures, something most progressives do not understand) attack Andrew Jackson for being an idiot regarding financial institutions, money, and banking but his policies and framework for the banking system left the US with a highly decentralized banking system where something like 20% of all banks failed within a 3-5 years for the entire “free banking era” in the US that lasted until the Civil War.

      • I’m worried that we’re lacking some direction of where we need our financial institutions to go by policymakers on both sides. I think what we need to do immediately is to work on shifting our entire financial structure to consist almost entirely of equity and capital assets. We should start using and creating capital assets composed of equity and shares. We could even use such structures to finance infrastructure projects across the country, and if something goes wrong or doesn’t generate revenue, there’s no debt hangover left on the community that used the financing.

        In the case of infrastructure, a local community could create a company that is obligated to revenues for some tax (ex. gas tax to build roads or some kind of a duty for a canal or port) or a portion of profits/revenues for some existing company (ex. water companies, sewer companies, etc.). Then we could take these equity companies, use a financial intermediary to force local governments to sell these newly created companies immediately to the financial intermediary (why immediately? to prevent the companies from leveraging up with debt), and then the financial intermediary could issue capital assets that are backed by the equity of the companies that receive the a portion from the tax/revenue. I wrote about it more detail here, but I really think this is something we could do.
        http://suvysthoughts.blogspot.com/2016/01/an-infrastructure-proposal-using-asset.html

        We should move to debt-free student tuition wherein we could use some kind of equity financing. This could work by taking say 10% of someone’s income for the next 10-15 years if they opt for public financing for their college. For a graduate school degree, you could increase that portion of income to something like 15% for the next 15-20 years or something of the kind.

        This is where the future is, but it seems like virtually all of the policymakers/politicians (especially on the left) are looking backward and trying to turn the financial system back into what it was in the 50’s and 60’s.

        We should shift over entirely to equity and capital assets. We should move away from debt as much as possible. I guess the purpose of debt makes sense so that consumers have access to credit, but other than that I don’t see much use for debt. Equity and capital assets provide every person involved with convexity AND a system built on equity and capital assets will have convexity for the system as a whole. When you have equity financing for assets that’re basically worth very little or close to junk or are junk, you have a payoff very similar to that of a call option except for the fact that there’s no expiry date. So for crappy companies or firms issuing financing not worth anything or worth very much, equity can actually be better than a call option.

        The thing is that our financial system is already mostly towards the equity and capital asset financing method. Total household debt is ~80% of GDP while the TOTAL listed domestic American equity comes out to somewhere around ~150% of GDP with this number increasing rapidly over the past decade. We should use equity for literally everything as much as possible.

        Another real advantage of equity is that an increase in the volatility of the earnings of a company, especially if it’s poor or the firm is highly risky, increases the value of the asset. You end up having an asset that provides convexity, is long volatility, and sets an absorbing barrier on the left tail while providing unlimited upside to everyone (hence the convexity).

      • Prof. Pettis,

        I also have one question for you which is regarding the size of the American banking system. When I look at the total assets of the American banking system, it comes out to ~80-85% of GDP. In other words, if the capital of our banking system got completely wiped out, it’d cost ~15% of GDP in order to capitalize the banks at a very cushy capital ratio of near 20%. The size of our equity markets is almost double the size of our banking system. On top of this, there’s been massive development in financial institutions that effectively compete with banks for financing and customers that includes brokerages (some brokers actually have debit cards where they actually refund ALL of your charges on the card like using a different ATM). We have the rise of credit unions, which many people use.

        So my question here is: shouldn’t we just move away from banking? What do we even use banks for today? It just seems like these are slimy organizations tryna extract rent in many ways (but not entirely).

        In most countries (like in Europe or in other parts of the world), the total assets of the banking system are often >250-300% of GDP, which is just downright scary. These places have lower capital ratios than the American banking system, they’re very oligarchic, and tightly regulated, but they’re all WAAAAY more risky than the American banks. To me, that seems far more dangerous than anything we have here.

        It seems to me that our financial system is the most decentralized it’s been in >100 years (probably back to before the creation of the Federal Reserve to see this kind of decentralization). This is having a real shift in our political system that has created a very Jacksonian like system where the political axis is centered purely around the financial system. What this does is that it effectively destroys party unity and creates a system where you have political parties becoming weaker than they already are. You have the Democrats–especially the progressive Democrats and hardcore “liberal” Democrats (who actually aren’t liberal)–that’re pushing for more centralization with an increased role for the Federal Reserve/Treasury that want to use deficits and massive government debts to basically control the private sector. On the other side, you have the Republicans wanting to decrease the spending and control over state governments by the federal government.

        Now, due to the power structure shifts that’ve made our political system more Jacksonian, you have division within the parties on how they wanna use the existing financial systems. You have the rise of the “business Republicans” (represented by Trump in the Presidential primary) who want to use the financial innovation and sophistication in order to invest in places like inner cities and for development of poorer regions. On the other side, you’ve got the Jacksonians (represented by Ted Cruz) who want nothing more than to throw a wrench in the system and take down established bureaucracies. The only problem with the Jacksonians, as you probably know, is that they’re total wild-cards. Most people on the left view these people as idiots who don’t know anything about anything and only win elections because they’re crazy nutcases, but that’s not accurate. These are people with a great degree of political cunning and many of whom are VERY intelligent and sometimes BRILLIANT (like Ted Cruz). So when they get power, no one really knows what they’re gonna do. Although I will say that on issues like infrastructure, financial reform, money, and banking, the Jacksonians have been the most reliable IMO.

  44. Hi Michael,

    I was wondering will you add your thoughts about India’s economy compared to China? What are the difference? is India Growth model more sustainable?

    • I am trying slowly to wade into Indian history, Moses, especially economic history, and get a better sense of its politics and institutional structures, including what seems like a very highly decentralized system in which state institutions can wield enormous power relative to federal in certain areas. Unfortunately the world has not been cooperating with my educational aspirations because there never seems to be enough slack time for me to forget about the latest economic turmoil in China, Europe or Latin America and devote several hours a day to trying to figure out how the various pieces are out together in India. But I guess India will be around for a while, and I’ll get there at some point. I’m interested in reading Keynes’ first book, on the Indian monetary system, where apparently he developed some of his thinking about money.

      • So do you think India will face the same problem as China right now?

        • From what I recall, India is running a large balance of trade deficit, is it not?

          I guess that would mean that if India needs to rebalance at all, it would be in the opposite way of China, and so investment would have to increase with respect to consumption going forward. But in a world where there is too much savings, India should be able to keep absorbing those savings (running trade deficits) for the foreseeable future, and since India hasn’t developed its infrastructure, it should be fine for a while.

          To caution against the above conclusion, I have no idea what I’m talking about and am just trying to use Michael’s reasoning from his other posts and apply it here. Since this seems like a very strong conclusion based on basically no information other than “I think India is a net importer” and “I am pretty sure the world is overly dependent on exports”, it could be way, way off (or at least stated with far too much certainty than the initial premises warrant), but maybe someone else can point out the flaws in my logic.

        • India is well early in their process, they have many domestic institutional alterations that can give efficiencies for growth, by altering domestic bureacractic, institutional logjams, thus growth can occur on, and within, domestic terms. The current environments limits evolutions along Chinese excess, limits on growth, but much more sustainable, and balanced, growth. Speed might be only useful in sprints, not marathons Then, longer term dynamics related to positive demographics. Offering both advantages and disadvantages. Dependency ratio issues, but also a strong captive domestic market. Thing of this in terms of broader de-globalization and structure of domestic economies in relation to issues of demographic change.

      • Our current view of India as a united entity is a modern concept that’s just not true. A place that’s been around as long as India has gone through most everything. In India, people are more concerned about local politics than they seem to be about national politics. India isn’t really a nation-state, but it’s thinking is very sophisticated and wise. It’s a beautiful place.

        In India over the past 500 years or so, you basically shifted from Mughal rule to British rule to self-government. Under the Mughals, India was still very decentralized with kings basically paying a tribute of some kind to the Emperor. During this period, India peaked under Akbar the Great. After that, it was a slow decline. After his reign, things basically got more rowdy and the center tried to gain more control. Over this entire process, civil order basically broke down. Trade routes weren’t safe, networking was less likely, banditry rose, infighting rose, etc.. This basically continued until the Mughal rule was broken completely by the Maratha confederacy and a power vacuum was created. Of course, the European powers were now involved as well. Sure enough, the British ended up consolidating the region basically during and after the Napoleonic Wars.

        So by 1820 the British were basically ruling India in some form or another. India’s decline continued until the mid-to-late 19th century (economically). Indian industry got wiped out in the 19th century, but I don’t think the reason was a lack of tariffs or protection. I think the reason Indian industry got wiped out was the fall in transport costs. I don’t think there was a tariff high enough to actually sustain Indian industry because the fall in transport costs from steam ships instead of sail changes the game completely.

        As I’m sure you know, these “free trade” policies combined with the fall in transport costs and the collapse of civil order caused Indian colonies to specialize in cash crops to imperial subjects. This was largely responsible for the famines in the late 19th century, although I believe most of the famines were regional. From then on, India actually started to develop and there was a little per capita growth, which was probably increased as a result of the famines due to the Malthusian principle.

        From the turn of 19th century, India did start to see a rise in industry and a rise in protection. Indian industry did actually do decently well from 1900-1945 or so and especially after World War I. After World War II, India got independence in short order and was actually a net creditor from the war. For some odd reason, the people in charge of the government decided that they’d side with the USSR for some BS ideological reason and turned to the gospel of “democratic socialism” that combined British parliamentary democracy with Soviet-style central planning. Now, you have massive bureaucracies and back then, you needed a permit to hire and fire someone.

        After Indian Independence, India took up the old Soviet model of turbo-charging savings rates even though India was somehow a net creditor and could use that to finance productive investment. Then, there was also a large wary of “capitalism” and “free markets”. So the leadership decided that only if they could solve some equations, optimize something, hold a gun to people’s heads, and tell them what to do that all the country’s problems could be solved. Sure enough, the centralized industrialization policies combined with the policy of radically changing things by centrally planned industrialization while ignoring fertility rates meant that in the 60’s, the government finally started to pay attention to it. Of course, by that time it was too late. Of course, more “I tell you what to do and give everyone what they want because ‘equality'” works for a while as it runs your country into the ground, but eventually you reach a crisis where the idiots in power are forced to give up power because of a crisis. In 1991, you had a financial crisis.

        Since India has taken up policies, it’s done great, but it might be too late. From 1945-1990, the population increased by AT LEAST 200-300% and GDP growth was barely positive. Rather than a Hamiltonian policy of centralizing the financial system as a tool to channel productive investment with a decentralized consumer base that targets high wages, what you had was a Marxist policy of holding a gun to everyone’s head and tell them what to do because “equality”. The result was disaster.

        I’m of the opinion that if you had British rule for 20-30 more years, you wouldn’t have these problems. If the transitions were slower and there wasn’t sudden, radical change, I think you’d see a lot less misery and suffering today.

        • A very quick note: I believe the first map of “India” was actually produced by the East India Company, and some historians argue that until then there really wasn’t a concept of India that corresponds to our modern concept. I am not enough of an expert on India (something of an understatement) to comment, but it certainly is an interesting idea.

  45. Dr Pettis ,

    Thank you for your generosity every time you write, you are The best teacher I’ve ever had … It would be great if you Someday write an article about how flows are evolving in the actual context!

  46. Michael had correctly predicted the recent decline in the prices of hard commodities as a result of the ending of China’s INVESTMENT boom. However, Michael had also prophesied that food (soft commodities) prices would stay high because China’s household CONSUMPTION would continue to grow.

    I disagreed with Michael on his prognosis for food (soft commodity) prices and commented on this issue 15 months ago in his article entitled, “Should Beijing raise subway fares”:
    http://goo.gl/asbgvA

    At that time, I said as follows:

    BEGIN>>”Food prices are also going to fall. Gold prices are also going to fall. You name the commodity– its price is going to fall.

    Michael’s idea that buoyant household income during China’s rebalancing will keep global food prices high, while other commodity-prices fall due to the slow down in China’s investment, is incorrect. The overall food index will go down by 20-30% by the time the commodity-decline is complete. The more specific grain food index will go down by 30-40% by the time the commodity-decline is complete.

    It may be hard to imagine, as the connection is not immediately obvious to a superficial observer, but it was China’s reckless investment-binge over the last decade that caused global food prices to rise. When the investment-binge ends, global food prices will fall.” <<END
    ——————————–

    That was 15 months ago. Interested parties can see the results NOW:
    http://www.indexmundi.com/commodities/

    As the data indicate, EVERYTHING is in the RED over the last 12 month period. Wheat is down. Rice is down. Soybeans, down. Palm oil, down. Pork down, Beef down. You name it– it is down. All food (soft commodities) prices are in the red, except tea & cocoa, both of which are actually neurotoxic stimulants (i.e. drugs) and not really "food".

    So now we come to the MOST interesting question: Why should the cooling of China's INVESTMENT boom cause FOOD prices to fall? What is the connection?

    Who wants to take a shot at this question? Suvy?

    • Debt incurred to buy farmland at the wrong price (inflated by speculation) during the boom phase of the cycle?

    • Vinezi, non-sequitur, but I thought it’s something you would comment on.

      We need better analysis on the effects of the one child policy.

      The truth is that If there are more men born than women, all of the men can still get married.

      Because, if normally the age difference between married couples is the male being 2-3 years senior. With more men born than women, the effect will simply be the average age difference will grow to, let’s say, 5-7 years. Everyone gets married. However, the cumulative years spent married will be longer for women than for men.

      Thus, the real issue in China is not that men cannot get married. It’s that moderate income young males cannot find young brides.

      Thus, it’s not an economic issue. It’s a social one, maybe.

      • The Law of Moses (= Biblical Law = Shariah = Islamic Law) recognized this problem long ago. Pre-Mosaic tribal societies living in poverty used to commit infanticide against baby girls leading to a skewed gender-ratio– similar to what we are seeing in China today. So Moses came up with a market-based solution in the form of the “bride-price”, which is still enforced all over the Middle-east by Islamic tradition. Under this Mosaic law, the groom must pay a negotiated price to the bride’s family. So in the event the gender-ratio got skewed and there were too few women, then this bride-price would automatically skyrocket. This acted as a market-signal that would encourage families to have/keep more baby girls and so raise the supply of women in order to bring the bride-price (and hence gender ratio) back to normal levels again. In short, Moses harnessed the power of good old-fashioned human greed and used it solve an ancient social problem.

        Note that it is precisely because of this Law of Moses that the Middle-east, despite being what Western feminists call “a hyper-patriarchal women-selling society”, does not have this problem of skewed gender-ratios that now threatens China. Perhaps the Chinese government should look into such market-based solutions?

        ALTERNATIVE: In the North-western states of India, where gender-ratios as just as skewed as in China, the local state-governments offer cash incentives to families to have baby girls. Families in these north-western India states first get a cash sum for each girl born, then they get paid a monthly-sum to send them to free-school, then they get another lump sum when the girls finish school, and finally they get a marriage-allowance when their daughters are married. Of course, this is not a market-based solution like that of Moses, but rather a Statist solution. Still, it does to seem to be working to an extent in north-western India. Perhaps the Chinese government, which loves grand Statist solutions anyway, could try something like this?

    • Cuz you challenged me, I’ll respond. *Shrugs*

      China has been a massive consumer in things like pork, beef, and soybeans (although I’m not very sure why this has been the case). I would think that these things are weird inputs in production for some crazy thing that some groups of people in China were doing to hit GDP targets that they get bribed to hit. That would be about as close to an answer as I can give you.

    • aren’t food prices down bcz the oil price has crashed? I know Michael predicted the prices of commodities used in construction would crash, but I don’t remember him predicting low oil (perhaps bcz it has little to do with China?). if the oil price goes back up food prices will follow in lock step for sure

      • What is the connection between oil prices and food prices?

        • Input prices in the production (global pricing of nat gas in index to oil, and fertilizer) and transportation of food could be lower, than prices lower.

          Dollar rising could see, traditionally although the relationship was broken a decade ago, some might still try to invoke of their ignorance, or dated review of trends, but, could see lower commodity prices, including food

          China….as part of their attempt to keep the story going, and likely efficacy of overseas investments, and to mitigate further collapse and divergence of imports from exports, and creating stockpiles across commodities, creating strategic reserves,…..this might have collapsed after they were accepted into the SDR, the impetus, taken away, after SDR inclusion, might have led to decline support, thus shrinking prices, thereafter.

          Same with oil.

      • I know Michael predicted the prices of commodities used in construction would crash, but I don’t remember him predicting low oil (perhaps bcz it has little to do with China?)

        I can’t find it, but in a reply to another poster on an older thread, Michael once said something along the lines that oil trades largely based on political motivations rather than purely on economic ones, and as he has no particular insight into the political machinations, he doesn’t bother spending too much time on it.

        • That’s pretty much what I did say, Claire. Although I continue to expect weak global demand across the board, and that will affects energy demand as much as it affects anything else, to predict what will happen to oil prices means also predicting political events in Saudi Arabia, Iran, Iraq, the rest of the Middle East, and Russia, as well as political attitudes in the US and Europe.

        • It seems pretty clear that this is not merely a demand story but a supply story.

          So, forecasts across environments.
          Rise of Global Middle Class, Rise of Euroland, Rise of East/South….projections, expectations, and growth in utilization of available resources led to investment in greater projected supply to meet needs.

          An interesting exercise, review data in 2005 and 2010 for projected consumption in 2010 and 2015 respectively (IEA, BP, Shell, OPEC, each).

          Then, review 2015 projections for 2020 consumption.

          Then reflect on China’s compressed time-frame for industrialization, the 2003 and later story, of Rich before Old, Old before Rich; on how it has impacted the B.) below insofar as A.)

          expectations
          sense-making and framing of developments and trends
          forecasting
          topical discussion/strategies/investment/priorities among academics, policy-makers, the business community, finance, international institutions, international NGO’s, criminal organizations, political movements, and so forth

          B.)
          growth in domestic denominated debt in EM
          growth in unsustainable current account dynamics
          growth of investment in the construction of GDP across the globe
          premature de-industrialization of low-income and low-middle income countries
          lessor emphasis on necessary structural reforms across the advanced and developing world (how long ago was it that Russia nationalized its oil industry, that transparency in Mineral extraction was the flavor of the INGO day, it almost seemed that a fair trade day was descending from Seattle to Singapore paid by the ineluctable demand of the few who provide final user consumption, etc…)
          little attnetion by policy elites of inequality dynamics, ensuring a tough hedge to row, and is why we are still mired; policy responses from German Austerity and beggaring anyone who didn’t get it as it descends into a demographic nightmare with a cheap southern periphery workforce for future utilization, and China working to import substitute as much of any value chain as was possible, while other emerging markets followed suit, with modicum attnetion to income and wage dynamics, although some have made more progress than others, just not materially in relation to the structure of their GDP’s, as they accessed the global savings glut, and queasy money.

  47. For those interested, I have recently gotten into an exchange on Twitter with Steve Keen and someone else. This was a discussion of the operation of the monetary system where they were referencing the Bank of England paper that, according to them, is how the financial system works. They also claim that our financial system is a government controlled financial system developed by the government creating the payment system for the banks to use when, in reality, it’s a PRIVATE financial system the government uses to clear payments.

    Neither Keen nor the other person realize that most everything today operates from shadow banking, which the Bank of England paper doesn’t even talk about at all. The entire financial system we live in today (and now globally) is primarily based off shadow finance, not commercial banks or government debts. They also claim that when the government issues a bond, it just spends it before it collects the money required, but this is a blatant lie. In the current financial system, governments must meet their cash flow needs by issuing bonds at auctions to dealers. Governments CAN run into serious cash flow problems if government debts get very high.

    Here are some threads for those interested.
    https://twitter.com/copito61/status/698655829713645569

    The reality is that the Bank of England paper IS NOT correct. If I were British, I’d be really worried about the leadership that operates at the BoE because they’re AT LEAST 40 years behind financially. The future IS NOT in debt or government debt. The future is in equity and capital assets, which is something both Steve Keen and the other person CLEARLY DO NOT grasp.

    They also don’t understand the history very well either. They were trying to tell me that the current American financial system was built on the government spending the money into circulation, but this is wholly wrong. The current system that we have came out of the Civil War with the National Banking System where you had the private banking system essentially mobilizing the Union for a war. Then, the Federal Reserve Act was added on top of the existing National Banking System to create a unified clearing and payment system for the PRIVATE FINANCIAL SYSTEM.

    If we wanna talk about Alexander Hamilton’s financial system created in 1790, then I can gladly talk about that as well. The First BUS was private where Hamilton used existing Revolutionary War debts and the existing private credit structure of the United States. He used the First BUS as a financial intermediary to create the first asset-backed security in American history to essentially make speculators, his cronies, and American elites wealthy while bribing Congress by making them them shareholders in the First BUS. Hamilton explicitly made this a PRIVATE system organized by private actors and specifically said so. Hamilton used the capital interests of the US in order to create a system to finance development. It wasn’t built on some “national will” of the people or some nonsense. It was some elite who was a former war general that created a system wherein some random immigrant kid who came from nowhere, learned everything on his own, and then was essentially given the most powerful position in the Empire. He then used this power to build a political support base of existing capital interests, bribe the legislature, and then ran the show. It was quite a successful development model that was, quite frankly, brilliant. Of course, even if their arguments about the structure of the financial system they envision were correct for Hamilton’s system (I would STRONGLY disagree with this assessment), this system was dismantled. The current system we have is a PRIVATE financial and banking system that the government uses to clear its payments. They then claim that the government is the money creator, but it’s clear finance capital operates the Fed and that the Fed is a PRIVATE institution by law.

    They seem to be using economic theories with implicit assumptions built in that they don’t fully understand. The history clearly disproves their assumptions, certainly in the case of the US. I don’t understand why they’re referencing a Bank of England paper when the BoE paper doesn’t even talk about shadow banking, market making, or the impact of market dealers. Do they choose to ignore the fact that the total size of American equity markets is ALMOST TWICE the size of the ENTIRE banking system of the US? The market for capital assets and equity combined is well over twice the size of the American banking system with basically all new credit being created in the form of capital assets and shadow banking. So the facts clearly show their theories cannot hold.

    They said my vision is filled with fairies, but I’m the only person that actually referenced both the current realities of the system (if the system operated their way, the numbers just don’t add up) AND the historical background, but somehow I must be wrong because the assumptions underlying their system cannot be wrong even though a basic historical background OR a basic understanding of the current structure of the American monetary/financial system can’t operate if their assumptions were correct.
    https://twitter.com/suvyboy/status/698660177554309121
    https://twitter.com/suvyboy/status/698664482701086720
    https://twitter.com/suvyboy/status/698656960187654144

    • This is the Bank of England paper they were referencing:
      http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

      In the paper, the first things they say are:
      “This article explains how the majority of money in the modern economy is created by commercial
      banks making loans”
      “Money creation in practice differs from some popular misconceptions — banks do not act simply
      as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’
      central bank money to create new loans and deposits.”
      “The amount of money created in the economy ultimately depends on the monetary policy of the
      central bank. In normal times, this is carried out by setting interest rates. The central bank can
      also affect the amount of money directly through purchasing assets or ‘quantitative easing’.”

      Those three statements are CLEARLY wrong. Most money today is created in shadow finance. If you have a margin account with a broker and you use that margin, your broker is letting you buy assets by essentially issuing liabilities (margin). When the market for equity is larger than the ENTIRE assets held by the banking system and the sum of equity and capital assets is almost 300% of GDP (if not more) and you’re claiming that most money creation occurs in commercial banks, the facts don’t reconcile with the reality.

      It seemed to me that Keen tried to portray and mock me as someone who didn’t understand money and banking, but it seems obvious that he is the one who doesn’t understand finance, money, or banking. He doesn’t even seem to understand financial intermediation well (neither do any of the people who seemed to have engaged with me on Twitter). Even Kindleberger talks about financial intermediaries repeatedly and the impacts (he generally seems to speak quite positively about financial intermediation, capital assets, and the like) of such financial institutions on the greater financial and economic system repeatedly in A Financial History of Western Europe.

      This is just a warning to us all: we must be more wary of the assumptions we make. We must understand that our current financial system operates DRASTICALLY differently than most of the financial systems we’ve seen in the last century. The rules of the game are completely different.

      Also, someone said to me (on a different comment) that brokers use the banking system to clear payments to each other, which is certainly true in some respects. Many brokers are licensed banks that even offer checking accounts. However, I also believe that some brokers use private clearinghouses. I know my broker uses Apex Clearing to clear its payments and I don’t think Apex Clearing is a bank, although I’m sure it clears payments with banks. Although I’m not sure about this, I believe that many of the organizations in our current monetary system clear payments outside the authority of the traditional banking system (PLEASE correct me if I’m wrong on this matter).

    • I also find it funny how all of these people who have put words in my mouth and are retweeting things they find crazy or absurd when they’re just, quite literally, facts. It seems to me that most of these people have read very little history and definitely have a very backward view of the finance, including the Bank of England. I’m just very glad that the American leadership isn’t this foolish. I was listening to an interview with Hank Paulson where he was talking about how the money market funds started to experience a bank run and regular businesses could no longer clear payments because the money market spreads were blowing out and liquidity was tight.

      The problem was resolved and I walked out of the interview realizing that Hank Paulson is a brilliant man. He clearly understood the problems and resolved these issues in a way that American financial panics usually get resolved. When he was given his post as Treasury Secretary, he actually understood much of the problems in the American financial system. He had a solid understanding of how these systems were operating and how they could end up being clogged. He handled everything SPECTACULARLY.

      It’s funny because I’m pretty sure that the cost of the American “bank bailouts” in 2007-08 will actually be FAR LESS costly than the future costs of all of these countries with more “regulated” financial systems. I also walked away from the Hank Paulson interview thinking that the Dodd-Frank was a good bill because it actually allows for us to deal with institutions like Lehman Brothers.

      The financial institution I have real worries about aren’t the private institutions, but the GSEs (Fannie Mae and Freddie Mac) that were operating far more recklessly than any private financial institution including Lehman Brothers IMO. The costs of dealing with the GSEs was far more than the costs of dealing with problem banks. The costs of bailing out the GSEs was almost triple AIG and almost sixfold to eightfold larger than the “bailout” that the other large financial institutions received. I’m also of the opinion that most American banks that received TARP money in 2008 actually didn’t need the money, but were forced to take it by Hank Paulson (I would’ve done the same thing as Paulson).

      What I began to realize is that Hank Paulson seems to understand money, banking, and finance more than the Bank of England based on the Bank of England paper Keen keeps citing. I’m also quite sure that Tim Geithner and Jack Lew do as well. Obviously, not all of these people are perfect people and I’m sure everything they didn’t wasn’t absolutely perfect, BUT the leadership of someone like Paulson during the crisis should not be underestimated.

      The future lies in equity and capital assets. I’d like to actually move away from the financial system using the banks to clear payments, which is what it seems like we’re headed towards. I could be wrong here (PLEASE CORRECT ME if I am), but it seems like we’re in a financial system where the repo markets clear the payments and the Fed just provides the liquidity backstop of the repo market. Of course banks that hold deposits at the Fed use the Fed to clear payments, but I don’t think brokers have to use the banking system or the Fed to clear payments and it seems like private clearinghouses have much of this responsibility. Their deposits are CONVERTIBLE into M0 (currency in the system), but that doesn’t mean that they use currency in the system or even bank deposits as a payment clearing mechanism.

      Anyways, this is the video by Hank Paulson I was referring to.

      • Note that Perry Mehrling also approvingly cites that Bank of England paper:

        http://www.perrymehrling.com/2016/01/great-and-mighty-things-which-thou-knowest-not/

        • Well then, I’d disagree with Prof. Mehrling. The BoE paper discusses how the world worked 50 years ago. It does not even touch on how the world works today. To be quite frank, the numbers do not add up for their view to be correct. There can be no accurate description of the financial system if there is no discussion of shadow banking, market-making, trading, or financial intermediation. Those things are simply not discussed in the BoE paper. I will say, however, that Ben Bernanke understood these aspects of the American financial system.

        • When the total size of your equity market is almost twice the total assets in your banking system and when the size of the government bond market alone is larger than the total size of the American banking system, but you’re claiming that somehow money is created when a commercial bank creates a loan by issuing a deposit, that clearly can’t be the case. The numbers simply do not add up.

          If you look through the assets of the banking system, you’ll also see that outside of deposits held at the Federal Reserve, most of the asset side is based on holding various ABS like MBS. So even if you look through the assets of the banking system, you don’t get the BoE view.

        • I’ve also gotta add in here that there’s no way Mehrling would disagree with me here. He basically says this in a video that he does. He discusses the same phenomenon in his books too. And in that post, Mehrling never says the BoE’s paper was correct or that it’s even an accurate view of a financial system.

          If you just look through basic data, there’s no way that paper can be right. When you’ve got an analytical framework or a theory where either the assumptions or the logical implications of the framework/theory/model(/whatever you wanna call it) contradict the facts, it’s the facts that win. I know Mehrling understands this.

          From the World Bank–Market Capitalization of Listed Domestic Companies (sum of share price times shares outstanding for listed domestic companies)
          http://data.worldbank.org/indicator/CM.MKT.LCAP.CD
          In 2014: $26.33 TRILLION

          Here’s other data from quandl.com, but this is data from 2012 which is in line with the World Bank data: $18.67 TRILLION
          https://www.quandl.com/collections/economics/stock-market-capitalization-by-country

          Of course, equity has only become more prominent since 2012. We are headed into a world of equity and capital asset financing. We need people in power who will start using financial intermediaries as a way to create capital assets by securitizing the ownership of companies. Whether this is in the larger financial institutions or in our government, this is where we’re headed.

          According to the Fed, the total assets of the American banking system are $15.69 trillion as of February 10, 2016. As of 2015 Q4, GDP was at ~$18.13 trillion.
          American Bank Assets Data: http://www.federalreserve.gov/releases/h8/current/
          GDP Data: https://research.stlouisfed.org/fred2/series/GDP

          If we assume the total market cap of listed domestic companies in the US has stayed flat from 2014 to 2015 (it has probably gone up) and use Q4 2015 GDP, we can find a lower bound of the Total Equity/GDP: 145% of GDP.
          Total Bank Assets/GDP: 86.5% of GDP

          Total Equity/GDP is probably closer to 150-160% of GDP if not higher as of 2015 and 2016. That also doesn’t include stuff like venture capital or angel investing where the firms are primarily small-scale firms using equity financing that aren’t listed. Now, when we add in that, of the assets held by the American banking system in the form of direct liabilities of the Federal Reserve (M0), we get total assets of ~3.92 trillion.

          So the total assets of American banks that isn’t cash parked at the Fed or in dollar bills is ~$11.82 trillion. Out of that $11.82 trillion, $2.24 trillion is in Treasury or agency securities. Of the remaining amount, $358 billion is in reverse repos with non-banks so let’s remove that too. Using basic arithmetic, we can now say the total assets of American banks that’s not cash at the Fed or Treasury/agency debt of some kind is ~$9.23 trillion as of 2/10/2016. Therefore, we can say that:
          Total US Bank Assets/GDP of actual bank loans (that’s not held as deposits at Fed/actual cash, that’s not Treasury/agency debt, and that’s not stuff like reverse repos or things like that): 51% of GDP

          Now, if that doesn’t tell you how insignificant our regular banking system is in the financing of productive enterprise, I don’t know what else to point out. You can go even more in detail to realize that what regular banks do to finance the private sector is basically negligible as many of those loans they hold are stuff like commercial real estate loans that can be ignored and you get numbers running at close to 40% of GDP, possibly less. Of course, household debt/GDP is running at~80%. So to say that most money is created by commercial banks issuing a loan by creating a deposit or by the Fed buying Treasuries from the Treasury (which is banned BTW) is clearly wrong and nonsensical. What they have is the description of a financial system wherein the NUMBERS SIMPLY DO NOT ADD UP!

          There is NO WAY that either Steve Keen or the Bank of England are correct. They MUST be wrong. Ben Bernanke, Hank Paulson, and Janet Yellen know this. Steve Keen and the Bank of England do not.

          • I did make a mistake on this, but the mistake is minor and scantily changes any of the implications. I was wrong to use $3.9 trillion as the total assets of the banking system held at the Fed as many of those deposits are held by non-banks. The total amount of bank reserves (bank assets held as deposits at the Fed) is classified as “cash assets” that amount to $2.54 trillion. However, you can also remove $224 billion of “trading assets” that aren’t commercial bank loans and $57 billion of interbank loans. So instead of $9.23 trillion not in commercial bank loans, that number should be $10.27 trillion or 57% of GDP. If you remove loans to non-depository financial institutions, we now have $9.9 trillion or ~54.5% of GDP.

          • I think what Mehrling (and probably Keen as well) endorse in that paper is the acknowledgement of what Mehrling calls the “alchemy of banking”, that deposits are created by balance sheet expansion and not simply through the money multiplier of the fractional reserve view. I don’t think either of them are endorsing what it omits about shadow banks.

            I’m not sure I follow your point about the total assets of the banking sector and money creation. You seem to be saying that because the non-banking sector has more assets than the banking sector they then must be creating more money than the banking sector. But aren’t assets and money creation two different things? Why does having assets mean you are creating money?

            According to Mehrling, one of the important differences between shadow banks and traditional commercial banks is that shadow bank borrowing is secured whereas commercial bank borrowing is unsecured. A commercial bank creates a deposit and gives it to a borrower in exchange for an IOU. The borrower can then use that deposit as a means of payment, and hence the deposit acts as newly created “money”. If the holder of that deposit (be it the borrower or the person the borrower pays) chooses to redeem the deposit for cash, the bank then must come up with “currency”. The commercial bank can discount the loan with the central bank if it doesn’t have the cash, and the central bank then creates new currency for the commercial which passes it onto the withdrawer. So this process can create new money in two senses: new deposits are created that can be used directly as payment, and the deposits can be converted into currency through the central bank.

            My understanding is that the process is different with shadow banks. The shadow bank starts out with a security (say an MBS hedged with a CDS) and then uses that security to borrow in the money market. The shadow bank then uses that money to buy another security, which it uses as collateral to borrow again from the money market and so on. Where is the money that the shadow bank creates? Can the market accounts of lenders to the shadow bank be used directly as means of payment in a similar fashion as bank deposits? I’m curious to know what actually happens and to what extent they do create money. If they do create money, it is almost definitely lower on the hierarchy than the money created by commercial and central banks. Perhaps part of the dispute you are having is over what counts as money, which can be a blurry line.

            As to your point about equity, I agree that it often seems to be neglected from a theoretical perspective. I was reading a book by Schumpeter recently where he kept talking about how banks fund businesses and how credit expansion is essential for capitalism. I kept wondering, what about the role equity plays? However, I am not sure about there being some sort of trend towards equity or equity somehow being the future. My understanding, correct me if I am wrong, is that equity has almost always accounted for the majority of financing. If we have seen an increase in equity financing in the last few years, it is probably just because the debt-burden had gotten so tremendously great that it is now reversing towards more normal levels. I don’t see any indication that debt will go away completely.

          • Dan,

            Money is a financial asset. The creation of money NECESSARILY means the creation of an asset. In regards to money creation, you can open up a margin account tomorrow where you place $2,500 of equity with the capacity to hold $5,000 of assets and you’ve created $2,500 of cash that you can use to buy anything. The “deposit” created doesn’t have to be in a bank and it can be in any fund, any broker, or in lots of other places. That deposit doesn’t have to show up at a bank.

            With regards to equity, the reason economists don’t talk about it is because they don’t understand geopolitics. In imperial systems of governance (the United States are an imperial system), there’s no real problem with equity financing because there’s no problem with foreigners gaining political power. With nationalism, you don’t want foreigners gaining political power so it forces countries to tighten their financial systems which forces populists to build coalitions with existing bankers. In nation-states, it’s not politically possible to let foreigners have ownership of companies or even deposits in your banking system. So nationalism forces

            BTW, anyone who says nation-states are better at making economic adjustments is lying to you IMO. Nationalist structures have usually made economic adjustments with wars. For example, Tsarist Russia handled the adjustment from a investment driven growth model to a consumption drive one MUCH BETTER than Russia has been able to handle it since. Of course, you don’t have to take my word for it–take Alexander Gershenkron’s instead. The regime fell because of imperial overstretch.

            Now, the real problem with Keen is that he’s using Marxist frameworks, and much of the most recent stuff is stuff regarding dialectics (which is faulty because there’s a straight up ignorance to the unity that gives rise to the duality that comes about since dialectics is, by definition, only about duality). I’m also willing to bet you that Keen would be very surprised to hear that much of what someone like Keen credits to Marx (like the usefulness of LLCs or of the importance for tariffs/protection in development) was actually written and well understood before Marx was born. All of those things were written for and pushed by Alexander Hamilton before the 19th century. I’d also be willing to bet that Keen hasn’t read very much of Hamilton and that he’s barely even heard of him.

            As for the “hierarchy” of money, it’s important to remember that the hierarchy doesn’t start from the top to the bottom. Secondly, why do we need a hierarchy? I think we need to seriously consider eliminating the Federal Reserve. Many brokers and financial institutions already use private clearinghouses to clear payments (my broker does).

            Where is the money a shadow bank creates? Where’s the money created when you open a margin account at a retail brokerage? The money is created in some random fund or broker somewhere in the system. It really doesn’t matter where as long as the balance sheets balance.

          • “Why does having assets mean you are creating money?”

            Money os a financial asset. If you hold commercial paper or a MBS or even many ARS or ABS, you hold a form of money. The opposite side of a financial asset is a liability, by definition. If that liability is a short term liability or can be used as such, that liability is essentially money.

          • I don’t think anyone disputes that money is a financial asset. The more contentious claim is that all financial assets are money. To me it is a bit like asking whether ice is water or not. There is a sense in which it is and a sense in which it is not. It is useful to equate them in some contexts and differentiate them in others.

            In the margin account, my impression was that I am borrowing the cash, not creating it. If I buy something with that money, my broker has to come up with the cash from somewhere to pay the seller.

            Your theory about debt and nationalism is very interesting. There is probably some truth there, but I think there are also other reasons for using debt financing. Entrepreneurs might want to raise funds for their business without relinquishing control, for instance. And debt-based assets meet the needs of investors who are looking for low risk and highly liquid assets.

          • “Entrepreneurs might want to raise funds for their business without relinquishing control, for instance. And debt-based assets meet the needs of investors who are looking for low risk and highly liquid assets.”

            Yea, the thing about entrepreneurs isn’t really quite true. From my understanding, most entrepreneurial innovation over the past few hundred years was primarily financed with equity including the industrial revolution or even venture capital and angel investing today. Credit is moreso for consumers, not for businesses. When businesses start to lever up very highly to increase production, that’s a very risky think economically because you create incentives to combine both financial leverage and operating leverage.

            I’d also dispute the idea that debt-based assets are “low-risk”. They have nothing to gain from volatility and there’s no convexity available with debt (unless we’re talking junk debt). With debt-based assets, your upside is capped, but your downside is not and there’s also feedback effects into the rest of the system. With equity, the situation is reversed.

            The only way you can consider debt-based assets “low-risk” is if you assume that volatility is a good proxy for risk, but alas, volatility IS NOT a good proxy for risk.

            “In the margin account, my impression was that I am borrowing the cash, not creating it. If I buy something with that money, my broker has to come up with the cash from somewhere to pay the seller.”

            Well, a broker is essentially just a clearinghouse. The important thing for a broker is to make sure that no one person gets too much of a position on one side or the other. When you open an account and deposit $5,000, but you can play with $10,000 do you really think that $5,000 comes from somewhere at the instant you open your account? It gets created like any other loan anywhere else does. The brokerage finances a loan by issuing you a deposit like any other financial institution anywhere else. Why should we work under the stipulation that banks create assets by issuing liabilities, but no other financial institution including shadow banks or brokerages don’t? It’s just so much easier and simpler.

            ” To me it is a bit like asking whether ice is water or not. There is a sense in which it is and a sense in which it is not. It is useful to equate them in some contexts and differentiate them in others.”

            This is the point I’m making. If you have a highly liquid asset that allows you to make payments any time you need to, it’s money. What we have is a financial system much closer to the 19th century US. We basically have free banking with centralized currency issuance. It’s a very different system than what we’ve had in the last 80 years and maybe even in the last 100 years.

          • “Yea, the thing about entrepreneurs isn’t really quite true. From my understanding, most entrepreneurial innovation over the past few hundred years was primarily financed with equity including the industrial revolution or even venture capital and angel investing today.”

            Sure, equity is the main source. But a portion of debt financing might still be used in those cases to ensure the owner/manager retains a controlling share or simply to reduce costs. Here is what Investopedia says about choosing between debt and equity to fund your small business:

            “Often you will not have a choice. Formal equity financing is difficult to secure especially for small, early-stage startups. Venture capitalists are looking for companies with global reach. Angel investors, those who fund on a smaller scale, are often looking to invest a minimum of $300,000 and possibly a 50% stake in the company, especially if it is in the very beginning stages, according to an article released by Entrepreneur.com. If your company is a startup serving a local market and does not need large-scale funding, debt financing is probably your best, and perhaps only, option.

            Larger startups often combine debt and equity financing to reduce the downside of both types.”

            http://www.investopedia.com/financial-edge/1112/small-business-financing-debt-or-equity.aspx

            “The only way you can consider debt-based assets “low-risk” is if you assume that volatility is a good proxy for risk, but alas, volatility IS NOT a good proxy for risk.”

            The way I am thinking of risk is in the way that Benjamin Graham and Warren Buffett have defined it. That is, risk is the chance of losing your principal. The chances of losing your principal is less for debt-based assets such as corporate bonds because companies facing liquidation are legally obligated to pay their creditors before they pay equity holders. Similarly, companies can easily slash their dividends but can’t so easily stop payment of their debt. But of course you are right to point out that debt-based assets are also less volatile, which is another characteristic that makes them appealing to investors and will help ensure that debt stays around for as long as capitalism does. The fact of the matter is that almost all investors hold some debt-backed securities in their portfolio, and they do so because these securities offer something that equity securities do not.

            A lot of heterodox economists these days, particularly ones coming from Schumpeterian and Minskyian perspectives, seem to emphasize the systemic riskiness of debt. While there is much that is valid in such an analysis, I think it would be a bit rash to assume that systemic risks would disappear if we simply got rid of debt. It may be that debt serves as a disciplinary mechanism preventing even worse crises. With debt financing, companies are forced to produce in a manner that generates regular returns in order to pay creditors in pre-agreed amounts year after year. A world of equity finance could make speculative production much more viable. Look at the dotcom bubble which was funded mostly through equity.

            “When you open an account and deposit $5,000, but you can play with $10,000 do you really think that $5,000 comes from somewhere at the instant you open your account? It gets created like any other loan anywhere else does. The brokerage finances a loan by issuing you a deposit like any other financial institution anywhere else.”

            Do you have a source that shows shadow banks issue loans by creating deposits? I’m not saying that you’re wrong.

          • *I just need to see some evidence that shadow banks operate that way before I believe it.

          • “Do you have a source that shows shadow banks issue loans by creating deposits? I’m not saying that you’re wrong.”

            This is how banking works. How can everyone with a margin account in a brokerage be playing with 10-15:1 leverage all at once? Brokerages can have runs or liquidity issues, as we saw in 2007-08 or as we’ve seen throughout American history. If there wasn’t any fractional reserve mechanism they were using, we wouldn’t see these issues. I’m simply arguing that if they require the funds beforehand, I don’t think it’d be possible for them to operate the way they do. My argument is more based on logic and the implications of assuming otherwise, which lead us to what seem like pretty absurd conclusions.

            BTW, systemic impacts disappear completely if you eliminate debt because bank runs become mathematically impossible. If banks have 51% capital ratios, a 50% fall in their assets doesn’t have any chance of affecting their depositors. If you have very high capital ratios for all financial institutions, there will basically be no systemic impacts on the financial system. I don’t think that’s a good idea, but that’s just the reality.

            Also, I don’t know why you’re assuming low volatility appeals to investors. It appeals to SOME investors, but would it appeal to someone like George Soros? I’d dispute that. There are many market participants that thrive off volatility and we can’t discount the importance of that when talking about the financial system.

            More importantly, most market participants aren’t Benjamin Graham or Warren Buffett. Hell, for guys like Buffett and Graham to even operate, there needs to be market makers providing liquidity. So when we think of finance, thinking in terms of Buffett and Graham is really misleading IMO.

  48. Prof. Pettis and others,

    Here is the head of the Minneapolis Fed, Neel Kaskari, talking about the necessity of breaking up the big banks and forcing the existing large banks to hold so much capital that they’d, in effect, be nothing more than public utilities. I don’t know how practical any of this is, as I see many advantages of scale in banking that didn’t exist even 30 years ago, but it may be something we have to consider.

    To me, the simplest solutions would be to raise capital requirements for large financial institutions sharply, bring all derivatives onto publicly traded exchanges, and force margin requirements for certain types of derivatives (primarily CDS). At a very fundamental level, a put option on a bond and a CDS contract have very similar payoffs. Of course, if you went short a bunch of naked puts, it’d eat up a large part of the margin in most traders’ accounts. In the case of large financial institutions, this isn’t the case. So the fixes seem pretty simple to me.
    http://www.bloomberg.com/news/articles/2016-02-16/fed-s-kashkari-floats-breaking-up-big-banks-to-avert-melt-down

  49. “8. By far the most efficient ways for Beijing to minimize the adjustment costs for the economy and reduce the risk of a debt-related disruption is to allocate debt-servicing costs to local governments by forcing them to liquidate assets directly or indirectly to pay down debt, and to increase household wealth by transferring wealth directly or indirectly from local governments to the household sector. Successful reforms must be consistent with these two goals.”

    I am wondering how realistic this idea really is. I certainly know little about it other than what I read here and there, but according to the February 2015 McKinsey Global Institute publication “Debt and (Not Much) Deleveraging,” local governments are only part of the Chinese debt problem (property developers, companies in general, and cement and steel manufacturers are also mentioned as big borrowers), so even if this worked to eliminate their debt other steps would also be needed. But then the local-government assets listed as typical in the McKinsey report (airports, bridges, subways, and both industrial and residential real estate developments) don’t really sound very salable, especially following a big real estate bubble, so it seems doubtful that selling assets would even solve their part of the debt problem. The McKinsey document expresses concern that many local governments are insolvent.

  50. What do people think about this?

    • I can’t remember exactly what this video covered (other than it was a Trump interview). From what I remember, I think this video involved Trump saying that he would force China to revalue (?) If that’s correct, then I think that I’ve been reading way too much Pettis lately, but:

      1. Can China revalue even if they wanted to right now? (For that matter, I don’t undertand why China doesn’t choose to devalue sharply right now).
      2. If China is forced into revaluation, then (as Michael pointed out before), China could try to counter the effects of its forced revaluation by expanding investment, expanding credit (maybe difficult to do right now, to put it mildly), and reducing interest rates. This would make China’s structural imbalances even more pronounced and worsen the eventual inevitable adjustment.

      If the video was of Trump saying that he was going to impose tarrifs to cut the trade deficit (and if he actually means it and can actually impose it), I guess this drives up the Euro, which causes a very ddep recession/depression in the Eurozone (esp. Germany), and causes it to split up.

      And, just because I’ve been reading so much of Michael Pettis lately, I guess that a Trump election would also increase the probability/hasten the speed at which the political parties in Europe go more to the far left and far right and abandon the centre (and also probably hasten their defaults). It also means that European sanctions on Russia (which are probably on the way out anyway) get abandoned as the European countries desperately lok for somebody to export to.

      What other countries could absorb all of the surplus production? Probably none, as Michael has pointed out, but I guess that any country that is not drowning in debt or in surplus capacity for whatever reason (e.g. Cuba and Iran, due to prior sanctions?? India?) can absorb at least some of the surplus and will experience a temporary economic boom in the process.

      There’s my stab at answering your question, at any rate.

      • China has been devaluing recently BTW.

        This was a video of Trump talking about renegotiating trade deals to force there to be sections discussing the event of currency devaluations that place American firms on a weaker footing.

        Also, the Chinese government introduced a “range” for GDP growth between 6.5-7% this year. So if we’re gonna see average GDP growth of 6.5%, then GDP growth towards the end of 2016 will be ~6% and maybe even <6% considering Q4 2015 GDP growth was at 6.8%. If we see GDP growth starting to slowly fall, that'll be good for China. So by the time 2017 rolls around and the new President (if it's Trump) takes office, China could be headed towards 5% GDP growth rates. So my guess would be that they'd slow down the pace of rebalancing if the US resorts to some form of protectionism. Honestly, I know China's growth rates have come down but I don't think China has actually began rebalancing. It'll be very difficult if we see an American administration that won't tolerate current account deficits any more. It'd be very difficult on Germany and Japan too. Trump has also said he'd make Germany and Japan throw us some cash for stationing our troops in Germany and Japan (these countries don't have sizable militaries since American troops are still stationed there), so that'd also add to the current account balance and shift it away from a deficit.

        So the countries absorbing the losses would be the country holding the corresponding trade surpluses with the United States. The chart that shows the largest trade balances with the rest of the world is shown on the link below.
        http://static5.businessinsider.com/image/56d701056e97c621048bada2-1600-1007/us-trade-deficits.png

        The largest trade deficit countries in relation to the United States are:
        1. China–$365.7 billion
        2. Germany–$74.1 billion
        3. Japan–$68.6 billion
        4. Mexico–$58.4 billion
        5. Ireland–$30.4 billion
        6. South Korea–$28.3 billion
        7. Italy–$27.8 billion
        8. India–$23.2 billion

        So almost all of the US trade deficit is accounted for by the top 4-5 countries: China, Germany, Japan, and Mexico. Three out of those countries (China, Germany, and Japan) are using an undervalued currency and screwing around in FX markets in order to push their deficits onto the US. A currency devaluation clause in trade agreements for currency devaluation should really be all that's necessary.

        • A currency devaluation clause in trade agreements for currency devaluation should really be all that’s necessary.

          How could you word this into an agreement so that there aren’t very large loopholes/ways to avoid it? I don’t think that countries would generally be willing to agree to anything that lets the “market” decide so long as the “market” is (American-based) Wall Street or the (London-based) City.

          Also, I guess that such an agreement would only be effective so long as those countries export more to the US than they do to other countries (which may be the case, but probably not forever under any circumstances, especially since the US needs to rebalance).

          But OK, let’s say that China decides to “fix” exchange rates to prevent “unnatural” devaluation, and that the US and China can both agree that the exchange rate is fair, but let’s say that Korea decides not to go along. Korea will no longer be able to sell to the US, but the higher RMB would allow it to grab market share in every other country in which it directly competes with China. How does this play out from this point onwards? (I’m not saying that it won’t work, btw–only that I don’t know how to track down where all the dominoes fall).

          But even if such an agreement can be worded properly and all countries follow it, I guess it would push the cheating to another area (for example, corporate espionage). So if Trump actually becomes president and actually manages to implement this somehow, I would start to go long network security companies 🙂

          Thoughts?


          BTW, I fogrot to thank you for the Gerschenkron link–I just got the book but haven’ yet begun reading it.

          • This clause is part of international trade agreements since day 1 and is still (theoretically) in force today.

            The preamble of the 1947 GAAT (the predecessor to the WTO) states (https://www.wto.org/english/docs_e/legal_e/gatt47_01_e.htm):

            [The various signing Governments] …

            “Recognizing that their relations in the field of trade and economic endeavor should be conducted with a view to raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand, developing the full use of the resources of the world and expanding the production and exchange of goods,

            Being desirous of contributing to these objectives by entering into reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade and to the elimination of discriminatory treatment in international commerce,

            Have through their Representatives agreed as follows:”

            There is no doubt that “reciprocal and mutually advantageous arrangements” includes cross exchange rates being set at levels consistent with cross trade balance equilibrium because the Articles of Agreement of the IMF – the twin institution to the GAAT founded two years before in 1945 – states in its Article 1 (https://www.imf.org/external/pubs/ft/aa/pdf/aa.pdf)

            “The purposes of the International Monetary Fund are:

            (i) To promote international monetary cooperation through a permanent institution …

            (ii) To facilitate the expansion and balanced growth of international trade, and to contribute thereby to…

            (iii) To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.

            (iv) To assist … in the elimination of foreign exchange restrictions which hamper the growth of global trade.

            (v) To give confidence to members, …, thus providing them with opportunity to correct maladjustment in their balance of payments without resorting to measures destructive of national or international prosperity.

            (vi) In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members.

            The Fund shall be guided in all its policies and decisions by the purposes set forth in this Article.”

            It should be noted that when the fixed but adjustable exchange rate regime known as Bretton Woods ended in 1971 by unilateral decision of the US, the Articles of Association of the IMF have not been amended. They are still what governs the IMF today in 2016. It appears the IMF is an institution without any raison d’etre for 45 years, apart of course for “absorbing graduates from very prestigious schools who have failed their other job interviews” in tax free jobs for the purpose of violating its articles of association.

            The appropriate wording is in the various relevant agreements since day 1. It is just violated on a daily basis for decades with the happy results that we see in terms of weakening real economic growth trend and rising debt loads.

            The diplomacy of prosperity, which inspired the IMF and GAAT delegates and is the secret behind the “Thirty Glorious”, is badly lacking today, as is evident each time the G20 meets.

          • Well, there’s several different ways you could deal with currency manipulation. You could just say to China that: if you guys start to devalue, we’re gonna place tariffs or start taxing the American assets that they hold. What you really need, in these cases, is smart people in charge so that you don’t end up getting ripped off.

            Remember that in the case of China, it’s not just currencies. China uses tactics like trade diversion, which is really just a form of rent-seeking. China also provides very cheap financing for its export and manufacturing companies that allow them to be “profitable” by an implicit financial repression tax. China has lax environmental standards that mean the full costs of production aren’t involved in the market price.

            So when we have American companies that have to abide by different rules, they end up being unable to compete.

            Regarding the international balance of payments, there’s two ways I look at it: (i) as trade (ii) as net international capital flows. Of course, those two must balance in the end. From an American standpoint, it’d flip our trade deficit and thus our current account deficit. What that means is that someone else somewhere else must absorb those costs. I don’t know how it’ll be resolved, but it will be resolved.

            With that being said, I don’t think Trump is an isolationist. I think he envisions a foreign policy like Teddy Roosevelt where the US is actively involved in managing international affairs both geopolitically and financially, but that we need to be more careful in how we use our power and our plenty.

          • Suvy,

            Rest assured that if the IMF has been able to operate for decades in violation of its stated purposes set forth in its articles of association with no consequences, it is because that has been the wish of its sole member with veto right.

            So, if you want to deal effectively with currency manipulation, there is a small pre-requisite: the official stance of the US with regards to the international monetary system has to change very explicitly. I don’t precisely follow the US election campaign and so correct me if I’m wrong but it is not my impression that this aspect is being explicitly acknowledged and debated. This is the key point. All the rest follows from that.

          • Well, with DvD’s comment, I’m sure there’s a lot Trump could do. From what he said, it seems like the policies taken up by countries like China and Japan is already illegal under international law. So we could just start to enforce the law. All you’d have to do is say, “we’re gonna blockade your ports and cut-off your lines of supply if you don’t start to change things.” If you just pose merely a threat of that, China will revalue.

          • All you’d have to do is say, “we’re gonna blockade your ports and cut-off your lines of supply if you don’t start to change things.” If you jjust pose merely a threat of that, China will revalue.

            But if Kyle Bass is corrrect (and I have absolutely no idea whether or not he is, although I personally find his reasoning compelling), China *can’t* revalue–in fact, they need to devalue (and have very little choice in the matter). Similarly, if the PBoC has a severe mismatch in its balance sheet, it too cannot afford a revaluing of the RMB (I am less certain about this, though).

          • Being desirous of contributing to these objectives by entering into reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade and to the elimination of discriminatory treatment in international commerce,

            Is it even possible to attain this arrangement (or to enforce it) across multiple countries without something like BANCOR? Also, how do a set of countries agree to what the cross-rates should be? The obvious solution is to let “the market” sort it out, but since “the market” basically means New York and London (at least so far as I know), why would other countries agree to this?

          • DvD,

            “So, if you want to deal effectively with currency manipulation, there is a small pre-requisite: the official stance of the US with regards to the international monetary system has to change very explicitly.”

            This is EXACTLY what Trump has said he wants to do. He’s basically said everything you just said and he’s being called a crazy right-wing nut who’s somehow a fascist.

  51. After having read the February 2015 McKinsey Global Institute publication, “Debt and (Not Much) Deleveraging,” I have doubts about the efficacy of your proposal in point #8 of the 9-point summary.

    The first problem is that there is apparently a lot of questionable debt in China beyond local-government debt. The McKinsey document mentions property developers, concrete and steel producers, and businesses in general as problem debtors in addition to local governments, so resolving those other entities’ shaky debts will likely require additional measures beyond what local governments can do.

    The second problem is that local governments’ assets don’t seem very salable. The McKinsey document lists typical assets as airports, bridges, subways, industrial parks, and social housing. The wisdom of selling airports and bridges to private enterprise is questionable at any time. Industrial parks would in theory be ideal for this purpose, but the end of a big real estate bubble does seem to be a bad time.

    The McKinsey document expresses the opinion that many local governments are likely insolvent. If they are right, then China probably needs to look elsewhere for entities capable of absorbing the costs of bad debt.

    • If they are right, then China probably needs to look elsewhere for entities capable of absorbing the costs of bad debt.

      I’m not in a position to comment on McKinsey’s analysis, but what other entities are capable of absorbing the debt? Or is it just a matter of nobody internally can absorb it?

      • I don’t really know, either. For simple non-bank loans where the lender doesn’t lend out more money than he actually owns, I suppose the creditors should be able to absorb the losses. If the government sits by and doesn’t meddle, that’s what would happen. I’ve read that some of this type of lending is from rich individuals, but I’m no expert on where the money is in China.

        I think that bank loans created in a fractional-reserve system can’t be absorbed except by the government creating more money and bailing out the banks.

        • I think that bank loans created in a fractional-reserve system can’t be absorbed except by the government creating more money and bailing out the banks.

          That’s all I could come up with, but after reading so much of Pettis’ comments lately (not that I’ve actually understood them all yet), I guess that means transferring more wealth from the household sector. How much lower can China’s consumption/GDP ratio drop, though? Is there some “practical” theoretical (i.e., non-zero) limit to this ratio?

        • Well, the creditors could take the losses, but what if there’s not enough equity in the banking system? Then the depositors have to take the hit or the government must get involved. Alas, that’s usually the problem.

          • but what if there’s not enough equity in the banking system?

            Sharp devaluation? Or, if the debt is mostly from SOEs, default on the debt which (I think) basically shifts wealth away from the government and to the household sector (since most households have no savings to speak of and aren’t on the hook in the future for current debts)?

            I haven’t grasped this part of Michael’s arguments too well, so this part could be wildly off.

          • How would a devaluation help increase equity in the banking system. I’d think a currency devaluation by the PBoC would increase capital outflows, as we’ve seen so far.

          • How would a devaluation help increase equity in the banking system. I’d think a currency devaluation by the PBoC would increase capital outflows, as we’ve seen so far.

            My best guess (and my thinking could be very wrong):

            1. From what I remember reading, I think the PBoC is insolvent, but because of its mismatched balance sheet, any decrease in its currency will at least help its balance sheet.

            2. An increase in the currency would increase the number of SME bankruptcies because it makes them less competitive.

            As an aside (totally irrelevant to my thoughts above), here is Kyle Bass’ very nice analysis as to why China must devalue:

            http://www.valuewalk.com/2016/02/kyle-bass-china/?all=1

            You may have already seen it before, but since I don’t follow markets very much, I didn’t even know that this guy existed…He seems to think very, very well, though.

            —-
            BTW, Michael: I am not sure if you are aware of it, but your site seems to have slown down *a lot* over the last month or so. I don’t know if you already know or even care, but I thought it might be worth mentioning.

          • What you said about the structure of the PBoC balance sheet makes sense, but my worries about more and more Chinese devaluations would be capital outflows from the banking system. The only thing to keep in mind for a devaluation is that the PBoC would be buying American assets by issuing Chinese liabilities. So they’d just be adding to their current short on the RMB. It’s a risky strategy because if something goes wrong, the shorts could get squeezed.

            Yea, I’ve seen Bass. His macro is pretty good for the most part, but I think his advice on equity or companies sucks. The important thing to keep in mind about Bass is that he’s primarily focused on portfolio structure and tail-risk hedging.

            When he talks about the Chinese banking system, he is correct. I’ve seen the data on this. I’ve come up with my own estimates based on simple growth assumptions and I get similar results. I believe the total assets of the Chinese banking system/GDP is ~300-400% and probably closer to the 400% mark, maybe even higher.

  52. Apologies for the two posts – my first effort appeared to error out but apparently was submitted after all.

  53. What were the usual policies adopted by government trying to transfer wealth to household? how effective had they been and feasible?

    More importantly, can China mimic those policies with equal or better effectiveness?

    In my own thoughts, I’ve came up ideas such as:
    1) Govt buys unused property houses that sells/rents back to lower income population at deep discount.
    2) Privatising SOEs — but that does not guaranteed wealth will be shared equally, as history have illustrated.
    3) Perhaps, packaging NPLs as ABS. I assume, in a perfect information world, a buyer would acquire ABS that would enhance its economic values of investment portfolios.
    4) Raising corporate tax; lower income tax on households; improve social benefits.

    It would be very amicable if anyone can offer guidance.

  54. As a part time expat in China for the past 7 years, I hope for China’s sake that they just get back to basics of producing and selling stuff, whether for export or domestic consumption. The trader in me knows there is no way this transition is going to be smooth… so many thought leaders are praying for a “muddy landing”… but even that will feel like a hard landing. Our own circles of executives (big 4 accounting firms etc) and friends in State owned enterprises strongly feel policy action has been lagging by at least 9 months….always too late to the party and very clumsy. In the end, our friends are preparing for a massive reboot (aka bailouts and writeoffs) of the economy should the hard landing occur. Recent Chinese culture has a propensity to rip things apart and start over as we all know, the only thing we are very confident of is that the policy response will be unlike what anyone in the west expects… Just our two cents from the krazychina.com bloggers…. Cheers!

  55. Brilliant piece (as usual). Considering that China is not a democracy in which citizens can express their discontent through elections when economic and fiscal polices fail, how do you think this will influence the path that the Communist party ultimately will take do address issues related to debt rebalancing ? The “right” decision to address China’s economic problems may set in motion civil unrest that potentially will pose a threat to communist party.

  56. I continue to look forward to your exceptionally educational, thought provoking posts, and am very appreciative for the insight. Thanks.

    I believe you previously mentioned in some of your analysis that you did not expect large increases in UST yields If the Chinese/Oil Producers began unwinding their FX reserves, that they had built up as a result of recycling of their Trade Surpluses. But at the moment we seem to be seeing the opposite with yields still actually dropping during the unwinding. Is that what you expected ? Any insight into your thoughts would be grateful.

    • My main point, Phil, is that the worries that the USG requires large PBoC purchases of Treasury bonds to fund its deficit is based on completely incorrect reasoning. Unless the PBoC were to dump massive amounts of bonds in a very amateurish and disruptive way, PBoC net selling — or Chinese and even global net selling — of USG bonds will cause changes in both the capital and current accounts that will balance out supply and demand for USG bonds, and there will be no obvious impact on yields. There might be changes in the shape of the yield curve, but even that is likely to be limited. So if US interest rates rise or fall when the PBoC is selling USG bonds, they are rising or falling for other reasons. By the way I explain this in much greater detail in my book, The Great Rebalancing.

      • I remember that in The Great Rebalancing. Trump talks about the financial leverage we have with China a lot and seems to make the exact same arguments you make all the time (he just says it like I do, which comes off as outrageous). It seems to be catching on in the political climate, especially on the right. Trump always gets asked about China using “financial blackmail” and never really responds to it or throws it off, which tells me that he understands the mechanism of the financial flows better than most think he does.

        The issue with the trade deficit is becoming heavily politicized, as you said it would Professor. As you also said, it seems like the candidate that appeals to the people and is really willing to discuss the issues important to them has the ability to defeat the rest of the system even if it is rigged against them.

        • Yes, it seems like some of the extreme candidates are re-politicizing issues that for too long we pretended were technical and largely neutral — trade and monetary policy, most obviously — and this must be part of their appeal. This is not just a US story but perhaps even more of a European story. The problem is if we allow the extremists a monopoly on the discussion, they will do well.

          • I don’t even know who’s “extreme” in the US any more. The GOP frontrunner seems less crazy than the #2 guy who successfully shutdown the government for 17 days. You’re certainly correct about the situation being more true for Europe.

            Are you paying to this election cycle Professor? There are serious regional divides in the Republic. Right now, the current GOP frontrunner is a guy who supported Clinton in 2008 and is barely on track to get the delegates necessary for the GOP nomination. If he becomes the nominee, he WILL NOT have the full support of the GOP and you’re liable to see a third party split off and run. If he doesn’t get the delegates necessary, then we’ll probably see a brokered convention.

            I can’t think of any parallels in this election in the 20th century. I think the only parallels are in the 19th century. If we get three major candidates (and I think we could get >3), no one could get to 270 electoral votes and the choice of President would essentially come down to the House of Representatives choosing the President with every state getting one vote..

            Can you make sense of this?

          • Not only will the GOP front-runner not have the support of the GOP, but for the first time I can think of, you’ll have a GOP candidate that’s explicitly hated and disliked by most of the GOP and held in contempt.

        • As you also said, it seems like the candidate that appeals to the people and is really willing to discuss the issues important to them has the ability to defeat the rest of the system even if it is rigged against them.

          Let’s say that both parties recognize this point, and they both make it aprt of their platforms. Let’s further say that whoever wins is actually serious about implementing it once the elections are over, and they get congressional backing to do so.

          What happens to the financial flows within the US? From my understanding, a lot of the money that was concentrated in the old money centres of NY and Chicago have increasingly diffused to California, for example (maybe I’m wrong?), in the form of venture capital, etc.

          Would this continue even after trade barriers get erected? Or is there some mechanism that would cause money to flow back to the traditional financial centers? (or, alternatively, if foreigners have less reason to buy US assets, do the traditional financial centres experience a relative outflow to the newer financial centres?

          Just curious.

          • Maybe there may be a shift in internal capital flows, but I wouldn’t think very much. I have no idea TBH, I’m just speculating.

          • Suvy,

            In one of Soros lecture series (which was ironically in China) he also foresees this situation (Trump) and explains why it happens. These lectures are available on the net somewhere.

            Anyhow, what are your thoughts on the recent action on bank debts by the PBoC?

            Thanks.

          • I’m sorry Daniel, but I’m not aware of the recent actions by the PBoC on China’s bank debt. I’m not an expert on China by any stretch. I just assume China is going through a certain adjustment process and view China as a massive black box. If GDP growth doesn’t start slowing down (like it has been for the past few years), I think China could really be at the beginning of a nosedive to put it kindly.

            The amount of credit created by the system in China is several times the order of what’s been created in the United States in NOMINAL AMOUNTS. When you add in that China’s economy is significantly smaller, the numbers are probably fudged, and China’s less developed, there’s real tail risks that begin to amount. I’d be more concerned about the geopolitical implications than anything else.

          • Also Daniel,

            I’d like to add my views about a Trump Presidency. Based on everything he’s said so far and what his campaign has been about so far, I agree with him on 90% of issues. People talk about him as being a racist or a bigot or a fascist or a white supremacist, but I don’t understand what kind of racist or white supremacist or fascist has a Jewish daughter and a handpicked black national spokeswoman. Personally, I think a lot of these are unwarranted personal attacks by journalists looking to get headlines.

            I don’t understand what kind of a fascist or an extreme nationalist says that it’s a serious problem when we have grad students from all over the world that often study in many of the best schools in our country who aren’t staying here after they’re done studying. Personally, I think we should give most of them green cards as soon as they get their degrees. If they’re productive members of society in short time, have no real problems, and have shown an allegiance to the Republic, I think we should make it easy for them to become citizens. From what Trump is saying, he largely seems to agree.

            I also don’t know what kind of fascist wants to localize education and bring it back to parents and small communities. Trump even pushes for charter schools, which are great BTW. I went to a charter school that offered 27 or so AP classes and Calculus III (which is not AP, but Calculus I and II are offered as Calculus AB and BC). Due to my high school, I finished Calculus III my junior year and I was taking differential equations and linear algebra during the summer before my senior year of high school. During my senior year of high school, I was taking 2 college classes each semester (in exchange for 2 less classes in high school, note that I chose to do 2 college classes each semester, but was only required to do one class each semester considering that there’s two semesters in a school year). So by the end of my senior year of high school, I was taking an intermediate undergraduate probability class–usually taken in the junior or senior year of college for a math graduate–with the most difficult professor in the department at the college (this is at a top 30-50 program in the country with a top 30 engineering school). The current public school system actively discourages these things, enforces monopolies on children, and treats every child as the same. My high school, which was a free and publicly funded charter school with heavily involved parents that volunteered at school events regularly. This is exactly what Trump talks about with regards to education.

            On the issue of trade, I’ve consistently voiced about how correct Trump is. Trump seems to be running as a strongman type of guy who’d stand up to other countries in trade, set the international order right, who’d stand up to certain types of large donors/special interests, and do all of these things while working within the underlying institutions of the Republic. I think he can do all of these things based on what he says and it seems like he’s the only one who really knows what’s going on in these things. TRUMP UNDERSTANDS BALANCE SHEETS! HE UNDERSTANDS INTERNATIONAL CAPITAL FLOWS!

            In his earlier interviews a decade or two before he ran for President, he said he’d use a revenue tariff of 40% to fix our trade deficit, then use the revenue generated from the tariff to finance investments in education and infrastructure, particularly in inner cities and minority communities. He’s largely advocating the same stuff now. He’s advocating for the creation of some kind of a bank to finance the development of inner cities. I don’t see why this is so crazy or how this is fascist or racist at all. The key thing about crazy dictators that makes them so crazy and autocratic is that they usually don’t understand balance sheets.

            The guys who understand stuff like banking and balance sheets are the guys who’re strong republicans that favor a firm-handed government. Quite frankly, Trump is running on a HIGHLY Hamiltonian agenda. He’s coming out and saying, these are the issues, these are the basic outlines for how my administration is gonna fix these issues, I’m gonna put my guys (cronies) in charge of the system in these particular areas (ex. he’s talked about guys like Carl Icahn negotiating trade deals), and we’ll see how it goes but I should be able to get all this done.

            Trump is also talking about issues like political correctness, which is something I agree with him on. When you walk in a college library and start saying, “republics work because they allow you to rotate elites, not because they give the people what they want” and others in there start to view you as evil. When you make a statement about something regarding placing temporary limits on something like Islamic immigration because there’s lots of worldwide issues right now and we can’t properly vet everyone and you immediately get called a “bigot” or a “racist”–even though there’s obviously no real discrimination by race–it’s very difficult to resolve these issues and the impacts of policies that deal within these regions.

            When Trump says that for everyone who comes in to the United States, we should know who they are and where they’re from, I agree with that. That just makes sense. We should encourage people who come here legally, encourage people who’re willing to work hard, encourage the intelligent, encourage the best and brightest, etc.. We shouldn’t reward those who break the law. With that being said, I’m not in favor of deporting millions of people and I don’t think Trump is either. I think he’s just saying a lot of these things to keep up with Ted Cruz. Trump has said he’d want to deport most of these people where they’d touch another country and then they’d come back legally with work visas. Cruz has just said he’d “enforce the law”. I think most of these kinds of outrageous things are just politicians pandering to the base.

            Along our Southern Mexican border, there’s ~$1.45 billion/day of trading in drugs, weapons, and even slaves that occurs across that border which must be stopped. So first, we need to deal with our people here who have drug issues. We must make sure they’re able to get help and, at the very least, make sure they do no harm. We need to try to help people that have these issues.

            We need to fix parts of our health care system. Every other Republican goes out and is against any sort of reform. When Trump says that, ” we shouldn’t let people die on the street,” I agree with that! That doesn’t mean you go to the other extreme of single-payer. Anyone who thinks you can operate a single-payer system across this massive landmass with 325 million people and growing is just fantasizing. Can you imagine trying to get all of Texas on the same health care system as New York?! Imagine trying to ration care between Texas, California, and New York and just think of the possible consequences. People point to places like Norway, Denmark, Sweden, or Finland, but these places have a COMBINED 27 million people, which is approximately the same population as Texas. Within 5-10 years, Texas will have a larger population than all of Scandinavia combined. With that being said, we need serious health care reform. Trump says he wants to remove and repeal the ACA, but he’s obviously lying considering that he says he wants an individual mandate and that he also wants to break down state barriers to buy/sell insurance. So in other words, he basically wants to slightly reform the ACA by breaking down state barriers, removing some provisions of the bill, and then expanding health savings accounts. In other words, it’s completely counterproductive for him to repeal and remove a bill that provides him with the underlying structure and framework for what he wants to do.

            Now, there are real issues I do have with Trump including issues regarding the environment, especially climate change. I don’t know if I can vote for someone who says climate change and that the impacts of CO2 emissions are all just a hoax by environmentalists. I don’t know if I can vote for someone who, at least as of right now, says he wants to keep coal miners at work. Personally, I think we should go off coal completely and this is a case where I agree with both Obama and Clinton.

          • Suvy,

            Re: Trump and trade barriers, etc.

            1. Can he actually implement this without Congressional approval?
            2. If there *must* be a rebalancing, doesn’t it follow that the US will eventually do this anyway, no matter who gets elected?

          • On trade, I think you can implement a lot of things without Congressional approval. Many of the agencies that enforce or deal with these things are in the Executive. In the specific case of TPP, the President would already have the power.

            In the case of getting Congress on board, I think Trump stands the best chance of doing that. Quite frankly, Trump’s worst enemy would be Ted Cruz and I think it may even be easier for Trump to work with Democrats than much of the GOP. Considering that the Democrats have a strong chance to win the Senate in 2016, I think you could see Trump be able to get a lot of things through.

          • In terms of anything involving monetary policy, trade, and international finance, you can do A LOT of stuff on these issues without Congressional approval. Presidents usually don’t do this for various reasons that range from not wanting to disrupt the political climate by politicizing financial or monetary topics to not really wanting to mess with things they don’t really understand.

            With that being said, I think Trump does understand a lot of these issues. He reminds me of a typical 19th century Yankee Republican, which is largely why I like him. I don’t think he’s a nationalist, although I do think there’s aspects of his economic policy that could be construed as nationalist by some people (especially leftists).

            Trump’s policy regarding the overlapping of international trade and finance reminds of Teddy Roosevelt. Many on the left are calling him an extreme nationalist or a fascist while those on the very right are calling him an isolationist. He’s definitely not an isolationist. He wants the United States to be actively engaged in international affairs and he wants to use actual diplomacy and deal-making to solve problems instead of starting wars everywhere. Trump wants to use our financial power to maintain the global geopolitical order, which is something I agree with.

            With anything regarding international affairs, Presidents do have a lot of power. In all of these issues that Trump actually understands well, he’d be having a lot of power within his administration to accomplish these things.

            Note: When I say leftist, I mean stuff that’s Marx-based or rooted in Marxist thought

          • I also have to add that I LOVE election years. The entire horse race is exciting. The entire structure of American elections make everything quite exciting because you’ve got the regional divides along with the two parties composed of factions that often don’t like each other.

            I know there’s been a lot of talk about how there needs to be power transfers to the people from the elites, but the people already have the power. It’s just a matter of them recognizing and using the power that they have. At the grassroots level, I’ve seen candidates being outspent 20:1 or 30:1 and barely being able to survive. Bear in mind that this isn’t in the general election of “moderate” or “swing” districts or states. These are primary races of right-wing districts. It’s not gonna be long before you start to see a real shift in the power structures at the top.

            My only worry is that if a Democrat gets elected into the White House, they’ll control the Supreme Court, which is why I might end up supporting a Republican regardless of who gets nominated. I think the next President could have up to 4 Supreme Court nominations and I don’t want people who’re gonna reverse stuff like the Citizens United decision, which was DEFINITELY the correct decision. I don’t want the idea that socializing campaign finance is somehow legal, constitutional, or sound (because it’s not). I don’t want Supreme Court justices who lean towards or end the current gerrymandering of districts right now.

            With all this being said, I’d be quite happy with someone like Trump if he wasn’t such a kook on the environment or on climate change.

          • OK, Suvy:

            I am not politically inclined at all, other than I enjoy the intellectual challenge of trying to reason issues out (along the lines of “if candidate A says this, how will others respond, and what actual impact will it have?”). So the following three questions are not intended to be a debate–I’m just trying to think through the implications:

            1.

            Trump wants to use our financial power to maintain the global geopolitical order, which is something I agree with.

            If the US continues to pay more into the geopolitical order than it gets out from keeping the status quo, then why should it want to maintain it? If the US pays less than it gets out, then why would others let the US maintain it? Also, given the complete basket case situation in Europe, can the US maintain it even if it wants to?

            2. Let’s say the US withdraws from the military “freeloaders” (which, from what I can tell, basically means almost all of NATO and Asia). What happens (does the US give up Okinowa if Japan decides not to pay Americans to remain? I very strongly doubt it, but who knows…)? Presumably those countries will need to increase military exenditures. Do they buy from the US, or from somebody else? Also, do the Asian countries cozy up to China and does Europe cozy up to Russia (in effect, will you get a “North American bloc” a “European/Russian block” and an “Asian block”?) If so, what are the implications? Where does that money come from? Do they issue more debt? Do they cut social spending?

            3. I assume the USD should drop because external countries no longer have any incentive to prop it up. But on the other side of the argument, I assume that most exporting countries go into an economic tailspin, meaning a “flight to quality” (I hate that term because I don’t think it’s accurate) to the US. Which of these outcomes (if any) prevails?

            Just curious…

          • I’d also like to add that with regards to China, Japan, and a whole bunch of international rhetoric of these countries, I think they’re actually quite scared because if Trump becomes President, they know the jig is up.

          • 1+2. I think what Trump has said on the topic is appropriate. I don’t mind contributing to NATO or having American troops being stationed in Japan or Germany, but we should be getting some royalties for it. With the way things are in the world, I think you have to maintain American troops stationed in other places. If you don’t, I really worry about peace internationally.

            3. There’s no doubt some countries could go into a tailspin, but that’s basically happening right now. With the whole “flight to quality”, I guess it’d depend on how everything gets resolved. If the trade deficit turns into a trade surplus, you could still theoretically see a “flight to quality” from foreigners while American finance accumulates assets abroad. All the current account balance tells us is that there must be a NET flow of assets in the other direction. The specific capital flows could be flowing in lots of different directions. So I’m not quite sure how to really answer that question, but this would be my best response.

          • I don’t mind contributing to NATO or having American troops being stationed in Japan or Germany, but we should be getting some royalties for it. With the way things are in the world, I think you have to maintain American troops stationed in other places. If you don’t, I really worry about peace internationally.

            You are assuming that other countries are willing to pay for a foreign presence, but that may not be the case (if they have to cough up a few hundred billion dollars for defence annually, they may simply choose to spend it to support their own domestic industries, for example).

            Let’s say that Japan and Korea both tell the US that their options are to either pay to keep the US military in their country or to withdraw (and risk the associated wars and the loss of influence, etc.). What should the US do under such circumstances? Also, if a country is paying for American troops, what exactly are they getting in return? Can they request the US to bomb an enemy country at their behest (or refrain from bombing a country, for that matter)? etc.

            Put another way, countries may tell the US that American troops are tolerated so long as they provide the host countries with a “free ride”.

  57. Chinese real estate will not collapse like Japan

  58. Suvy,

    “I’d be quite happy with someone like Trump if he wasn’t such a kook on the environment or on climate change.” – March 20, 2016 at 1:27 am.

    I’m sure you will look at this a few years from now and laugh… I hope so anyhow.

    Trump has clear authoritarian tendencies. This, by itself, is enough to define him as extremist and have him disqualified from the position of POTUS.

    Yes, he is right about some of the core issues which he talks about, as Prof. Pettis already noted, just like some extreme parties in Europe do. But the cost of electing these parties or Trump will be tremendous.

    • Trump is definitely not an extremist. Hell, he’s probably the most anti-war Presidential candidate remaining on BOTH SIDES! Trump wants to localize education back to parents, teachers, students, and loved ones while removing Common Core. A large part of his platform is anti-war, cutting taxes, and reducing regulations on firms. These aren’t things authoritarians do.

      And with those protesters showing up at his rallies, I think they should be in jail for doing the kinds of things they’re doing. I’ve watched this stuff live on my computer. The people that’re instigating the violence are on the right. Here’s a black police officer from Tuscon, Arizona who showed up to a Trump rally off-duty and this is wha the has to say. Everything you hear in the news and from journalists is mostly wrong where they take some small soundbite and take it way out of context.

  59. Hi Michael, Douglas Turnbull from the Neptune China fund says: “Chinese debt is very, very concentrated. Something like 45 per cent of loans all to the property and property-connected sector. Actually the household is massively underleveraged. Debt to income in Chinese households is about 60 per cent, that’s under half the level we have in the UK. Likewise, government debt at about 55 per cent of GDP is really low for pretty much any large economy. Also, the private sector has very limited levels of debt, it’s very concentrated in these big ugly state companies and a lot in the real estate sector”. Do you agree with his analysis ?

    • Yes, pretty much, except that government debt isn’t low if you include its contingent liabilities. Even a lot of the private sector debt should really be thought of as a contingent liability of the central or local governments, and when you consider that most debt goes directly or indirectly through an already-insolvent banking system, which the government cannot allow to fail, you can argue that almost all debt is implicitly government debt in the end. This is one of China’s problems — because the government is believed to stand directly or indirectly behind everything, it is hard to get lenders to worry much about credit risk.

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