Last week Derek Scissors, a think tank analysts at the American Enterprise Institute, published an article in which he referred to an October, 2014, study by Credit Suisse that attempts to measure total household wealth by region and by country. Scissors argues that in the interminable debate about whether or not China will overtake the US as the world’s largest economy, it is widely assumed that there is only one correct way to decide the answer, and that is by comparing the GDP’s of the two countries. Some people argue that nominal GDP at the current exchange rate is the appropriate measure, whereas others prefer the to use PPP-adjusted GDP, but there is no reason, Scissors points out, that either of these in fact are the appropriate comparisons:
There is a debate over which country has the world’s largest economy. One side cites gross domestic product adjusted for purchasing power parity and puts China on top, while various other indicators show the United States ahead. The claims are used to gauge China’s importance, highlight Sino-American competition, and sometimes identify China as a threat.
What is almost never in dispute is that China is rising economically relative to the United States. If China is not ahead yet, it is said, the day is coming when it will be. However, at least one vital indicator casts doubt on that thesis: national wealth. From the beginning of 2008 through the middle of 2014, China may have lost ground to the United States in total wealth.
As Scissors points out, “Credit Suisse put net private American wealth at $42.9 trillion, compared to $4.7 trillion for China: a ratio of more than 9:1”, meaning that the US is 9.1 times wealthier than China. However their GDP ratios are very different. A quick check shows that at the end of 2014 China reported GDP of $9.18 trillion, whereas the US reported $16.77 trillion, so that US GDP is 1.8 times China’s GDP.
This might at first seem strange. A country’s GDP is supposed to measure the amount of wealth created during the period measured, and is often thought of as analogous to the earnings generated by a business. I am not sure exactly what the Credit Suisse estimates of total household wealth represent, but if we think of them as being equal, or at least proportional to, the total market value of each economy’s assets and of their ability, combined with the labor of American or Chinese people, to produce goods and services, it seems that every dollar of American income is 5.0 times as valuable as every dollar of Chinese income. To put it in stock market terms, the US P/E multiple is five times the Chinese P/E multiple.
Is that plausible? Yes it is, although I make no claim about the accuracy of this particular ratio. While the US should certainly trade at a higher “multiple” than China, whether it should five times higher, or more, or less, is impossible to prove. Although I don’t find the debate about whether the Chinese economy will overtake that of the US, and if so, when, especially interesting or even intelligent, I do think the question about the relative economic value of the two countries is interesting because it illuminates quite a lot about both the Chinese economy and about how we should be thinking about economic growth.
But before I explain why a higher US “multiple” can easily be justified, let me turn back to the question of GDP. A country’s gross domestic product, or GDP, is supposed ideally to be the aggregate value of all the goods and services produced during the GDP period, including any improvement or deterioration of that country’s capital stock. The OECD defines it, perhaps not very elegantly, as “an aggregate measure of production equal to the sum of the gross values added of all resident, institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs).”
What good is GDP?
GDP, as we all know, is intended to measure a country’s (or region’s) economic wealth creation during a particular period. But, as we also all know, it doesn’t do this very accurately. Simon Kuznets, the person who is generally credited with having “invented” GDP, in a 1934 report to the US Congress, understood its weaknesses, and he fairly consistently warned about the ways in which GDP can be mis-used. The problem with GDP is that there are many things included in the standard GDP calculations – some people propose for example that these include military expenditures, or brokerage fees – that don’t reflect any real change in the ability of the economy to produce goods and services, whereas other things that do reflect such changes are often not part of the GDP calculation. The most typical examples of the latter are things we call positive or negative externalities. For example while there may well be positive economic value in the activities of a factory that produces chemicals while dumping the effluvium in a nearby river, if we ignore the economic costs associated with polluting the river, which may include lower future returns on farming and fishing, higher future health care costs, and less “pleasure” for future hikers, boaters, and nature lovers, then the “real” economic value of producing the chemicals is likely to be lower than its contribution to reported GDP.
What’s more, for something to be part of GDP it has to be part of the recorded cash economy. Prostitutes certainly provide a highly valued consumer service, and an argument can be made that drug dealers do too, at least in a way analogous to bartenders, but their activity is rarely included in GDP figures (although in some countries economists are starting to do so). Babysitting provided by an agency is part of GDP, but if a neighbour or relative baby-sits for free it, it is not part of GDP. I also want to mention something that is rarely given enough credit as adding to household consumption, certainly to my consumption, which nonetheless I think has enormous value as a consumer service. My life has been transformed, and this is not an exaggeration, by Google’s search function, and I am certain that its contribution to my welfare, and that of the rest of the world, vastly exceeds whatever contribution it is calculated to add to global GDP. Maybe not everyone is as ecstatic as I am about the fact that from my office, home, or even while sitting in a taxi, I can easily access vast amounts of information, references, and data, and so put together in hours something that once would have taken me weeks, but if internet searching were taken away from me, it would impoverish me far more than losing a car, or most of my wardrobe.
There is no question that GDP, in other words, does not measure what we usually think it measures, but this doesn’t make GDP a useless number. There are two reasons why it makes sense to invest the time and effort into calculating GDP. First, as long as we constantly remind ourselves of the errors implicit in calculating GDP, and try to correct for them, if only informally, GDP can give us a rough proxy for total value creation. The second reason, probably much more important, is that GDP can be very useful in allowing us to make comparisons between economies, or between different time periods.
In fact this is one of the main uses of GDP, and it can be very accurate, but its usefulness depends crucially on a condition that is very easy to specify, and yet is so poorly understood and so often violated by economists, that it is frankly a little shocking. The GDP calculation might not capture real value creation with great accuracy, and sometimes this failure to capture real economic value creation can be substantial, but as long as these “failures” are consistent, and biased in the same direction, the comparisons are still useful and can be extremely precise and accurate. For example the errors in the calculation of US GDP in 2013 are probably consistent with the errors in the calculation of US GDP in 2014, so that the ratio of 2014’s GDP to 2013’s GDP, which we call the GDP growth rate, is probably extremely close to the real growth in the value of the US economy.
Similarly the GDPs of Canada and the UK, while also embedding incorrect measures of value creation, probably do so in ways that are fairly consistent with the incorrect measures embedded in the calculation of the US GDP. When I say that at the end of 2014, the US economy was 9.1 times the size of the Canadian economy and 7.4 times the size of the British economy, according to their reported GDPs, I can be reasonably confident that the truth is not too far from that number. With other countries, however, I should be much less confident about how usefully the ratio of reported GDPs represents the ratio of the real value of one country’s creation of goods and services to the other’s.
Let me add that while some people might immediately and intuitively understand why it must be the case that comparing reported GDPs with one set of countries provides a more accurate description of the relative size of the US economy than another set of countries, as I will show later not every economist understand why this must be the case. The problem is not mainly that in calculating GDP different countries classify economic activity in different ways, although this certainly is the case. The real reason is that economies are systems, as Hyman Minsky so richly and usefully explained, consisting of interlocking balance sheets, and economic activity is mediated through the connections between the various balance sheets which themselves reflect very different institutional structures.
One of Albert Hirschman’s great insights, whose implications I think are still not fully appreciated by many economists, is that all economic activity, especially rapid growth, creates imbalances within the system, and these imbalances always eventually reverse themselves. The ways in which they do so, however, can vary greatly and are necessarily constrained by the institutions that characterize each economy. In some cases — obvious examples include economies with a very powerful state sector, or economies heavily dependent on the production of one or a few commodities, or economies dominated by other highly concentrated sectors (the alarming increase in banking concentration in the US, perhaps), or economies in which a very large, underemployed rural population is streaming into urban centers, or economies in which business activity is extremely corrupt or heavily bureaucratized, and so on — these institutions can distort the rebalancing process or hamper it long enough for the country to develop deep imbalances.
These deep imbalances can introduce equally deep systemic biases in the calculation of GDP that undermine the implicit assumption behind all GDP comparisons: although GDP calculations necessarily fail to capture accurately the aggregate value of all the goods and services produced during the GDP period, including improvement or deterioration in capital stock, as long as these “failures” are broadly consistent, and biased in the same direction, comparing GDPs can be a meaningful exercize. But economies with very different institutional structures are likely to have very different sets of biases, and I am not sure why economists who understand easily the concept of the “agency problem” — their different incentive structures lead managers to make decisions that might not be in the best interest of the shareholder — have trouble understanding that different institutions can create different sets of biases in the way economic activity correlates to wealth creation, and this undermines the usefulness of GDP as a tool for comparing economies. The agency problem itself, after is, is an example of one such institution, and can cause significant value distortions especially in an economy dominated by the state sector. Economic agents in countries with artificially high interest rates, to take another example, will treat capital very differently than will economic agents in countries with artificially low interest rates, and so the true economic value of activity involving capital will be reported in very different ways when GDP is calculated.
What can you measure with a broken scale?
Fortunately not all factors that undermine GDP comparisons are quite as intractable. There is one way that GDP between countries can be distorted, and that is because GDP comparisons are made according to current exchange rates, and of course these vary constantly in real terms. It may turn out that once you adjust for cost, the standard of living in the US may actually imply that the US economy is more, or less, than 9.1 times the Canadian economy or 7.4 times the British economy. There is however a way to correct for this, and that is to adjust the British and Canadian GDP numbers on a purchasing power parity (PPP) basis, so that price difference caused by fluctuations in the real value of the currencies of the three countries are eliminated. This isn’t necessarily easy unless Canadians, English and American households divide their purchases among various goods and service in exactly the same proportions, but it is possible to do a reasonable approximation.
It may now sound like I am belaboring the point unnecessarily with my next metaphor, but there is a reason for this, so please bear with me. I want to make an extremely important point, one which I have made before, and while engineers, mathematicians and bond traders find it annoying that I would even bother making such an obvious point again, economists seem to have so much trouble understanding it, and through them journalists, that I am going to try again to explain.
We often hear that the real way to compare two economies is not on the basis of reported GDP but rather on the basis of the PPP-adjusted GDP. This is not true. PPP adjustments are useful in certain contexts, not in most others, but this essay is not the appropriate place to explain why. At any rate in the article I cited above Derek Scissors notes that in the debate over whether China or the US is the world’s biggest economy, “one side cites gross domestic product adjusted for purchasing power parity and puts China on top.” In another article Scissors explains why he dismisses the PPP-adjusted GDP calculation, and while his reasons are correct, I think he misses the main reason to reject the usefulness of China’s PPP adjustment.
To explain why, we will switch gears altogether, and assume that I have a broken scale at home that causes the recorded weight of anyone who used it to be consistently higher than his real weight. This would be annoying, but it wouldn’t make the scale useless. It would still serve two useful purposes. First, and most obviously, if I weigh myself every day, I will get a fairly accurate record of the percentage change in my weight on a daily basis, and although I might not know what I really weigh, if all I care about is how well I am managing my weight, the broken scale is as good as an accurate one. This is the equivalent of comparing a country’s GDP growth from one period to the next — the actual numbers might not be accurate, but the percent change is.
The second thing I can do is compare my weight with that of my friend, who also uses my inaccurate scale, which perhaps we do every January 1, and publish on my blog. This allows our friends to compare our progress and to make jokes at our expense. The progress, or lack of progress, indicated by the broken scale is real, even if the recorded weight isn’t. If we do it January 1 on any given year, for example, and he turns out to weigh 10% more than I do on my inaccurate scale, it’s a pretty safe bet that he also weighed 10% more than I did in reality, and our friends can make fun of him for weighing more than me. This, of course, is analogous to comparing US GDP with that of the UK or Canada. The real numbers may be inaccurate, but the comparisons are valid.
But what happens if we always weigh ourselves in the morning after getting out of bed, whereas this year my friend was away from hone, and by the time he was able to come to my home to weigh himself it was evening and he had already eaten dinner, when he was likely to be heavier than he would have been in the morning. In that case the comparison between us will have been distorted, in my favor.
There is however a way to fix the problem. I can ask him to weigh himself every morning and evening over several days, and to average the difference, and then I can use this average to adjust the weight he recorded this past January 1. This adjustment won’t be perfect, but we can all agree that it is a useful adjustment because it gives us a more accurate measure of our weight difference on January 1. This adjustment, of course, is analogous to the PPP adjustment – it isn’t perfect, but it certainly improves the accuracy of the comparison.
But let’s say, for some weird reason, I have a second friend with whom I engage in the same ritual. The problem is that this second friend has his own scale, which is also inaccurate, but it is not inaccurate in the same way mine is. Because we live so far apart, we have never been able to figure out what the difference is, but we just know that the two scales are inaccurate in totally inconsistent ways.
Obviously while this second friend can use his scale to measure how well he is managing his weight, any comparison between his recorded weight and mine is pretty much a useless exercise. We know how he is doing on a year-to-year basis, and we know how I am doing, but if we wanted to find out which year it was that we both weighed exactly the same, we wouldn’t be able to tell.
My second friend, however, isn’t terrible smart. If on January 1, he also weighed himself in the evening, and then went through the same adjustment process as my first friend, it would be absurd if he then published the adjusted number and said that this adjustment made the comparison between us much more accurate. Why? Because the adjustment would be functionally random. If his scale recorded higher weights than mine, and the difference was greater than the adjustment, then he would be right to say that the adjustment improved accuracy, but this would just be a result of chance. If his scale record lower numbers than mine, or if it records numbers that are higher by less than half of the adjustment, his adjustment would actually make the comparison between us less accurate.
Damned PPP again
If everyone understood that the weight comparisons between me and my second friend are inaccurate, and my second friend went through the adjustment process as a joke, and everyone understood that it was a joke, it wouldn’t matter much. If when they heard about the adjustment, however, they took the comparisons seriously because they believed that this adjustment represented a real improvement in describing accurately the differences in our respective weights, I would probably find the whole thing either annoying or even funnier.
So what am I talking about – is there really anything analogous to such an absurd story? Unfortunately there is. It is the comparison between the US GDP and China’s GDP on a PPP-adjusted basis. When the World Bank announced China’s PPP-adjusted GDP, it turned out that the PPP adjustment was much larger than expected, and it implied that on a PPP basis, China would overtake the US economically much earlier than expected. I posted a blog entry explaining what I though was quite obvious, that because China’s GDP was constructed differently than that of the US, direct comparisons between the two were not terribly useful. Worse than useless, however, it was downright foolish to make PPP adjustments and imply that what was in effect a random change in comparability somehow improved the quality of the comparison.
Some people interpreted this to mean that I was arguing that China was using a different set of rules to compile its GDP, but this is not at all what I meant. My point was only that because these two economies were so different, not least because of the enormous roles the two governments played, especially in the financial system, and most especially in the widespread perception of moral hazard within China, it was inevitable that the many ways in which US GDP was miscalculated would differ significantly from the many ways in which China’s GDP was miscalculated, so that the differences would involve very different biases between reported GDP and the “real” value of goods and services produced. In that case any kind of “adjustment” that did not specifically eliminate all the differences in bias, especially a PPP adjustment, would as likely make comparability worse as it would make it better.
I assumed that it was obvious how institutional difference were so great between the two that their inconsistent biases would render GDP numbers incomparable, but just in case, I mentioned the most glaringly obvious such difference, which was the very different ways in which the two countries recorded the impact of loans made to projects that did not generate increases in productivity that were large enough to justify the investment. Because these were far more likely to be written down in the US than in China, and because most economists agree that the difference is very large in GDP terms, the failure to recognize bad loans in China is by itself more than enough to invalidate any PPP adjustment.
But it turned out to be less obvious than I thought. A few months later a friend of mine sent me a Bloomberg article with the title “Bad Math Makes China’s GDP No. 1”, and I discovered that I was the perpetrator of this bad math. I was a little worried at first, because I am enough of a math geek that I think launching into a discussion about the sheer beauty of probability theory during a dinner with friends makes me a charming conversationalist, and usually when I try to do economics, and smart people around me patiently point out my mistakes, math is usually not the part that I get wrong. Logically speaking, it seemed that there were only two ways the author of the article, Noah Smith, might prove me to be mistaken. One way was to prove that GDP calculations are actually always very accurate measures of real value creation, and the second way was to prove that the conditions of moral hazard within which much Chinese lending occurs nonetheless makes Chinese banks as likely as US banks to write down loans they have made into projects whose economic value is less than their cost.
Is an obsession with accuracy unhealthy for the economics establishment?
It turned out that I was being rebuked for a very different way of committing my bad math than I had expected. Smith’s spanking, if I understand it correctly, was because he thought I was trying to get economists to stop accounting for GDP in a consistent way. Actually I wasn’t doing any such thing. All I did in my PPP essay, or at least what I thought I did, was to point out that accounting models are attempts to approximate reality according to a consistent set of rules, and sometimes, even usually, they do so reasonably well, but there are times when they distort the picture of reality enough that we should recognize that the model is largely useless, and so we should ignore its implications.
Smith seemed to think I was doing something far more subversive. I may be a little confused about his objections, in part because I assume that my explanation for why we should ignore the whole PPP excercise for China are pretty unremarkable. At any rate he writes:
There are plenty of doubts surrounding the Chinese figures, of course. The latest price survey might be just as inaccurate as the earlier ones. Chinese provincial gross domestic product figures are notoriously overstated by job-seeking officials. And the calculation the IMF uses to adjust for price differences, called purchasing power parity, contains a lot of assumptions — using market exchange rates, the U.S. still has the biggest economy.
So when I clicked on a Quartz article entitled “Nope, China’s economy hasn’t yet surpassed America’s,” I expected to see these concerns highlighted. Instead, what I found was that the usually reliable and perspicacious China-watcher Gwynn Guilford had bought into a dodgy theory being promulgated by the renowned Beijing University professor Michael Pettis.
Pettis’s theory, in a nutshell, is that bad investments shouldn’t be counted in GDP… What Pettis is suggesting is that we change the whole way we measure GDP. He wants us to use the discounted present value of assets — in other words, a guess about the far future — as our GDP measure. In other words, he thinks true GDP ought to be a measure of wealth creation rather than a measure of current production.
…We must resist that urge. If economists start trying to subtract perceived malinvestment from GDP, then estimates of GDP will vary wildly from economists to economist, based on how big each one thinks the bubble is. For example, suppose it’s 2007 and I think most of the houses that are being built will eventually be occupied, but you believe that most of them will stand empty and eventually be demolished. If we do what Pettis recommends and subtract our subjective estimates of the percentage of future unused housing from GDP, then you and I will come up with two different GDP numbers!
The friend who emailed me the article is a mathematician who became interested in economics through finance, and he was a little too delighted with the article because he knows how frustrated I get by the way economists regularly combine clunky mathematical intuition with a reverence for mathematically formulated statements that often exceeds their worth. He also knows that in class I am particularly insistent that every model has implicit underlying assumptions, and we should not use the model until we have worked them out and find them consistent with the rest of our assumptions (he had taken my arbitrage class many years ago at the Columbia Business School). Because he understood that I called the PPP adjustment for China useless not because I wanted to tear down the edifice of economics but rather because an implicit assumption fundamental to the PPP model is that if the adjustment is supposed to improve the quality of the comparison, any biases in the reported GDP numbers must be broadly consistent with the biases in the reported US GDP numbers. Here is what my friend said in the email:
This guy says you’re wrong, not because your sacred implicit assumption remained intact [i.e. the assumption that biases must be broadly consistent for GDP to be comparable], and not even because Chinese banks didn’t make bad loans (that’s what I expected him to say). You are wrong because China followed the accounting rules in calculating GDP, and if you start questioning the rules you’ll make it impossible to do economics.
He’s right, you know. If you start running around sacrificing precision just because of an unhealthy obsession with accuracy, no one is going to be able to get their work published. Maybe if China wrote down its bad debt, its GDP number would be totally different. Well great, and if they did, you could have a whole different set of GDP numbers to play with, and everyone would be happy. But they didn’t. So deal with it.
Very funny, but actually I don’t think Smith understood that I wasn’t saying anything quite so heretical as he thinks. I wasn’t arguing that because GDP is “wrong”, it is therefore always useless and should be jettisoned altogether. I was only making what should have been an obvious mathematical point, which is that without dismantling the whole structure of economics we can still recognize when certain numbers are useless, and we should understand that the PPP adjustment for China is useless. Smith accepts that are many reasons to question the PPP adjustment, some of which he notes in the first paragraph.
He thinks these are legitimate reasons, and they certainly are, but they are also either minor or debatable. The most important discrepancy in our ability to compare the reported GDPs of China and the US, however, forces us to treat the PPP adjustment as a useless exercise, and it is neither minor nor, I would have thought, debatable. Mathematicians, engineers, and bond traders usually roll their eyes at the obviousness of my explanation, and I suspect that some of the regular readers of my blog will comment with eye-rolling avatars, if they exist (or do I mean icons?), but this is why I put together the little story about inaccurate scales, which is not a story about why we should throw all our scales away but rather a story about how they can sometimes be useful and how sometimes they can’t. It may seem silly, but so are the constant references to the implications of China’s PPP adjustment, so one way or the other we’re stuck with silliness.
National P/E ratios
But I started this essay out by saying I wanted to discuss a number of reasons that might explain why the US economy would be valued at a higher “multiple” than the Chinese, and while the US should indeed have a higher multiple, for reasons I explain below, I am not trying to suggest here that the higher multiple implied by the numbers to which Scissors refers is in fact the right one. There are, of course, two parts to the higher multiple and these correspond to “price” and to “earnings” in the P/E ratio. Of course if the “earnings” part of the P/E multiple is calculated in a different ways, as GDPs for China and the US clearly are, that is obviously part of the explanation, but there are a few other points I thought worth mentioning.
1. The difference in the discount rate obviously matters tremendously. In financial terms, the fact that the US economy is more diversified and less volatile means pretty automatically that its income should be discounted at a lower rate. Every unit of annual American wealth creation should be more valuable than the same unit of annual Chinese wealth creation. One big problem here might be in determining expected volatility. Historical volatility is probably a useful proxy for expected volatility in the US case, but not in China for at least three important reasons.
2. First, many analysts dispute the veracity of Chinese GDP data and also claim that reported GDP tends to smooth out fluctuations. While the former claim hasn’t been proven conclusively to be true over the long term, at least as far I can tell, the latter is almost certainly true. I have seen many studies that try to provide alternative measures of GDP, and while they disagree on whether or not GDP is overstated over the long term, they all agree on the smoothing of data. There also seems to be a consensus, which is consistent with both claims, that growth in the past two quarters has been overstated.
3. Second, a country’s balance sheet structure can systematically exacerbate or dissipate volatility, and I showed in my 2001 book, The Volatility Machine, that developing countries tend to design highly inverted balance sheets for a number of reasons (Hausmann’s “original sin” being among the more obvious). This creates high levels of pro-cyclicality that boost reported growth above the “natural” growth rate during the expansion phase, but of course the same reflexive mechanisms do the opposite during the adjustment phase.
Economists don’t often seem to understand this mechanism unless they are also finance specialists, or historians (or read a lot of Hyman Minsky) and in most previous cases, when “miracle” growth turned out to be largely based on excess leverage and the reflexive relationship between the two, while they were often at first surprised by the unexpectedly strong growth, they nearly always eventually attributed it to unique but sustainable circumstances. Over time, it seems that economists simply adjusted upwards their estimates of potential growth in order to provide a consistent explanation for the higher growth numbers. It is probably worth noting that in nearly every case, the unique but sustainable circumstance that most economists believed explained the surprisingly high growth turned out to be the implementation of either a new kind of growth model, or, and the two were usually intertwined, a new, superior way of economic thinking that had developed among a highly sophisticated policymaking elite (usually belonging to that most flexible of schools, “non-Western” economics). It is surprising how consistently this pattern repeats, and, although perhaps less surprising, how quickly the consensus eventually spreads within the policy-making elite (although you can nearly always find grumpy internal resistance to the presumed superiority of “non-Western” economics).
Investors have usually done a better job of recognizing the reflexive relationship between growth and credit, although in the end the this-time-is-different story ends up enchanting investors anyway, whether the reason for thinking that this time is different is a new economic growth model that creates a growth miracle, or new technology that promises to cause a productivity surge enough to justify any stock market price, or a new kind of financial organization that is expected all but to eliminate financial risk or to control it more rigorously. Most bubbles seem to be set off in one of these three forms, and I think it was Charles Kindelberger who pointed out that the story explaining the bubble is always plausible and nearly always justified during the early stages, sometimes powerfully so, and this makes subsequent skepticism all the harder.
If you believe this model applies to China’s case, you might argue that the combination of destruction brought on by the Japanese and civil wars, followed by three decades of “experimental” policy-making, left the country seriously underinvested both in manufacturing capacity and in infrastructure relative to it institutional ability to absorb investment productively. For that reason Deng’s reforms in the 1980s, and the subsequent early stages of the implementation of the investment-driven growth model (to which I have often referred as the Gershenkron model) were probably periods of such spectacular real growth, and of real increases in wealth, that it seemed even easier than in previous cases to reject any explanation which pointed to deteriorating imbalances and unsustainable increases in debt as an important source of continued growth.
4. And third, of course, is that the discount rate must include a premium for “gapping risk”, by which I mean the risk of an unexpected and sharp drop. If investors believe that a developing country like China is more prone to downward shocks than an advanced country like the US, or if investors believe that China’s autocratic political system is more likely to break down than US democracy, or if investors think a more centralized economic system with a few very large players that excercise disproportionate control, like in China, is more vulnerable to “systems breakdown” then the more decentralized US economy (and there are many other kinds of gapping that can occur), then even if none of these have happened in the past, investors must raise their discount rates anyway — unexpected events (“gapping”) are, of course, unexpected, but some systems seem more prone to unexpected events than others, and so they have greater gapping risk, and this should be priced in. Investors might interpret the significant capital flight from China, and perhaps more importantly the growing flow of wealthy and educated Chinese households from China to the US, as indications that well-informed Chinese households assume that gapping risk is much higher in China than in the US, and may be rising.
As an aside I worry that in the last of my three examples, China may not be at as big a relative disadvantage as we think. The increasing concentration of financial power in the US to a limited number of institutions cannot help but increase gapping risk in the US economy. As long as investors believe there is a greater chance of gapping in China, the impact on the discount rate can be very high, but Americans should recognize that when any important sector of the economy is heavily concentrated, especially one of such centrality as the financial sector, which intermediates the relationships between most other sectors of the economy, while there may be efficiency gains (although I suspect that these are vastly overestimated), this concentration necessarily creates much stronger institutional constraints that can prevent the economy from the natural tendency automatically to adjust as it eliminates imbalances.
These powerful institutional constraints allow imbalances to deepen while creating the illusion of greater stability, which is made all the more dangerous because the deeper the imbalance, the greater the risk ultimately of a disruptive adjustment – which is a form of gapping risk. One of the greatest long-term strengths of the US economy (and of highly institutionalized democracies in general) has been its ability to adjust quickly, if at times brutally. We tend I think vastly to under-appreciate Albert Hirschman’s insight that the long-term success of an economy depends far more on the institutional flexibility that permits it to manage a successful adjustment, following an earlier period of rapid growth or economic disruption, than it does on how successfully it manages the period of rapid growth, which often is enhanced by institutional rigidities. If Hirschman is right, and I think he is beyond any doubt, the concentration of power within the US financial system may represent a vulnerability far greater than those typically discussed in the press and among academics.
All of this suggests that the rate at which we discount US GDP is likely to be much lower than the Chinese discount rate, but we cannot forget that because China is expected to grow more quickly, this too should be factored into the discount rate, to China’s benefit (i.e. it reduces the Chinese discount rate). Of course both US and Chinese GDP growth rates are uncertain, let alone the expected difference between them, and there is too great a dispute among analysts about expected Chinese growth rates even to begin to address it, but if we are trying to explain valuation differences, this has to be part of the explanation.
5. Finally I would argue that all of the above implicitly assumes that GDP is a good proxy for wealth creation. Of course it isn’t. As I discussed above, there is far too much economic activity included in the GDP calculation, or excluded from it, whose real impact on wealth creation is not the same as its impact on GDP growth, for it to be an accurate measure of wealth creation. But GDP might be a reasonable enough proxy as long as we recognize the implicit assumptions in any GDP model, in which case the real value of GDP to economists is not the reported number itself but rather its usefulness in making comparisons.
For the reasons I discussed above, I don’t think we can place much confidence in the quality of the information we can extract from comparisons between the GDPs of the US and China. I would propose that there are at least two very different biases that might explain part of the higher valuation of US wealth. The first has to do with externalities that are not included in GDP calculations. If the US has higher positive or lower negative externalities, this should show up in the form of a higher wealth valuation. It is easy to come up with lists of externalities in favor of one or the other, but I would argue that among higher positive externalities in the US, there are at least two important ones. First, the value of education, especially at the elite level, which is structured not so much as a distribution of knowledge but rather as a way to process knowledge under changing circumstances. Second, the US has evolved an institutional framework that encourages a level of business, technological and cultural creativity that, certainly from the outside, seems almost astonishing. This framework seems fairly robust but it is partially vulnerable to the extent that attitudes towards immigration and the chaotic and highly diverse financial sector are important components within the framework. I have more broadly referred to the latter as “social capital”, and have discussed several times what I mean by it, perhaps most extensively in a June 10, 2013 essay. Some analysts might argue that the latter is already included in the US GDP numbers, but if investors believe that the US is more likely to benefit from the unexpected creation of an important productivity-enhancing technology, this is the equivalent of embedding a kind of option in the total value of US wealth, and these options can be quite valuable.
On the flip side I would argue that among higher negative externalities in China it is hard not to think immediately of environmental degradation, which leaves China poorer in a way not measured in GDP. I should also mention China’s huge water problem, which is widely recognized and, by implying significant future costs, their properly discounted value should reduce China’s wealth without showing up in today’s GDP numbers. Of course water is becoming a problem not just for China, and I understand that in California it is starting to become a severe constraint on the agriculture sector, but I think the sheer extent of China’s water problem may be unprecedented.
6. And finally, the second of the obvious and large GDP biases that makes it nearly pointless to compare the two GDP numbers — in spite of all the excitement generated by these comparisons, especially the most foolish of them all, the PPP-adjusted comparison — is the treatment of debt. I have already discussed why this is such an important issue to invalidate GDP comparisons at face value, but to summarize, if investors believe that the US financial system is far more likely than that of China to write down loans that have funded projects whose returns do not justify their costs, then they also must believe that real economic losses, which would have reduced the amount of GDP calculated for the US, did not reduce the amount of GDP calculated for China, even though the real economic impact would have been identical. If this is the case, US GDP is relatively understated by the amount of the bad loans that are unrecognized in China but that would have been recognized in the US. Some estimates of this number are extremely high, amounting to 30% of GDP or more.
Multiples and growth differentials
There is a lot more to say, but the much greater disparity in US and Chinese wealth than the disparity in their GDP growth numbers might not be hard to justify. I have ignored reasons that might justify lower discount rates or higher GDP adjustments for China mainly because the purpose of this essay is to explain why the US multiple is so much higher than China’s, and of course these reasons exist, but I think whatever the correct ratio should be, there is no question that advanced economies always justify higher multiples than developing economies because they tend to be economically more diversified and politically more stable, and they usually have institutions, including clearer legal and regulatory frameworks, more sophisticated capital allocation processes, less rigid financial systems, and smaller state sectors (which make smooth adjustment, one of the most valuable and undervalued components of long-term growth, more likely).
At the risk of repetition (a risk, some regular readers say, I don’t often duck) in the case of China and the US, I would summarize very broadly by making two points. First, although it should be clear that neither GDP is “correct” as a true measure of wealth creation, I think there are good reasons to argue that the difference in real wealth creation might be greater than the difference in GDP – in other words that US wealth creation is higher relative to US GDP than China’s wealth creation is relative to China’s GDP – and it is this adjusted GDP, representing real wealth creation, whose value must be discounted to determine the economic “wealth” of each country. However, depending on how much faster China’s “adjusted” GDP grows than US “adjusted” GDP grows, this difference must show up in China’s favor in the discount rate.
In fact the growth differential must be among the most important factors in determining the relative “multiples”, and it is nominal growth, not real, that matters. There is, of course, a great deal of skepticism about the 7% real GDP growth rate that China has reported, but we should remember that in the first quarter, nominal GDP growth was much lower, 5.8%. What is more, in the past two days there have been a number of announcements that suggest that Beijing is worried enough about the growth slowdown that it may unleash a new wave of infrastructure-based spending. If this is true, it should cause GDP growth to pick up, and so should widen the growth differential between China and the US, but unfortunately this does not mean that there should be a corresponding drop in the rate at which we discount Chinese growth. The decision about how to adjust the discount rate depends on whether investors believe that additional infrastructure spending will increase the country’s potential growth rate, or instead that it will simply increase economic activity at the expense of higher debt and a misallocation of resources. If we assume that Beijing has been reluctant to do this in the past, and is only doing so in response to weaker expected growth numbers, it would suggest the latter explanation, which implies a higher, not a lower, discount rate, and so a lower “multiple” for the Chinese economy.
Second, ignoring the factor that represents the growth differential, there is absolutely no way to justify similar discount rates for the two economies. Every dollar in the adjusted US GDP must be more valuable than every dollar in China’s adjusted GDP, because US wealth creation almost certainly must be discounted at a lower rate. But how much lower? However you measure it, it seems to me that the appropriate US discount rate should be substantially lower, but the two most important adjustments, one of which I discuss above as consisting of the difference in respective growth rates, are likely to be among the most controversial. The other is the impact of balance sheet inversion on the discount rate.
If investors believe that a very large component of China’s GDP growth is explained by the pro-cyclicality of balance sheet distortions, or if they accept the validity of CAPM in valuing higher expected growth based on higher leverage, then they will have to raise the Chinese discount rate to eliminate altogether the value of this additional growth.
I plan to write about this balance sheet issue a lot more elsewhere, including in an upcoming review of Nick Lardy’s excellent recent book, Markets over Mao: The Rise of Private Business in China. I believe the review will be published in the July 2014 issue of Asia Policy, the journal of the The National Bureau of Asian Research, and will feature short review essays by five to six experts, followed by a response from Lardy. The point of my review will be to explain why what seems like a paradox is in fact not a paradox.
I don’t think anyone has an understanding of the fundamental nature of China’s economy, its political economy institutional structure, and the evolution of its economy since the beginning of the reforms, better than Lardy. He is also very careful in his work and not prone to excess. His book explains the evolution of China’s transformation from a state dominated economy to one in which the private sector has become the engine of employment and productivity growth. This explanation leads him inexorably to the conclusion that China will continue to grow rapidly during the rest of President Xi’s administration, which is expected to end in 2023. He forecasts average growth rates as high as 8%.
I have read his book and agree with nearly all of it, or at least I am not smart enough or knowledgeable enough to show why he is wrong. And yet just as inexorably I conclude from his book that the risks are substantial, and that if China is able to grow on average at half that rate, Xi will deserve to be widely acknowledged as having pulled off an extraordinary feat.
Whatever the topic, I always see balance sheets
How can the same set of facts lead to such widely differing forecasts? The reasons, I will argue, have to do with how we evaluate the impact of the two sides of an economic entity’s balance sheet on its growth. Lardy, I will argue, and like the majority of economists, thinks of growth largely as a function of how productively the asset side of the balance sheet is managed, and this is true of all economic entities, ranging from businesses to countries to the global economy. The liability structure is not irrelevant, according to this view, but it matters mainly because too much debt creates the risk of a debt crisis, or can undermine confidence. Otherwise it is functionally irrelevant.
For me, and this view is not unanimous but much more widely held among finance specialists, this “asset side” view of growth is only true under specific conditions. Once debt levels are high enough, or the liability structure is sufficiently distorted in ways that can be specified fairly accurately, debt moves increasingly towards functional centrality. It does so in two important ways. First – and although there have been scattered references throughout the literature about this process, there has been no attempt, as far as I know, to describe it systematically – distorted liability structures, or what I call “inverted” balance sheets in my book, The Volatility Machine, can create highly pro-cyclical and self-reinforcing mechanisms, especially through the financial sector, that systematically exacerbate expansion and contraction phases in the economy. These can be so powerful that, especially in developing economies, they can turn rapid growth into growth “miracles”, but they also can cause the subsequent adjustment to become a surprisingly difficult period of stagnation.
The second important way debt can become functionally central to growth emerges from the well-known and much studied process that in finance theory is referred to as financial distress. As regular readers of my blog know, I think of the trigger not as the rising probability of default, which is the standard corporate finance explanation, but rather rising uncertainty about how debt will be resolved. This of course necessarily includes but is not limited to the rising probability of default. I have redefined it in this way because while financial distress is almost always assumed to be something to which only businesses are vulnerable, in fact the theory is applicable to the full range of economic entities, for which in some cases default is irrelevant.
There is a lot more to say, and I hope to develop these ideas more fully in the next few years, but for now I think the discussion Scissors triggered with his essay can be a useful way to think about the Chinese economy – not so much because we need a way to decide which economy is the world’s largest, but rather because the value we place on current and future growth tells us a lot about the quality of that growth. It also has important policy implications that can be very useful to leaders in Washington and Beijing. Thinking about the reform process, especially in China, can be helpfully refined by understanding the value of different kinds of growth.
But its now 4 a.m., a little late even for me. Please pardon the many typos there are bound to be.
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Do you know any good books (maybe textbooks or something textbook-like) for learning finance theory? Economics that doesn’t discuss finance seems largely useless and error-prone to me.
There’s also so much erroneous thought in the way “math” is used by economists that drives me insane. They consistently misunderstand and misrepresent fat-tailed effects. In particular, I get infuriated when people say that a fat-tailed world is one where large deviations become more likely–it makes no mathematical sense. The most fat-tailed environment, for something like income, would be 1 person having 100% of the income and everyone else having none. Obviously in such an environment, large deviations are far less likely, but the deviation when it occurs is more consequential.
It’s the same problem that you discuss about the risk of a centralized financial system. It doesn’t have to mean corrections become more likely. What it most likely means is that corrections are more consequential even though they can occur less often.
This also leads to erroneous conclusions on wealth creation because I believe wealth creation to be fat-tailed (we don’t know an upper bound which is epistemologically the same as having no upper bound) while there’s an obvious lower bound at 0. Therefore, it means that wealth is gained in a winner-take-all manner. What it also implies, albeit indirectly, is that class mobility is more important than having a low level of inequality. Because wealth accumulates in a winner-take-all manner, you need mobility so that the amount of trials can be increased for that one winner.
I’ll end this with some lyrics that I find to be profound:
“Let’s play ball
Aim for the stars, winner takes all
Take it to the top and watch them fall
Don’t be alarmed that’s who you are
What a thing to say
Everything to lose and nothing to gain
Looking for the sun, but you end up in the rain
Truth be told that’s everyday”
I won’t even start on this whole issue of math mis-use, but I do think that if you use any model at all, because every single model is just the logical outcome of combining a bunch of assumptions, even the simplest, you have to make sure that you work out those assumptions and that they make sense.
It’s been a long time since I’ve read any finance textbooks, and so I can’t come up with any recommendations, but most textbooks with the names “Corporate Finance”, “Bond Math”, “Options and Derivatives” or anything similar, will give you all the basics. I think if you can get yourself into intuitively understanding the following:
-interest rate compounding;
-how to construct forward prices;
-how to chop up a yield curve into its forward components (these two meanings of “forward” are very different);
-how to think about the way kappa and delta affect option values; –
-why debt, equity, and every instrument you can possible imagine, as well as all kinds of decisions, can be disaggregated into portfolios consisting of nothing but long and short positions in risk-free forwards and in put or call options (this is an astonishingly useful trick that among other things allows you to pinpoint exactly which part is the part that you don’t understand) ;
-why every kink in a cashflow curve has an option hidden inside;
-why Modigliani and Miller are right when they say capital structure doesn’t matter;
-why taxes and financial distress prove Miller and Modigliani are wrong;
-how financial distress reduces value by forcing stakeholders to alter their behavior;
-how leverage is pro-cyclical,
you’ll be able to figure out for yourself most of what matters, at least to me, and you’ll have learned most of my secrets (the rest will come just from reading every book or paper on economic and financial history you can get your hands on). My mentor at Columbia also told me that if any time you see an economic paper with a hugely complicated mathematical structure, if you assume that the paper either a)proves something obvious, b)proves something trivial, or c)got the math wrong, and so you skip it, you might miss out on a few important papers, but you’ll have saved yourself so much time that if you apply that time to reading something else, you will unquestionably come out ahead.
I’ve seen papers that talk about sound math, but they don’t come from economists. Taleb has lots of excellent papers on these topics.
Here’s one he has on inequality where he shows that the very, very rich benefit more from shifts in the tail behaviors of the wealth distribution rather than a shift in the overall wealth of a society, but it assumes fat-tails (which is the case for both wealth and income).
http://www.fooledbyrandomness.com/Onepercent.pdf
As you can clearly see, his papers have a very different structure than a typical paper from an economist. His paper is rigorous, he explicitly states the assumptions, and the analysis is well done with pictures all over the place.
Here’s the introduction to the paper I posted in my comment above from Taleb.
“The one percent of the one percent of the population is vastly more sensitive to inequality than total GDP growth (which explains why the superrich are doing well now, and should do better under globalization, and why it is a segment that doesn’t correlate well with the economy). For the super-rich, one point of GINI causes an increase equivalent to 6-10% increase in total income (say, GDP). More generally, the partial expectation in the tail is vastly more sensitive to changes in scale of the distribution than in its centering.
Sellers of luxury goods and products for the superwealthy profit from dispersion more than increase in total wealth or income. I looked at their case as a long optionality, benefit-from-volatility type of industry.”
Here’s a paper he did where he proves that the way economists measure inequality (Gini) is fundamentally flawed and understates inequality.
http://arxiv.org/pdf/1405.1791v3.pdf
In his notebook (see link below), take a look at note 158 where he explains intuitively why Piketty is obviously wrong.
http://www.fooledbyrandomness.com/notebook.htm
Taleb also has a bunch of stuff on risk management and basically wrote a mathematical textbook that’s available online for free (see link below). When I get back to the US, I’ll probably spend my entire summer working through his textbook line by line (along with learning corporate finance, financial history, and options pricing).
https://drive.google.com/file/d/0B8nhAlfIk3QIR1o1dnk5ZmRaaGs/view
The reason why I bring up Taleb is that although he’s kinda arrogant–although I wonder if his arrogance is just a marketing ploy TBH–he’s rigorous. It’s funny because I had a numerical analysis professor last semester who I spoke to about Taleb’s work and I mentioned that Taleb was an options trader for 20+ years. My professor responded, “now that’s where the money is”. My professor had a very sound understanding of these concepts. I did a project for his class where I showed mathematically how fixed cost heuristics under nonlinear dose-response curves are absolutely necessary for systems under survival constraints provided that the dose-response curve is convex enough.
Here’s another paper by Taleb where he attacks the conventional model that’s obvious wrong on portfolio construction and comes up with a different method that’s more robust to shifts in the tails. I’ve attached the abstract from the link as well as the link below.
http://arxiv.org/pdf/1412.7647v1.pdf
“In the world of modern financial theory, portfolio construction has traditionally operated under at least one of two central assumptions: the constraints are derived from a utility function and/or the multivariate probability distribution of the underlying asset returns is fully known. In practice, both
the performance criteria and the informational structure are markedly different: risk-taking agents are mandated to build portfolios by primarily constraining the tails of the portfolio return to satisfy VaR, stress testing, or expected shortfall (CVaR) conditions, and are largely ignorant about the remaining properties of the probability distributions. As an alternative, we derive the shape of portfolio distributions which have maximum entropy subject to real-world left-tail constraints and other expectations. Two consequences are (i) the left-tail constraints are sufficiently powerful to overide other considerations in the conventional theory, rendering individual portfolio components of limited relevance; and (ii) the “barbell” payoff (maximal certainty/low risk on one side, maximum uncertainty on the other) emerges naturally from this construction.”
Sorry for sending you all of these papers, but I thought you (or others) may find some of these papers valuable or interesting even though many of them may be obvious intuitively. Certainly, many of these papers are pretty intuitive, but they’re also highly technical and debunk all of the economic and finance theory garbage that’s taught in classrooms everywhere. On top of this, I’m nerdy enough to find this stuff cool for some odd reason.
Professor Pettis, you reminded me of an anecdote regarding my MBA Finance Professor over 25 years ago. He was handing back our work on a discounted cash flow model for a theoretical project. He looks down at an unsuspecting student as he hands him his paper and says “You’re a CPA aren’t you?” The student looks up and say “Yes, why?” My professor jokingly says “Because I asked you to model a project where I gave you ten broad assumptions and you gave me an answer right down to pennies. I accepted correct answers rounded to the million.”
That’s probably funnier to me than others, but it always reminds me of how people place so much belief in the precision of models.
I can promise you Phil that this sort of thing happens so often that there isn’t a finance or accounting professor in the world who can’t tell the same story. One academic recently published a paper that projected the next decade of Chinese growth with pinpoint accuracy. I don’t remember the number, but it was something like 8.67% annual average growth from 2014 to 2024.
Hi Professor Pettis,
Thanks for another piece of well-explained economics for dummies like me.
One question I have relates to the point you raise in the 2nd to last para – “think of the trigger not as the rising probability of default but rather rising uncertainty about how debt will be resolved”. This brings to mind the recent debt swap that the central government has implemented for local government debt, which is in turn usable as collateral with PBOC.
What is your perspective of this exercise? In effect, it is monetizing the debt. How does this help improve the consumption side of the Chinese economy, or do you think it is fine given how far inflation has fallen in China?
Thank you.
There have been several different exercizes, but if we’re discussing the same, the effect has been presumably to make the paper more liquid and more easily transferred and, probably far more importantly, no longer constrained by regulations affecting loans.
I think the main takeaway here is that you should a new, revised and updated edition of “The Volatility Machine.”
Ha ha thanks. I’m thinking about it.
After 15 years there is a good case for a new edition (if I recall correctly you wrote it in the mid to late 1990s so maybe closer to 20 years?). Since then we have seen the creation of euro, a full commodity super cycle, and the China story to name a few noteworthy events.
PS: I do have your book and I would line up to buy a new edition.
Yes, please!
Even Soros updated his first book with some material update about reflexivity.
So, when is it coming out?
I have first to decide whether to write a new book on debt more generally and the importance to long term growth of getting adjustment right, or whether to revise the Volatility Machine and incorporate the new book. This would make the revised book more than twice as long, and it would become a book that incorporated debt and balance sheets into macroeconomic analysis, with sections on financial sovereign distress, the role of balance sheets in exacerbating expansion and contraction, how growth leads to imbalances and how the balance sheet determines the adjustment process, and finally the role of balance sheet inversion in developing countries. In that case The Volatility Machine would mainly be absorbed into the first and last sections. Which do you prefer?
While The Volatility Machine is only around 270 pages, I found it a tough read that I had to go through slowly. If a new version would require double the length, the new version would have >500 pages consisting of extremely technical material that could, I think, be summed into a 3-4 semester graduate sequence of classes.
I really think the material in there and all the stuff it covers (along with the stuff you plan to add into it from your comment) would go that far assuming you go through the history, the integration of various ways of thinking across different domains, and a whole host of other stuff.
If you were gonna double the length of The Volatility Machine and the stuff you’re adding in is stuff in your comment, you’re basically gonna have a textbook.
Write the new book and update the Volatility Machine if you can find enough new insights to add to it. Better to keep works orthogonal, because a separation-of-concerns forces you to be organize your concerns. This concept comes from computer science, but I think it is generally applicable.
Do you realise that your numbers are outdated? They are from the year 2000. For 2015 the numbers are 83.7 trillion for the US and 21.4 trillion for China.
Thanks, but I don’t think the actual number matter much. All that matter is whether the ratio of wealth to GDP can vary.
The broken scale analogy does not work. The change percentage will be skewed. If it’s off by 500kg and I gain 5kg, then I only gained 1%.
Yea, but it can still be used to compare. The percentages might not hold, but you’re still using the same barometer and its consistent. In other words, your comment is just nitpicking. The point being made is still clear, obvious, and holds.
The 500kg is irrelevant. All you are looking at is the 5kg gain, and how it relates to any gains or losses over time.
And it depends on how it is broken. If it is broken because it record 120% of the real weight, which is how I think a broken scale is more likely to work anyway, then the analogy is fine. Sorry, but I went for the easiest analogy I could come up with and really didn’t think anyone would find it so confusing.
Hi Michael,
There is however yet a different way to think of GDP that you seem to be overlooking … and yet that in some ways forms the core basis for the “league tables of GDP” approach to comparing national economies.
To the extent that GDP represents an estimate of national “economic output” – admittedly not a good estimate, but the best we have – it serves as a proxy for the amount of production that could (in theory) be mobilized by a state and directed towards a given goal.
So, to take the most obvious example, the ability of Germany to crush France during WWI is not unrelated to the fact that Germany’s more industrialized economy was able to pump more “GDP” each year into armament production. Likewise, the fact that Russia was able to rebuild its military and eventually stop Germany was not unrelated to the fact that their resource base (and more effective mobilization) delivered them a higher GDP than that of Germany.
Applied in the broader sense, it is their high GDP that delivers the US a sufficient surplus to fund their military, the massive national R&D and Education system, and even the (both implicit and explicit) propaganda engine that is Hollywood and New York.
It is in THIS context that China’s growing GDP represents a “catch up”. It is what enables their China’s current activities in South China Sea, their public diplomacy efforts with the Confucius Institutes, etc.
The question then becomes not so much what sort of adjustment needs to be done (PPP or otherwise) but rather the extent to which the GDP as measured (or estimated) is “organic” (how much of it is based on “tied” IP (including branding) and orders from US firms and would disappear in the event those firms decided to “onshore” their production), and how much ability the “state” has to mobilize and redirect said capacity as desired.
SB
I assume you mean World War II not World War I because Germany didn’t crush France in WWI. The battle lines were, for the most part, constant.
BTW, Germany didn’t really come that close to winning WW II. The French were just idiots and completely screwed up. Actually, I believe both France and Germany actually produced more weapons in World War II, but the French were literally idiots. Once the Americans jumped in and invaded North Africa with the British, the war was done.
With regards to Russia holding off Germany, the biggest factor IMO was the Russian winter (it was early too). It just shocks me at how stupid people like Napoleon and Hitler actually were. Why the hell would you try to invade Russia? That’s asking your troops to go on a suicide mission.
I did mean WW II, and while Russian winter did stop the German advance in 1941, it was Russian production that enabled them to continue to hold the Germans off in 1942, and then produce the armaments for the 1943/44 counter attacks.
Regarding the French, I can’t comment on the question of idiocy, but as far as military production is concerned, Germany well outmatched France, and … as that famous non-French French general so wisely said … “God is on the side of the big battalions”.
If I’m correct, both France and the UK outproduced the Germans in armaments, but I’d have to check the data which is in a book that I ordered, but I had to go out of the country on family issues. Here’s a source for all of this information.
http://www.amazon.com/Wages-Destruction-Making-Breaking-Economy/dp/0143113208/ref=sr_1_1?ie=UTF8&qid=1432053635&sr=8-1&keywords=the+wages+of+destruction
Also you should remember that the blockade of Germany and the allied air campaign against her industrial plant became an increasing factor as the war proceeded. Also the fact that the Nazi’s alienated (including by expelling, gassing, and just being ideologically so unable to utilise) a significant portion of Germany and the axis (including occupied lands’) innovative and scientific abilities (the Jewish science and business establishment was just one part of this).
War economics is pretty interesting. Germany in the 1930s versus Germany in the 1940s is a very interesting comparison in economic structure.
I think what your point suggests is something that I try regularly to remind my class. Usually when someone asks you how much inflation there Germany had last year, or what is the size of Russia’s GDP, or how much did Spain’s money supply expand, or what impact a current account surplus will have on Japan, or how much debt does the Chinese government have, or a million other things, the correct answer is “Why do you want to know?” Most of this information is only valuable within a specific context.
Too true …
I am disappointed by this article. It is quite clear why China has a much lower asset to GDP ratio than the US. Assets are accumulated wealth. And that can not be compared to a P/E ratio of companies because, let’s take AirBnB for example, they don’t actually have any assets. Their earnings and market position are their only asset. Assets for a country are not measured in the same way.
From this and earlier comments I can understand your disappointment because I think the essay has left you very confused. I think it is indeed clear why China might have a lower asset to GDP ratio than the US, but the reasons, or at least some of them, are the ones I discussed above. The reason is most certainly not because “assets are accumulated wealth”, which even if it were true, or if meant something, wouldn’t explain China or any other country has a higher or lower multiple (unless maybe you are suggesting that China hasn’t accumulated any wealth?). But you are right in suggesting that assets in China are not measured in the same way as they are for AirBnB, so there’s that.
Hi Professor Pettis. I have a question on the asset side of the balance sheet. The above referenced Credit Suisse report shows something like half of China’s wealth being in “non-financial assets”. Per their definition and from what I know of China, this would be dominated by housing and other property stock. I’ve been thinking more and more about this in the last year and it’s a problem that afflicts Hong Kong and Singapore too. It relates to how much of privately held property are actually long leases that amortise and not the permanent land or property holdings that most of the world is accustomed to. To keep this comment short, I wrote more about it here: http://acceptablysharp.com/?p=123. I posited that private wealth in the form of property is shrinking from amortisation and the pace of that accelerates over time (which shouldn’t be controversial) but that this hasn’t been something people pay enough attention to. However, surely this is something that over time should have a meaningful impact (mostly negative) on everything from consumption and savings patterns to bank credit quality in China. I was wondering if you a view or any perspective on this. Thank you.
The value of buildings might depreciate with wear and tear but I don’t think real estate itself does, although if real estate in Singapore and HK is only held in the form of leases (and this isn’t something I know much about), then there would have to be some amortization schedule that depends on a number of things, including the mechanism for renewing leases. This amortization wouldn’t reduce the value of the land, however. It would simply reduce the value to the leaseholder by transferring it to the owner, which I assume is the state.
In grossly general terms and all dependent upon varying tax regulations of different countries – a company may depreciate its tangible assets, like the building and the land owned or leased, and amortize its intangible assets like finance. As owned buildings can be depreciated over something like 39 years in the US, and can often last much longer (if constructed properly!) there is often a mismatch between the market value of the real estate and the depreciated value on the books of the company which owns it presenting fodder in the US for the leveraged buyout. The LBO along with “synthetic leases” under which an intermediary company is set up with the express purpose of “leasing” the real estate from the company on whose books it is fully depreciated with the express purpose of kick starting the depreciation schedule, can be viewed favorably as mechanisms which address this mismatch. Now leveraged buyouts and synthetic leases themselves are not treated fairly in tax terms in my view – (corruption) however they do present mechanisms in which address the mismatch between market value and depreciated value. China absent such mechanisms or a taxation system which even attempts to inadequately work out the ramifications may be present yet another drag on the broader economy. Whats more badly built buildings rife in China of course can decay faster than their straight line depreciation schedules. And all this depending upon the yields: income over value – which are very low when real estate and long term lease values are in bubble, to calculate its present value, and very dependent upon – guess what – the RISK adjusted discount rate! used in the calculation. Another strike for the importance of institutions.
And how is a mismatch between depreciated and market value a drain on the economy absent institutions which enable mechanisms to address this mismatch? Because if you are a company who real estate is worth more than you are allowed to depreciate it then you are not getting fair depreciation. And if you are an owner who will have paid too much for property whose value falls faster than you are alllowed to depreciate it then the PV of your investment will be less than you paid for it. I not saying this very well but I hope you get the drift.
However enjoying thinking about this some more, in terms of GDP it may be just as MP says that there is a simple tradeoff if the money is in the hands of the state is equivalent to the hands of private companies in terms of economic multipliers. In the even of a mismatch either the lessee gets the tax deduction and the state does not get the revenue or vice versa. It would then depend upon whether the multipliers are greater for the state having the revenues or private companies having the tax deduction, ie who spends their money in fields with greater multipliers. Dont know the answer to that in the US let alone in China but it is a very interesting question which puts the relevance of real estate accounting in the US v China under the microscope. I would like to try to prove it but the gut feel is that any mismatch without scope for remediation would decrease GDP.
Professor Pettis, another great article. It pushes me to start trying to examine the liability side of the Australian economy, particularly the Big 4 banks. Nearly all commentators in Australia are peddling the “This time it’s different” theory or in Australian academic acumen, we are “the lucky country” where economic theory no longer applies.
Alas, reading through the comments on your previous post and just above in this post, it seems like your regular readers are all interested in getting your thoughts on the LGFV debt swap with the banks and in turn the monetization of the collateral by the PBOC. While it has been noted by a number of economists that the value of the bonds monetized was only ~5%, I don’t see many commentators acknowledging the more important fact that the bonds monetized was ~50% of LGFV bonds maturing this year that needed to be refinanced.
The question that is probably on the market’s mind is where does this leave the shadow banking sector’s debt, which has a significant % due to mature this year. It seems like we are getting into the middle of the 2008 cycle where everyone starts to look around at each other’s balance sheets to figure out who will and won’t be bailed out. This doesn’t have a good track record of ending well.
II don’t think people worry too much about debt rollovers, bank runs and the possibility of sudden stops because there is a pretty wide-spread perception, and probably correct, that most of the financial system, even large parts of the shadow banking system, are back-stopped by the government. Moral hazard has always been a big problem, and in fact the government has been trying to erase that perception, among other things by making deposit insurance explicit, so as to convince the market of the need to impose lending discipline. So far their attempts have been pretty tentative and not very credible, which isn’t a surprise. If you could suddenly and credibly convince everyone that the only credit the government stands behind is credit with an explicit and written guarantee, there would be a portfolio “readjustment,” to put it politely, that would be pretty destabilizing. I am not sure how you go about convincing lenders of the need to avoid the risk of big, messy defaults without having a few big, messy defaults, but it isn’t clear just how much of a mess the financial system can take.
As for your point that a big chunk of the securitized loans were coming due, I assume that is because once they’re securitized they aren’t constrained by various ratios, most importantly the loan-to-deposit ratio, and that might be a big inducement for the banks because although the yield is lower, it won’t displace other loans, and so as long as the carry is positive the bond is profitable.
There is still a lot of confusion out there, but the way I think about it is that basically monetary policy has three useful goals: to reduce growth in the debt burden (either by forcing the country to cut back on investment, or to transform the lending process so that only productive borrowers get the money, which is a lot easier said than done) , to encourage consumption growth, or to reduce balance sheet fragility. Whenever the PBoC or anyone else does something, I try to figure which of the three, if any, they have accomplished. If none, then I assume it doesn’t much matter.
Thanks Professor Pettis,
In your book, Avoiding the Fall (and on this blog), you emphasised that average growth of c.3% can be achieved in China if the reform programs proposed at the third plenum were implemented, delivering a shift in economic growth from the state sector to the household sector (apologies if I haven’t got your comment exactly right, my friend is reading the book at the moment). The recent article in Forbes provides some high level observations (primarily sourced from Reuters) regarding a split in Beijing between reform and debt fuelled growth:
http://www.forbes.com/sites/gordonchang/2015/05/24/did-china-just-launch-worlds-biggest-spending-plan/
It seems that more recently the geo-political ambitions of Xi are starting to take priority over reform. This lends itself to a possible harder landing than many envision for China’s economy.
Former Federal Reserve Chairman Alan Greenspan commented last week that the most concerning piece of news around the world for him was the order by the State Council and the PBOC to Chinese State Owned Banks not to foreclose on existing loans, even if borrowers default. He believes this will effectively freeze up a significant chunk of savings in the economy and put pressure on newly generated savings to be funnelled into covering the losses on loans that the State Owned Banks cannot foreclose on. Ultimately, this would contract future growth as savings are no longer being invested into the most productive new projects. I recall you also talking to this issue in your book as a possible outcome – instead of recognising real losses the Chinese government could force a long amortisation process, similar to Japan in the 1990’s, and suppressing future economic growth.
The talk I refer to is a recent conversation at the Peterson Fiscal Summit 2015: https://www.youtube.com/watch?v=pfpEHwARhvc
“Credit Suisse put net private American wealth at $42.9 trillion, compared to $4.7 trillion for China: a ratio of more than 9:1”
These figures are from 2000, why are they relevant in 2015?
He already commeneted on this further up.
Michael, Not sure I understand your comment on Google search. I think it will be accounted fairly but current GDP measurement. If you do anything economic, say based on search come up with a new business idea that generates value, then it would be accounted on its own in GDP. The value of search to you is also accounted by amount of advertisement you see (and if that leads you to take action) then it would be accounted as well. If google search leads you to be more efficient, make more economic decisions then it would be accounted as well. Accounting for it in anyway else would be double counting I think. Thoughts?
the point was that the increase in economic welfare resulting from instant access to the sum of human knowledge is much greater than google’s revenues – the contribution to gdp might be accounted for correctly, but doesn’t really reflect the improvement in people’s quality of life (the consumer surplus is huge, partly because the price of a search is effectively zero). I’ve also thought for a long time that when people talk about the problem of rising inequality and stagnating working class wages in western countries over the last generation their rhetoric fails to recognize that everyone in the west who has a smart phone almost certainly has a higher standard of living than anyone living in the 1980s, even if their real wages are no higher and real prices of other stuff they buy have gone up
Inequality is a problem, but it’s a problem in a very different way than the way most people who think it’s a problem think of it as.
Many of these people think that equality is the goal; that in the end everyone should be the same in everything. They view winner-take-all effects as morally wrong and feel that if everyone isn’t the same at everything, guns and violence should be the first thing to equal the playing field. Rather than be grateful for the blessings they were given, these people automatically blame those that have more for their faults. Such a person is Karl Marx. Unfortunately, I wish I was exaggerating about this topic, but I’m not.
What kind of psycho wakes up in the morning thinking that because someone else has more than I do, has certain things I approve of to be vices that I can’t in any way defend with any sort of reasonable sense, or does things I don’t approve of then gives me the right to completely ruin them because I perceive myself to be superior by not having those supposed faults.
The thing is I run into these kids all the time. It makes me wanna slam their faces into a wall, not because I don’t like their ethical or logical structure (I don’t give a shit about that), but because every opportunity they get to use someone else’s force any chance they get to ruin people who are more virtuous and prudent than them. Often times, these are the same kids who claim that they’re not violent and have no pension for violence while claiming wealth is what causes violence AND that more violence should be used to overthrow and ruin anything they disapprove of but that the source of violence they want to be used is never involving of them in particular.
Then these same aforementioned people then claim that they’re completely “rational”, but they have very little ability to investigate systematically, possess no rigor, make implicit assumptions on a regular basis without realizing it, talk about things no one can possibly understand, and make gigantic logical leaps all the time. The worst part is that these are the same people that run the social science and humanities departments in our universities. If you think academic economics is bad, then you haven’t seen all the other bullshit they teach.
Sorry for the rant that seems offensive, but I really do run into this kind of thinking EVERYWHERE. I’ve sat in classrooms where professors are literally propagandizing kids with this kind of nonsense who’re indirectly getting paid by the same guys who they seem to denegrate and want to ruin.
Survey,
FYI, Upon further review I have reevaluated my perspective on Zeihan, and am surprised at how close many of our long term study interests, it seems, have yielded similar perspectives. There are few places where our perspectives diverge, and he is one, like Michael, that needs to be heard. I wrote a piece on Global Governance for a journal, and couldn’t, actually could, believe, how far removed from reality some perspectives of fellow authors were. Well out on some fantastical plain of philosophical indifference to reality, trends, a more clear review of history, a non-ideologogical, non-bias based view of what is happening, free of my personal interests. Such an important issue, and Zeihan, really puts in focus so many issues that are simple, basic, direct and useful for adding to ones worldview. Where’s most people are running around in personal ideal world on tang Niall fantastical plains of no relevance where modal verbs (would, should, coulda) and adjectives (better, best, good, bad, evil, etc) reign to the detriment of, by the year 2050, country X will have Y, whereas country Z will havey(+\~^%)…. A few areas we disagree. It is a shame, really b cause people are so far out in som fantasy land.
I would like to see what DvD thinks about zeihans notion that th global baby’s-boom population has created both volatility, rising debt loads, and these booms and busts, with capital cheap now, and expensive around the world in the future, for x number of years, against his/her, normal load of criticism.
I do like Zeihan because I think he’s one of the few geopolitical guys that actually doesn’t completely throw finance out of the window. For example, if we take someone like Ian Bremmer who just assumes China’s growth rates are sustainable while saying China needs to rebalance its economy without realizing the contradictions between those two statements. While some of Kaplan’s views aren’t as egregious, he still displays an ignorance towards finance.
The one thing I can’t stand is when random people start using “globalization” without understanding what it actually is. It’s shocking how few people realize that globalization is just liquidity movements/capital flows. This one single realization leads to many, many errors and flaws in both thought processes and conclusions. For one, Zeihan (although he doesn’t have a deep understanding of globalization) doesn’t mindlessly throw out terms and then go on to use some linear logical process that completely ignores 2nd and 3rd order effects like others.
I think Zeihan could be particularly right about the impacts of climate change, which are little related to rising average temperatures. The real risks lie in shifts of weather patterns that can change the swaths of arable land and the shifts in water movements. A far bigger worry than rising water levels or rising average temperatures is shifts in weather patterns for certain countries that, for example, rely on 2 weeks of any given year for most of their rainfall.
Zeihan points out what’s obvious and right in front of our faces that many people choose to ignore, primarily out of ideological zealously or things they can’t fathom or imagine or other things they feel to be morally wrong. It’s easy to tell that Zeihan used to work at Stratfor.
Not familiar with Zeihan.
Which doesn’t mean we can’t discuss the role of demographics in the current situation.
But, since you bring it up and since i’m not familiar with the notions you are referring to, can you please first be more explicit on how exactly the global baby boom population has created rising debt loads (on a per capita basis and relative to production and income per capita) as well as boom-bust sequences in asset price and economic developments?
Thank you
DvD,
These should sum everything up. They’re not long videos.
https://www.youtube.com/watch?v=_hMYp8zSdYQ
https://www.youtube.com/watch?v=n9zH1dWeKE0
Here’s an hour long video. I think you’ll find it extremely interesting. I also recommend his new book, The Accidental Superpower, which is primarily about the US. His entire thesis is about the upcoming shifts in the world’s geopolitical financial structure and the upcoming US retrenchment.
Thanks for the videos of Peter Zeihan. I watched the two short ones on demographics and the long one to get a broader perspective.
The first thing to say is that it’s a good show. Stage performance is a job in itself, perhaps the most important one for “experts” like him working the conference circuit. He certainly does it very well.
As for CSteven statement that the global baby boom generation has created rising debt load as per Zeihan:
– From the video, Zeihan’s assumption is that mature adults aged 45-65 have a higher than proportional share of wage income and are capital rich and seeking outlets for their savings while young adults aged 20-45 have a lower than proportional share of wage income and are capital poor and seeking to borrow for their spending. Retirees above 65 are presumed neutral. Taking data from the US Census Bureau, the ratio of mature adults (45-64) to young adults (20-44) started to increase in 1991 from 0.46 and is peaking since 2011 around 0.78-0.79. If Zeihan’s assumption was true, there would have been relatively more working age people in debt-pay-down mode than working age people in borrowing mode between 1991 and 2011. Yet, US household debt to wage income skyrocketed from 129% end 1990 to 220% in 2009 and 197% end 2011 largely thanks to write-downs. Zeihan’s arguments seem completely contradicted by the empirical data. But perhaps it’s not fair to stop here, for his lifecycle pattern sounds intuitively plausible. The “mature adults” among us might be able to relate their own personal experience to this pattern. So, if Zeihan’s lifecycle pattern is correct after all, and yet US household debt / wage income has evolved like it has, it can only mean that household debt load has increased despite this lifecycle pattern acting as a deleveraging influence. In which case, whatever the drivers for the rising debt load (I have suggested some, what CSteven refers to as my “normal load of criticism”), they are even more powerful than initially envisaged because they have more than counteracted a demographic trend pushing in the other direction.
– The above paragraph looks at the demographic argument from a domestic US perspective. Perhaps it is not the appropriate perspective. Perhaps, the argument is meant to work globally in the sense that capital-rich developed economies with a “mature workers” demographic profile have financed the investment needs of capital-poor developing economies with a “young workers” demographic profile. Since, up to 2009, rising debt load were mainly a characteristic of developed countries rather than developing countries, we might conclude that capital rich developed economies didn’t finance the capital needs of capital poor developing economies by debt but rather by equity. This would be consistent with the large flows of direct foreign investments from rich to poor countries since the mid-1990’s. So, taken globally, Zeihan’s demographic argument might be valid but it would explain rising equity inflows in the form of FDI into developing countries rather than rising debt load in developed countries as CSteven suggested. But then, if the savings of developed countries mature workers have been channeled to developing countries as equity investments, who on earth financed the steeply rising debt load of developed countries seen during that period? Where did it come from? Here, you can’t escape the worldwide duplication of credit out of the same pool of real savings arising out of the combination of global trade imbalances and fractional reserve credit systems in a set-up where cross exchange rates are not set at levels equilibrating cross trade balances, thus allowing systematic labor cost arbitrage on a global basis. This is the root cause of the too low global demand / too high global supply forcing up global debt load with the help and encouragement of inappropriate monetary policy. Which is my “normal load of criticism”. A simple reform of the world exchange rate system towards fixed but adjustable exchange rates equilibrating cross trade balances and a simple evolution of the credit system towards full reserve (100% money) are necessary to get the same benefits out of global trade without the major drawbacks that we are now experiencing.
Please let me know if you have a different understanding.
Thank you
DvD,
While I do tend to agree with you on demographics in relating to the globalization cycles, I do think that consumption smoothing does account for some part of the capital flows.
BTW, the household debt/wages numbers and the rise in household debt is something Zeihan talks about in the exact manner you say he’s wrong, ironically enough. When you’re 35, you need to buy homes, cars, you have expenses that come up seemingly randomly because your kids do stupid shit, you’ve gotta peddle them in and out of soccer practice, etc.. Basically, the 20-45 age group (as Zeihan says) are net borrowers and will always be net borrowers.
Also, when you talk about “debt paydown” of the 50-65 age category, they can accumulate assets rather than pay down debt.
Let me restate that I DO NOT think Zeihan’s arguments about demographics being the primary driver in capital flows (consumption smoothing) is correct, but I do think it’s likely to be a smaller factor–I think the primary factor is interest rates/monetary factors.
As for your attacks on Zeihan, Zeihan’s geopolitical perspectives are actually one of the best out there. If you read Stratfor (I do), virtually all of his views are in line with Stratfor, but this shouldn’t really be surprising as he used to work there.
The most valuable thing I got from Zeihan’s analysis and perspective was very specific, targeted data and facts that allow us to have sound perspectives to think about. For example, he’s got a wonderful map in his book about the countries that import most of their calories. Now if we combine that with a world where trade is protected by American naval power, capital is cheap and abundant, and security/protection of trade costs are basically nil; any small shift in the underlying circumstances causes major shifts in patterns.
Another area I think Zeihan understands risks better than almost everyone is on the issue of climate change. The “risks” constantly brought up by ecologists and biologists aren’t really the true risks. The real risk of climate change is not sea levels rising and sinking a few cities or even the Arctic melting. The primary risks of climate change are its second and third order effects like how shifting weather patters can manufacture shifts in the location of fresh water, how shifting climate patters can shift swaths of arable land, how the possible resource wars could break out, etc..
From a geopolitical sense, Zeihan’s perspective seems to make more sense to me than most others out there.
DvD,
Here’s a good intro to Zeihan’s book. This video is about an hour long, but I think you’ll find it interesting. His geopolitical stuff is pretty dead on.
Here’s the link.
Yes about Google but UGTBK about the phone. PU for kids in terms of distraction, sensory deprivation, inability to read faces and so to empathisize. A generation of sociopaths raised to consume content not produce content which is irresistable when you sit at a desk to be in front of a screen and with keyboard at your fingertips.
This generation of sociopaths should include me according to your description.
Yes, but they said even worse about TV. The kids lose something that we know about but gain something that we won’t know about for many years.
what was it we gained from TV?
With television we gained a means to spread knowledge quickly, a form of entertainment, and a common set of images and ideas. It is easy to disdain what television has produced, but I do not think that before television we were people of higher learning or morality.
We are always told that new technology will turn us into lower quality humans, that trains would cause women to give birth to monsters, that telephones would eliminate long, thoughtful letters and so would make us stupid, that radio would eliminate our individuality. When the movable printing press became popular, we were warned that because now books were cheap and would be written for stupid people, we would lose the quality of elite thinking. Also if ordinary people could read the Bible for themselves rather than had it correctly explained by highly trained priests, they would misunderstand it and become depraved.
New technology always frightens us that we are becoming more stupid, or less moral, or more depraved, but throughout history it seems that smart people behave with intelligence and stupid people without. With the new internet technology, perhaps we will lose some things, like the discipline of memory, and perhaps we will produce less content, as you say, but we will gain from the ability to process content more quickly, and those with more imagination, logic or creativity will give us more even as those with more ordered minds, the brilliant accountants and engineers, give us less.
Maybe Mr. Pettis welcomes the world of google search because his great talent is to look at the same things all of us see, and to make startling comparisons and logical conclusions which, once he has shown them to us, seem so clear and even obvious. Of course he will welcome any technology that allows us to look at more things from more angles, because it gives people like him an advantage, even as it lessens the advantages that others had, who we once admired.
For example, in the future will we admire the qualities of good doctors as much as we admired them in the past, if a kind of search engine can take our symptoms and more correctly diagnose our diseases? But what we lose is replaced with something whose value we will not always recognise at first. This is our history.
Just a note, I think you’re right about the average person, but in these kinds of domains, the averages don’t mean anything. It’s the extremes that matter. In today’s world, the potential is virtually unlimited. The world is more winner take all than ever before.
I don’t watch TV btw.
“The discussion paper, published by the London School of Economics, found banning mobile phones in schools resulted in a 14.23 per cent improvement in test scores for low-achieving students, and a 6.41 per cent improvement overall in the schools that had introduced a ban.
That benefit was equivalent to an additional hour of school a week, or increasing the school year by five days, authors Louis-Philippe Beland and Richard Murphy wrote in The Conversation.
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Nonetheless, the authors – both assistant professors of economics in the US – noted that phone bans had “no significant impact” on high achievers. They primarily looked at test scores at age 16, but could not replicate the same results for 14-year-olds – an outcome they suggested could be explained by “low phone use” at this age.
The paper, titled Ill Communication: Technology, Distraction & Student Performance, also concluded that mobiles could still be useful as a learning tool “if their use is properly structured”.
The study examined test scores from 91 schools across four English cities between 2001 and 2011. During that time, all but one of the surveyed schools introduced some sort of ban on phones. The authors surveyed school officials about their mobile phone policies and the rigour with which the policy was enforced.’
———
The problem is the time lag between the overwhelming uptake of the technology, disintermediating the value chain, and the time taken to think up new intermediaries. In the mean time productivity gains contribute to stagflation.
Who cares about test scores? I’m sorry, but if you’re talking about how unnatural phones are, there’s nothing more unnatural than forcing a bunch of kids to sit a classroom so that they can be told what to do by some person. Why the hell would you expect kids to want to sit in a classroom? If you put metal bars on the windows and doors, there’s nothing separating a classroom and a prison.
BTW, those studies cannot account for winner-take-all effects. As I’ve said, averages don’t mean anything and the sample mean is never indicative of the true mean in domains with winner take all effects. Note that anything involving technology almost always has winner take all effects.
Exactly. Google’s activity is certainly added to GDP, but the amount of value it has created for me far exceeds any addition to GDP my behavior might have added. This happens all the time, but I wonder if the recent technological changes in the past two decades haven’t caused a major gap in valuation. Ignoring economic transactions it has facilitated, my smart phone, for example, has transformed my life almost as much as Google search, and by far more than the few hundreds of dollars I have spent on my phones. I have so many more hours every day.
I find that reasoning a bit odd, the google search example. The same reasoning holds for all technological progress all through history. It is the point made by Richard Koo that the washing machine and the fridge have enormous worldwide eonomic impact by freeing (mostly women) from the task of fetching water, washing clothes by hand, and shopping food daily with no good way to store. You would probably quickly dump your internet and google search if you would be given the choice of dropping internet or having to spend most of your day washing, water fetching, food buying/preparing.
Fascinating. Completely. There is an important book in this.
As money speak is the only doublespeak, it needs to be reinforced not just to the Chinese but also to DC and the Fed who fall ever more under the sway of Wall street, that making policy which reinforces some freak financial starter advantage of a handful of neither the best nor brightest but the most unethical, violent , or politically well connected, means volatility which means risk and risk is correlated with discount rate!.
Now about the risk to humanity. Will corrupt plutocrats in the US and China bristling over who has the biggest GDP start with miltary skirmishes and ethnic cleansing and move on to all out war? Will soaking the US middle class and laundering through ZIRP with each crash of the business cycle or oppressing the Chinese middle class at a time of slowing economic growth mean civil war and revolution in either country? These scenarios would certainly put a halt to stagnation! And then there is the risk that neither China nor US leaders look to history and grow humane social and financial institutions ( and lets be clear most came neither but from Europe! ) which have evolved to not only encourage and temper capitalism but nurture universal human rights. It seems to be what the Chinese want too. With the avalanche of borrowed money smuggled out of China in suitcases went their children!
I can’t work out what this essay is about at all…
“Credit Suisse put net private American wealth at $42.9 trillion, compared to $4.7 trillion for China: a ratio of more than 9:1… US GDP is 1.8 times China’s GDP…This might at first seem strange.”
It doesn’t seem strange to me at all. GDP is a flow; it is a function of money over time. Wealth is a quantity. There is no reason why one should be related at all. Didn’t Pettis make this same point in one of his recent blogs? I can’t see the reasoning here.
“estimates of total household wealth represent…the total market value of each economy’s assets…it seems that every dollar of American income is 5.0 times as valuable as every dollar of Chinese income.”
What? Why? This seems like a reversal of reality. Assets generate income; income doesn’t generate assets (obviously it can, if retained as savings, but that’s a separate equation). It’s not clear what the concept of the “value of a dollar of income” would even mean.
“To put it in stock market terms, the US P/E multiple is five times the Chinese P/E multiple.”
No, the total household assets isn’t much like the price of a company. The price of a company is a variable determined by the market. Total household assets is largely a stock of fixed assets. I understand the comparison, but it seems spectacularly inapt, because the largest asset held by most households is real estate, which is a non-productive asset.
The total wealth of a country is fairly obviously going to be a function of how long the people in that country have been amassing wealth. In the US, it’s been going on for a lot longer than in China. Where’s the mystery?
I think there is a lot of confusion here, Phil. The essay is about how to think about and value the ability of a country to increase the amount by which it produces goods and services (including welfare) and adds to the value of capital stock, and how this is related to attempts to measure these quantities. Not only is this not such a strange thing to do, but you can argue that it is one of the most commonly discussed topics of all.
One thing. You say: “The total wealth of a country is fairly obviously going to be a function of how long the people in that country have been amassing wealth. In the US, it’s been going on for a lot longer than in China. ”
I think this is fairly obviously incorrect. I am not sure why you think the US has been amassing wealth longer than China, but I think we can agree that at least in “modern” terms it hasn’t been amassing wealth as long as France, Spain, England, or any of a number of other countries, and yet I think it wouldn’t be easy to argue that it is therefore poorer. It is precisely because of confusions like this that I hope my essay might be useful. Clearly people have a great deal of trouble understanding these ideas, and I would suggest that just the idea that there is anything at all obvious about any of this might be a very red flag.
Thank you for the reply, Prof. Pettis.
I remain unconvinced. I’m sure the discussion of GDP and econometrics generally is valuable, and so I suppose it doesn’t matter that your lede was weird. But it is weird. I mean, I can see the value in thinking metaphorically about a country’s economy – and comparing it to a company with a P/E is just that, adopting an unusual metaphorical view to see if it yields any insights. But I can’t get over the problems that I identified:
1) GDP is not wealth creation. A portion of GDP is consumed, so it is non-consumption GDP which contributes to wealth. The link between wealth and GDP doesn’t make any sense without reference to the consumption ratio.
2) Most Chinese assets are non-productive (basically, housing). I’m not sure if that’s also true of the USA, because it has such a large commercial sector. It’s possible that the USA’s productive assets are worth more than its non-productive assets. But still, this is another ratio (productive/non-productive assets) that has to be included before the comparison makes any sense, surely? A company’s market value is a calculation that assumes the entire unit to be productive; a survey of national assets is not.
I can’t see what you even mean by your comments on time spent amassing assets.
“I am not sure why you think the US has been amassing wealth longer than China.” I’m only taking a common sense approach here: China went through horrific war and revolution in the mid-century, so in 1978 its asset stock was very low indeed. Any measure of assets will show that – in light of recent massive consumption of concrete and steel, those numbers have been thrown around a lot. As I recall, China still has much less steel infrastructure per head of population than the USA, right? And that’s fairly obviously a function of the fact that it has been building steel infrastructure for a much shorter time. It’s still playing catch-up. I’m not sure if you want to dispute these ideas, but you can’t tell me you haven’t heard them before!
“the US…at least in “modern” terms it hasn’t been amassing wealth as long as France, Spain, England”
I certainly wouldn’t agree to this. Modern assets are basically modern transport infrastructure, steel buildings, and utilities (including communications). All of these have been built exclusively since 1900, in the USA and elsewhere. The one exception is institutional capital, and the USA got a massive leg-up by importing a lot of political ideas from France and the UK.
Also, I did say “a function”, not “proportional”. Clearly there are exceptions, but as a rule of thumb, the countries which started modernisation in 1900 are rich, and those that didn’t aren’t. I don’t think that’s a confused observation.
Your reasoning sounds more circular than common sense to me, Phil. Japan also went through a horrific war and revolution mid-century, and yet Japan is rich. Basically I think what you are saying is that countries that are rich are rich because they got rich, and countries that are not, didn’t, and you can’t really use this to explain value.
You also say: “GDP is not wealth creation. A portion of GDP is consumed, so it is non-consumption GDP which contributes to wealth. The link between wealth and GDP doesn’t make any sense without reference to the consumption ratio.”
I don’t want to take sides here, but I agree that this is totally confused. GDP is not wealth creation, but for the reasons Professor Pettis outlined. It is meant to be a measure of wealth creation, but accounting for wealth creation is hard, and so it fails to be a perfect measure.
The idea that wealth does not include the ability to make things that are consumed is totally backwards. Wealth consists only of the ability to make things that can be consumed, either now or in the future. The more goods and services the US can produce, which is what GDP is supposed to measure, the wealthier the US and the more valuable its assets. Also the higher the quality of that GDP, the wealthier the US and the more valuable its assets.
To measure the US wealth as a function of GDP and to compare it to a P/E ratio is not weird at all. It’s sort of obvious, and is the US is more valuable relative to its GDP than China, then it is exactly like a company with a higher P/E than another company — either the quality of its earnings is higher, the risk of bankruptcy is lower (for a country that could be the risk of a financial, political or demographic collapse), or its growth potential is higher.
Internet companies are obviously not the right analogies because an internet company is usually valued mostly as as an option on future earnings potential, and not as a a set of higher or lower quality earnings, but most companies are valued on the basis of their ability to produce an income stream from producing things that are mostly consumed, and their P/E ratios measure the quality of that income stream.
Think about a company that consists of a farm. The farm produces stuff that is either consumed immediately or saved to be consumed in the future. What’s the value of the farm? It’s the discounted value of its expected future food production, plus any additional expected value it might have (quality of life, more lucrative future uses of the land, etc). That is expressed as a P/E ratio, and the stability in the value of the food it produces, or any expected growth in its value, or the possibility that in the future the farmland might have an alternative, more valuable use (which I believe is is the equivalent of the option the professor described as the “unexpected creation of an important productivity-enhancing technology”), and so are all things that would increase the farm’s P/E ratio.
The analogy between a company’s value expressed as a P/E ratio a country’s wealth expressed as a function of GDP may not be not perfect because countries are far more complex and have very difference governance characteristics, but it is extremely apt, and I am sure the professor will easily admit that he is not even the first person to make the analogy. It is pretty common.
Thank you for the comment.
“GDP…is meant to be a measure of wealth creation”
Yes, but as I said, every year a country consumes a certain portion of the wealth it creates. Two different economies could have identical GDPs, and yet economy A’s wealth could grow more than economy B’s. Why? Because A consumed less of its GDP. This is nothing to do with the error in GDP measurement, it’s just the definition of GDP (Y=I+C+G…).
“The more goods and services the US can produce, which is what GDP is supposed to measure, the wealthier the US and the more valuable its assets.”
No, this is only true of productive assets. If house prices go up 10% in a year, that doesn’t make the houses more productive.
Phil H: You say that the US is wealthier than China because it has been amassing wealth longer than China, not because it produces more GDP than China. But what is this wealth that is being amassed? I am sure you don’t mean gold and silver or paper money. You must mean mainly productive assets that produce things we can consume, plus also a few items of consumption that retain value, like art, or national parks. This means the US is wealthier because it has amassed more assets that produce goods and services that can be consumed, which is the same as saying that the US is wealthier because it has a higher GDP. If you disagree, I am interested in knowing what are these assets that the US has amassed that has made it wealthy.
Thanks for the reply. I said what the assets are in my comment: modern economy assets. Steel buildings, road networks, rail networks, airports, telecoms networks. China is still way behind the US on all of these metrics.
“Most Chinese assets are non-productive (basically, housing).”
I don’t think most Chinese assets are housing. I think most Chinese assets are factories, infrastructure, farm land, mines, commercial real estate, and most of all the productive capacity of educated and uneducated Chinese labour, and this is true of most countries, including the USA. I also do not understand why housing is non-productive. It produces an important consumer item, just like factories, infrastructure, farm land, mines, commercial real estate, and the productive capacity of educated and uneducated Chinese labour also produce consumer items. Why do you think wealth is separate from consumption? Isn’t it that my wealth is the sum of the things I have that I can consume plus my ability to acquire more things that I can consume, either directly or in exchange.
I think maybe you are a little like King Midas, who confused wealth with gold, and not with the ability to exchange gold for things that he could enjoy or consume.
Thank you for your comment.
I may be wrong about the mix of Chinese assets, but given how real estate prices have soared 10-fold in the last ten years (and the economy only doubled in size), I would expect the value of housing to now make up a very significant proportion of the value of Chinese assets. I guessed over half; I may be wrong.
You don’t know why housing is non-productive? Because we don’t produce anything with it. Also, crucially, because its value does not depend on its ability to produce future revenue. Housing is consumed, and its value depends on how much we want to consume it, not on how much money it can create.
“Why do you think wealth is separate from consumption?”
Wealth is a quantity; consumption is a rate. They’re mathematically distinct.
@Prof, The CS report on national wealth might be better characterized by you in this essay as a measure of “enterprise value”- not an accounting entry of assets-liabilities on the balance sheet of each country. A market-discovered price of enterprise value is comparable to P/E as a market-discovered price, not a accounting report of earnings to book-value.
National wealth, or the book value of net assets in a country is generally lower in countries that bought (invested) in assets long ago, such as France and England- and USA., because the assets usually remain on the books at “cost” and not market-value. The cost of concrete, copper and oil was a 1/10th of its current price, and the infrastructure assets are booked at cost, not market rates, or ongoing economic value.
The accounting measure of book value is rarely important- rather as you belabor constantly… it is the structure of the balance sheet and the ability to service debt with a cash-flow that is important, The economic ability of a country’s “enterprise value” to produce a positive cash-flow is the important metric.
Overall I found your hand-waving and philosophic-delve into GDP and weigh-loss illuminating. I was not disappointed in the lack of a conclusive description of what the exact china/usa ratio should be. 1) Institutions, 2) diversity of cashflows, and 3) structure of liabilities matter greatly- and qualitatively the USA is clearly ahead of China.
‘No, the total household assets isn’t much like the price of a company. The price of a company is a variable determined by the market. Total household assets is largely a stock of fixed assets. I understand the comparison, but it seems spectacularly inapt, because the largest asset held by most households is real estate, which is a non-productive asset.’
… but how is the value of real estate determined? if I own a piece of prime agricultural land in New York State and a similar piece of land in eastern Ukraine, it’s probably fair to assume that one will currently be more valuable than the other, and for the same reason an apartment in San Francisco will sell for a higher price than a similar apartment in Detroit (because San Franciscans generate more GDP per capita, not because California is a nicer place to live). If I have a million dollars in a US bank and a friend has an equivalent amount of money at current exchange rates in a Greek bank, we can’t assume that the value of our accounts will still be the same in ten years time. All wealth (savings, stock, real estate etc) is a just a property right, and the value of property is always determined by the market (think Greek bank deposits). Apparently equivalent assets in the US and China will sell for a higher price in the US if they are used more productively in the US, and if so the owners of US assets will be wealthier than owners of Chinese assets.
‘The total wealth of a country is fairly obviously going to be a function of how long the people in that country have been amassing wealth. In the US, it’s been going on for a lot longer than in China.’
This makes sense if you mean the US has been accumulating capital for longer than China and so has more infrastructure/machinery/know-how etc, but then ‘wealth’ is just another way of saying ‘market value of land and capital’. The question is why, if China’s land and capital is capable of generating a similar GDP to the US at PPP rates, is the market value of China’s land and capital so much lower than the value of US land and capital? Clearly there is something weird going on, and expectations of future earnings should be a part of that (restrictions on the sale of Chinese assets to foreigners might be another, of course)
I think your last sentence gets it right. One might expect two assets of similar productivity to have the same price IFF they are being traded in the same market. But American assets and Chinese assets are not being bought and sold on the same market at all.
Because if the wealth of America > the wealth of China, but the GDP (i.e. the utilization of that wealth) of China is a greater proportion of their wealth than America’s, then wealth should transfer to China to seek a better return through a higher utilization.
If that hasn’t happened, then there must be confounding effects. Pettis’ argument is that these confounding effects can be found in a risk assessment, and not, for instance, through structural impediments to wealth transfers.
Excellent post.
IF the WORLD BANK is expounding this PPP nonsense, as you so clearly describe, (and I agree), then what does that tell you about the world bank? They are pushing a political agenda where the US can tell the world to cheese off b/c the world is “apparently” wealthier than they think. ALL application of PPP adjustments will bias ALL GDPs toward equality b/c they are measuring “output” in “output” you can purchase using the output you just produced. ENtirely circular and a rubbish argument! TOtally agree w Prof Pettis.
I wouldn’t be so harsh. PPP adjustments do have value in specific cases, but there is no objective mechanism the World Bank can use as a filter, and certainly none that cannot become politically charged.
No problem. But i do believe it is tautological, the way “purchasing power” is defined and understood, that PPP will bias any GDPs (high or low) towards parity in the middle. it’s circular. Just pointing out flaws vis a vis circular thinking, as such it’s a useless tool.
There is also the problem, widely understood but no one knows how to resolve it, that GDP is better at measuring how many carrots or how much steel you produce, but tend to underestimate more sophisticated kinds of production that embed service, so there is a bias that affects poor countries differently than rich: the more wealth creation is likely to be understated and inflation overstated the more advanced an economy is.
How much of the US “wealth” will evaporate again when the market crashes next time? 5,10,20 trillion? Financialization is not wealth creation. Much of the american “wealth” is an illusory, non-existent, debt/FED fueled bubble.
But who knows, maybe the american taxpayer will get TARP-ed again, and the rich can keep their illusory wealth.
Of course the monstrous chinese real-estate, overcapacity and stock exchange bubbles are not any better.
In sum then, comparing the illusory, debt-fueled american “wealth” to illusory, debt-fueled chinese “wealt” is a useless lunacy.
I think total American wealth and total Chinese wealth consists of a little more than high-flying stock markets. I know that comments filled with mis-spellings and that mutter about conspiracies, and vast illusions, and lunacy aren’t normally taken seriously, but you should consider that the US economy actually does create quite a lot of stuff, enough to keep a lot of people not just alive but consuming in fairly wasteful quantities, so maybe it isn’t all illusion. And yes, there is a lot of debt. But people don’t eat debt. They may borrow to overeat, but they eat stuff that’s produced, most of it in the US if they are American or in China if they are Chinese.
Thanks for proving my point. Yes, indeed, they borrow to eat and consume, ie the production would not exist without the unsustainable debt binge, hence it´s illusory.
Anyway, i didnt say all the wealth is illusory, what im saying is that it´s a lunacy to compare two bubbles. The “wealth” that disappeared with 2008 crash was not really wealth, because the real wealth does not just evaporate, from day to day. What im saying is that much of the presumed wealth is in fact illusory and will evaporate when the current bubbles burst. And i dont only mean the stocks bubble, but also the governments finance bubble, etc.
OR in short, what im saying is that you cannot print wealth. You may consider this a conspiracy, but in fact it´s only basic economics, or common sense.
according to the Credit Suisse report mentioned above, net American private wealth was $64.5 trillion in 2007, and $83.7 trillion in 2014. so how did American households accumulate this extra $20 trillion private wealth in the 6 years since the great recession? Most American wage or saving has not increased in these 6 years. So i think this extra $20 trillion wealth is mainly due to increasing asset prices.
Energy use is a good way for country comparisons. There´s no economic activity without energy, more economic activity = more energy used.
Total energy consumption in China was 3013 Mtoe, in the US it was 2187 Mtoe. China thus consumed 38% more energy. On the other hand, energy efficiency in US is higher than in China. Energy intensity of GDP in China was 0,261$/koe, while in US it was 0,158$/koe, so China needs 68% more energy for the same output. From this we can calculate that the US GDP is roughly 20% higher than the chinese GDP.
The data is for year 2013 and energy consumption in China is rising by roughly 5%/year, while in US it´s more or less stable. That means China should overtake US as the biggest economy sometime in 2017-2018.
pretty sure the energy intensity figures are calculated from GDP and energy consumption data, rather than the other way round
which means the conclusion in the last paragraph depends on the accuracy of the data for China’s current GDP, which is what much of the debate is about. and straightline extrapolation is always a dangerous game, of course
To even think that awesomeness of Google search can be counted towards the GDP is plain stupid.
Of course Google makes our lives thousand times more efficient and gives us a great benefit. So what?
I get a lot of pleasure from spending my time with my kids and my wife, recharge my batteries at home and work more efficiently. Should we count my family members towards the GDP too?
strictly speaking, yes
Not merely pleasure, but the information and knowledge gained, the ability to make better decisions, avoid pitfalls, and to operate more efficiently goes far beyond the beneficial effects of pleasure, it is ridiculous that you could even make such a statement. Google has altered absolutely everything.
If the pleasure of spending time with your family could be measured accurately, Johnnyboy, of course it should be counted as GDP. To put it crudely, if you have sex with a girl, it doesn’t become part of GDP until she charges you, in which case it adds to GDP by whatever the amount she charges. It shouldn’t be hard at all to understand from that example why GDP is so hard to measure accurately.
Because you don’t find the use of the word “stupid” in a debate offensive, of course you won’t mind my telling you how incredibly stupid it is when people do not understand this very simple idea. As a rule, I find that whenever a commenter begins his comment by pointing out how stupid someone is, there is a high probability that he isn’t terribly bright and will follow it up with something idiotic. You don’t disappoint.
So let me try this: I should charge you for posting comments. This would make us both happy. Why? because in my world, total value created is unchanged, but because I get paid to read your comments, there is a transfer of wealth from you to me. In your world, GDP is higher by the amount you pay, and so you believe that we are actually wealthier in the aggregate. Do you see the paradox here?
Paradox: a statement or proposition that seems self-contradictory or absurd but in reality expresses a possible truth.
The thesis of the article reminds me of interesting and controversial theory appeared around 2006 which tried to explain the perpetual US trade deficit by proposing that the US is in fact not a net debtor, but a net creditor, if we simply factor the awesomeness we export into the current account data. The authors of the theory, Ricardo Hausmann and Federico Sturzenegger, dubbed this mysterious and magical American export “dark matter”. It actually consists of the expertise and know-how we export to the rest of the world.
Brad DeLong explained the theory well in a 2006 post on his blog titled Dark Matter. So below is his interpretation of the theory.
In the BEA’s book-value accounting, in 2006 U.S. companies will invest $600 billion in foreign direct investment elsewhere in the world and In HS’s accounting, that $600 billion in visible FDI will be accompanied by $300 billion worth of “dark matter” organizational and technological know-how that American firms carry to their operations abroad. The FDI flow will thereafter generate as much income as would a pure $900 billion bricks-and-mortar FDI flow.
In the BEA’s book-value accounting, U.S. residents will also purchase $600 billion in foreign securities, and U.S. banks and other corporations will acquire $400 billion in loans payable and other credits. The gross overseas asset accumulation of Americans will thus amount to about $1,600 billion (in the BEA’s book-value accounting) and to about $1,900 billion of income-producing assets (including the $300 billion of “dark matter” that boosts the income-producing potential of U.S. FDI).
Now let’s look at the liabilities side. In the BEA’s book-value accounting, in 2006 foreign governments will invest $800 billion acquiring U.S. securities–Treasuries, Fannie Maes, and others. Because the U.S. is at the center of the world monetary system it has the “exorbitant” privilege of being able to sell its securities at lower interest rates. In HS’s accounting, that $800 billion consists of the U.S. providing foreign governments and central banks seeking foreign exchange reserves with $600 billion of income-producing potential and an extra $200 billion of “dark matter” liquidity.
Similarly, foreign private investors will spend $700 billion acquiring U.S. securities, which HS assess as consisting of $600 billion of income-producing potential and $100 billion of extra security–insurance because whatever happens to foreigners’ assets in their home countries, their U.S.-housed assets will still be there.
In addition, foreign companies will make $300 billion of FDI investments in America, and foreign banks and companies will acquire $600 billion in loans payable and other credits from U.S. residents. The gross accumulation by foreigners of assets in America will thus amount to about $2,400 billion (in the BEA’s book-value accounting), and to about $2,100 billion of incomes-producing potential (plus an extra $200 billion of liquidity and an extra $100 billion of security provided by the superior qualities of [the assets]).
The way that HS see it, U.S. trade is nearly balanced. We are importing some $2,000 billion and exporting some $1,200 billion of regular goods-and-services every year, but we are also exporting (a) $300 billion of technological and organizational knowledge via FDI, (b) $200 billion of liquidity services by serving as reserve banker to the world’s central banks and governments, and (c) $100 billion of security services by giving foreign private investors a safer place to plant their wealth.
Not really could this argument remind of that perspective, but for some peculiar operation of the mind.
Just watched an interview with David Stockman talking about the distortion created by low U.S. interest rates raising the value of total U.S. equity and debt to over 5:1 to GDP. He said it was 2:1 when he was Reagan’s budget director in the early 1980s.
This deserves some consideration. The global savings glut and Fed monetary policy has definitely driven down U.S. interest rates to unprecedented levels. This has had an incredible wealth effect on U.S. equity and bond markets.
I think David Stockman is completely convincing on this. Its possible for him to have been wrong under Reagan and right now I suppose.
Very quickly, and during the Reagan period, he renounced the economics, and manifestations, deformations of the economics, that are now commonly bandied about as related to Reagans beliefs,both by critics and supporters, both of whom like to create straw men, to destroy. Some who readily criticize the era for leading to the inequality we find today, others for pre2008 reference to success under the broader conservative free trade, and liberal cosmopolitanism banners, while some segments of conservatives still fail to see the blunders more broadly or how Stockman distanced himself and critiqued the policies recent to their enactment, while these said same supporters and critics are largely dichotomized around their profound ignorance.
We have the banner of “free trade” which China capitalized upon. They have their banner of communism.
Thank you for another thought-provoking article.
So, your message is that it is not the overall volume of capital (at cost) which is important but the more or less productive use of these accumulated savings, translating into a higher or lower asset value (at market) relative to production? In other words, it is the efficiency of the economic system in allocating capital towards the production of desired goods and services which drives value creation, not the amount of capital itself.
Completely agree. Judiciously allocated capital earns a good and lasting return by procuring great customers satisfaction and so constantly regenerate itself and compound over time, whereas poorly allocated capital earns an inadequate return by not meeting or satisfying demand and so can’t regenerate itself, which means no or slower compounding over time, hence much lower present value. This can be demonstrated academically but also, and more importantly, empirically: at a micro level, this is the secret of superior stock picking (ie. the ownership of strong businesses and management teams) and the essential lesson of Warren Buffett (with a little help from Charlie Munger apparently). At a macro level, the US has probably not become and remained the world economic powerhouse by coincidence or by the sole virtue of its geographic location and natural resources endowment, however important. If China aspires to sustainable world economic leadership, it is a lesson it needs to meditate, with the related and delicate question of what political system is best conducive to this more valuable economic system?
In any case, it’s true that both GDP and Total Capital measures are biased, “adjusted”, “revised” and sometimes outright manipulated (for example, the Fed simply deleted $ 2.5 Tr of corporate bonds from the US debt record between the first and second quarter 2014, meaning a change of statistical methodology alone altered the Capital / Output ratio of a large economy such as the US by 14 percentage points, showing that the impact of a single government statistician – not to mention a Fed chairman – on this ratio far exceeds the cumulative impact of thousands of zealous entrepreneurs). In fact, it is clear from all these Credit Suisse, Deutsche Bank, McKinsey, Geneva Reports on the World Economy reports that there is no consistently agreed methodology on how to account for wealth. Take debt for instance: How to treat financial sector debt? Is it double counting and should then be excluded in the consolidation? Is it double leverage and should then be added to non-financial debt or deducted from equity? Sometimes the data are not even recorded. How to treat central banks is not such a small question anymore now that they own assets worth 1/4 of GDP? Should debt be taken at face value or market value? Listed equity value is easy but listed companies don’t produce much more than 20% of global GDP, so how about the “market” value of unlisted businesses equity? And so on. Just to say that these measures and the relationship between them for any given country and even more so across countries should be taken with some caution and can in any case only provide rough orders of magnitude. Not that defining a consistent approach would change the order of magnitude materially but it will force governmental statistical agencies to, in some cases, collect the data and to properly think through and clarify the understanding of issues that can illuminate policy. In the meantime, reports like the Credit Suisse you mention are more frequent and received with increasing interest, as a useful source of data more than for their largely missing explicative power.
Also, the comparison of these numbers or ratios on any given date is not nearly as meaningful as their comparison over the long range. Indeed, the capital / output ratio is not even close to constant, even for a country where both the numerator and denominator incorporate the same biases. The US is may be the country with the most comprehensive data over the past century: since 1916, the capital / output ratio has varied between 2.6x in 1943 and 6.2x in 1929. It’s not just single year outliers: the capital / output ratio has varied materially over long periods of time, around 500% on average in 1927-1937 and 1994-to date, around 300% in 1941-1981. So, instead of whether the US capital / output ratio is higher than China as of mid-2014, the more interesting question might be whether it is consistently higher?
The analogy with a company P/E ratio is not the most adequate in my view, for the economy-wide Capital / Output ratio is much closer to a company Enterprise Value / Gross Profit.
There is also the question of globalization which complicates the attribution of wealth and output to individual countries. Take the Apple / Foxconn value chain, for instance. Is the split of equity market cap created between the US and China (or Taiwan in that case) proportional to the contribution to GDP in these countries? Could it be that the US gets a bigger share of wealth via the US domiciliation and equity listing of Apple and China gets a bigger share of GDP as all the manufacturing takes place on its soil, thus increasing the wealth / GDP ratio of the US relative to China? It could very well be the case.
The fact that the capital / output ratio fluctuates so much over time – say between 3x and 5x – for the same economy makes it difficult to conclude that the sole factor is the quality of the capital allocation process within the economic system considered. I mean, the Chinese marketcap increased by +$ 4.1 Tr or 40% of GDP in the 7 months since the publication of the Credit Suisse report. It is at least doubtful that such a material move reflect a sudden strong improvement in the judiciousness of Chinese investments.
Over the last century, the periods of “multiple expansion” – rising capital / output ratio – for the US economy have been 1921-1929 (from 3.3x to 6.2x) and 1981 to date (from 2.9x to 5.6x). See for instance the chart page 6 of the Credit Suisse report (their ratio is on household disposable income, not GDP). The empirical experience doesn’t lend itself very well to the conclusion that US investments were becoming increasingly productive during these two periods: 1921-1929 was followed by the Great Depression so all this capital had in insight been horribly allocated, while 1981-to date has been punctuated by financial crisis of increasing severity every 9 years on average (1987, 2001, 2008). So, there must be something else driving the level of the capital / output ratio, other than the more or less judicious use of capital to the production of desired goods and services. The 1921-1929 and 1981-to date periods suggest that this something else is the international reserve role of the $ within a globalized economic system and the associated fast credit expansion arising from accumulation and duplication of $-denominated debt, feeding speculative bubbles. The two speculative blisters are clearly visible on the chart page 6 of the Credit Suisse report. In that case, comparing the capital / output ratio of the US with any other country would necessarily be biased for only the US has the dubious “privilege” of an international reserve currency. In that case, the interpretation of a consistently higher than average capital / output ratio for the US would change somewhat. If the use of $ as international reserve currency means the US is taking on itself the cost of the global trade and monetary system, as you have argued previously, it would mean that the capital / output ratio of the US should be more volatile than that of other countries (barring destructive shocks such as wars or major natural disasters), in addition to being on average structurally higher due to the impact of the international bid for $-denominated assets on the numerator and the detrimental effect from a concomitant rise in the trade deficit on the denominator. May be a discussion of that aspect would have been interesting in the context of this article. It would be fascinating to try to break down the extent by which the higher capital / output ratio of the US reflects the intrinsic strength of its economic organization, ie. the intrinsic valuation premium of its assets, on the one hand, and the role of its currency as international reserve instrument on the other hand. For this is the key reason why the concept of wealth and the current debate on wealth inequality is so utterly confused: the same terminology “wealth” is used to define real economic value creation and legitimate wealth arising from the satisfaction of real economic needs, on the one hand, and the creation of false rights and accumulation of unearned, hence illegitimate, wealth through the monetary system. This confusion is apparent in some of the discussions in the comments section, people use the same expression “wealth” or “wealth creation”, yet they mean different things. To reach clarity of thinking and make progress on the inequality debate which relates directly to the dysfunctional international trade and monetary system, it is now important to clearly distinguish between these different types of “wealth”: the one created by providing desired products and services, the one created by wage and exchange rate arbitrage allowed within the international trade system, the one arising from money creation in excess of the requirements of the production sector. Only the first type is genuine “wealth creation” and is unquestionably socially legitimate. The two other types are in fact “wealth redistribution” and, when pushed too far like they are at the moment, are highly likely to become socially unacceptable and disruptive, no matter what amount of political control is enforced to defend them on behalf of their beneficiaries. The future of politically free and economically productive societies is at stake here and the least we can say is that we’re not going in the right direction.
Finally, if we take the 3.8x average capital / output ratio of the US since 1916 (50% debt – 50% equity as it turns out, rather remarkably) as the approximate long term “fair value” level around which total capital will fluctuate relative to production, the problems posed by total debt-to-GDP level of 3.5x becomes immediately apparent: operating cashflows are becoming insufficient to service the debt, constraining growth and making the system more fragile, at risk of falling into a vicious circle at any time. The sole policy response, consisting in “doubling the financial bet”, is in itself a gigantic balance sheet inversion.
I expect this will have no influence to your bet with Economist
It will have no effect, Mr. Real Name. Check out the original bet:
http://www.economist.com/blogs/freeexchange/2012/03/china-will-overtake-america-within-decade-want-bet
It’s pretty clear that they are talking about nominal GDP at the current dollar exchange rate.
You sound like you think Mr. Pettis is looking for ways to sneak out of the bet because things are looking grim for him, right? So do you think he’ll lose the bet? Maybe you’ve read all those articles that say China will have caught up by 2015? I hope you realise that those are all based on PPP, which Mr. Pettis pretty much proves is nonsense and is not part of the bet anyway.
In fact at this point it will be pretty hard for him to lose. Take a look at the numbers. When they made the bet, China’s GDP was $7.32 trillion and US GDP was $15.52 trillion. For China’s GDP to catch up to the US GDP in 2018, China had to grow faster by 11.3 percentage points (or by 9.8 percentage points, if the catch-up occurred in 2019, which The Economist tried to say they really meant).
That sounds like a pretty big gap, but according to the NBS data, in 2003, when growth really began to impress, and until 2011, China’s nominal GDP growth in yuan was in the high teens or low 20s every year except for the very depressed 9.1% growth in the crisis year of 2009. GDP grew by 18.3% in 2010 and by 18.4% in 2011.
But the comparable number in the bet is not nominal GDP in yuan but rather nominal GDP in current dollars, and the two were not the same after China broke the currency peg, some time in the summer of 2005. During the seven years of 2005 to 2011, the yuan appreciated by an average of 3.6%, so that in the nine years from 2003 to 2011 China’s nominal GDP rose in dollar terms by just over 20.0%, reaching 19.4% in 2010 and 24.1% in 2011.
What was US GDP doing? In both 2010 and 2011, nominal GDP grew 3.7%, up from negative 2.0% in 2009 and 1.7% in 2008.
For Mr. Pettis to lose, as I calculate above, China’s nominal GDP in current dollars had to grow at least 11.3 percentage points faster than nominal US GDP, but what looked like a big gap was actually very low relative to the typical gap during previous years. Between 2003 and 2010, the gap in growth rates ranged from 17 to 19 percentage points, and in 2011, just before they made their bet, the gap was 20.4 percentage points, which was nearly twice the required gap if Mr. Pettis was going to lose.
So hat’s off to you Mr. Pettis. That took real balls, if I may. A lot of people thought that for a famous economist like you to risk his reputation on a very public bet with The Economist that, over the next six years, the gap between US and Chinese nominal GDP growth would drop to just over 50% of what it had been during the previous six years, meant that either you were crazy, or that you were absolutely certain that you understood what was driving the crisis, while nearly everyone else, as represented by the Economist, didn’t.
That might be a little arrogant of Mr. Pettis, but how do things look now, nearly three years later? Is he in line to win, or to lose?
According to the IMF, at the end of 2014 China’s GDP at current dollar rates was $10.4 trillion, and the US GDP was $17.4 trillion. US GDP was 67.8% bigger than China’s GDP at current dollar exchange rates.
How much faster does China’s GDP have to grow for it to catch up to US GDP by the end of 2018? That is quite easy to calculate, and it turns out that China’s nominal GDP growth in dollars has to exceed US nominal growth by 13.4 percentage points every year (or by 10.9 percentage points, if the catch-up occurred in 2019, to be kind to The Economist). That means the gap between the growth rates of the two countries must be even higher, which wouldn’t bode well for The Economist even if, during this time, China’s growth hadn’t slowed sharply and its nominal growth has fallen a lot more.
But they have, so what will it take for The Economist to win? China’s nominal GDP growth in 2014 was 8.2%, according to the NBS which, when you add in the appreciation of the yuan, turned out to be 9.1% nominal growth in current dollars.
Nominal growth in US GDP over the past five years has averaged 3.9%, and in fact was exactly 3.9% in 2014, so the gap between US and China nominal GDP growth in dollars was 5.2 percentage points in 2014. This, needless to say, is much lower than the 13.4 percentage points excess growth for China that The Economist needs if it is to win.
It gets worse. In the first quarter of this year China’s nominal GDP growth dropped even more, partly because real growth is dropping, just as Mr. Pettis predicted, and partly because the GDP deflator has turned negative, which I think no one predicted but no one thought unlikely either. Even if China’s GDP growth stops slowing, and remains at 7%, a more negative GDP deflator will cause the gap to drop even further.
Is there any way The Economist can win this bet? I suppose if US growth, which is currently running around 2%, where to turn massively negative over the next three years, say minus 3-4% on average, which I don’t think has happened since the worst years of the Great Depression, and if the US GDP deflator went from roughly positive 1% to negative 1-2%, and if, in spite of the global economic calamity that this would represent, China’s GDP deflator, which is currently negative and declining, managed immediately to turn around and become positive by 1%, then even if China could maintain real growth of 7%, which Mr. Pettis says is almost impossible, and I believe him, only a stronger yuan, appreciating every year by half a percent, would allow The Economist just barely to eke out a victory.
I think Mr. Pettis will win this bet pretty handily. That took real guts at the time, but now seems obvious beyond belief. In fact, if China’s hugely negative PPI (minus 4-5%, I believe) can force the GDP deflator down another point or two, any reduction in real GDP growth might actually cause China’s nominal GDP growth in current dollars to actually drop below nominal growth in US GDP, especially if the central bank were to allow the yuan to decline a little. Mr. Pettis says it won’t, but deflation in China might cause the authorities to depreciate the yuan. Now wouldn’t that be a shock?
Thanks for the numbers, Moonunit. I might steal your idea, do the calculations myself, and post it somewhere. I haven’t done the numbers myself, but yours seem plausible. For those who don’t read long comments, Moonunit is saying the following:
Nominal Chinese GDP growth, adjusted for changes in the dollar value of the RMB, must exceed nominal US GDP growth by more than 13.4 %-age points for China’s GDP to exceed US GDP by the end of 2018.
Last year the currency-adjusted nominal Chinese GDP growth exceeded nominal US GDP growth by a little over 5 %-age points. I expect China’s nominal GDP growth to continue dropping by 1% a year, and if I am right, and if we assume no change in the currency, US growth would have to drop to negative 6% in 2015, negative 7% in 2016, negative 8% in 2017 and negative 9% in 2018, in order to keep roughly to the timetable.
As long as I am commenting about brave and gutsy predictions, I remember in 2009 and 2010, Mr. Pettis said that the US would be the first major economy to recover from the crisis, and China the last. Many people thought he was a little too far out on the edge because the US was barely able to stand up while China was on a tear, but I remember in his famous “12 predictions” blog post in early 2012, he explained that “the US tends to adjust quickly, often brutally, but it adjusts”.
He wasn’t as impressed with China’s response as everybody else was. Stephen Roach testified to Congress around that time, and he lavishly praised China’s fiscal response to the crisis, calling it the “gold standard” of fiscal expansion, and Nicholas Lardy, who was next, also praised it to the skies. They were both reflecting a very large consensus. But later that day, when it was his turn, Mr. Pettis was very circumspect. He said some fiscal response was necessary to prevent unemployment when China’s trade surplus plunged, but he said the expansion was too much and was going to lead to a massive debt problem.
What a great call. Mr. Pettis doesn’t seem to give a damn about the consensus, although maybe he ignores the consensus only because he can’t be bothered to remember what everyone else thinks. When I lived in Beijing in 2012 and 2013 I was able to sneak into his lecture classes pretty often because they usually had around 200 students (a lot of other young bankers did, even though PKU is far from the banking area), and I remember him saying jokingly that the only reason he has a reputation for being a nice guy who is never spiteful towards other academics is because he has such a crappy memory that he can’t remember why he was criticized and who he should be spiteful to.
If that’s true he probably doesn’t know much about John Ross, a very excitable economist, who was a Trotskyite in England, and a state capitalist in China, and, no doubt, would be a royalist in Saudi Arabia. Even as a Trotskyite Mr. Ross managed to get himself accused, along with our attention-seeking Trotskyite former Lord Mayor of London, of shenanigans that enriched the two of them in decidedly non-Trotskyite ways, which some no doubt unkind people think are not just as unethical but also illegal, before they got tossed out by an angry electorate. Mr. Ross ended up teaching at Renmin University, where is reputation among students, I understand, is a great deal of fun to discuss. He used to try to become famous by telling everyone who’d listen that he and Mr. Pettis were the two big opposing guns in the China debate, but that story never stuck. Like his boss Ken Livingstone, the former Lord Mayor of my beautiful city, who liked to explain why rich Jews hated him, he is better at publicity than at economics, and more recently he has discovered that the Global Times will publish certain kinds of articles, and refer to the author as a renowned expert, no matter who writes them, as long as the author has a foreign name and is willing to attack anyone who is disliked by someone in the Chinese government, including his own country as often as possible for its imperfect democracy.
My favorite thing about Mr. Ross, besides his theory that if you join the lemmings and run with the market consensus, but do so with bad manners, you may pretend that you are not a lemming so much as a romantic salmon, swimming against the tide, is that even though he never seems to get any of his economic analysis right, his blog has a sign that announces something to the effect that his economic specialty is making accurate predictions, and anytime someone points out his bad track record and his lack of credibility, or when he was accused of bullying a young reporter at the Global Times into retracting the parts of her article that accidentally showed Mr. Ross’s bad predictions, and replace them with praise, his instant reply is that he must be a great economist because Gavyn Davies at the Financial Times once politely referred to his blog as “widely respected” (Mr. Davies, it was quickly agreed, knows more about public school manners than about the state of the debate in China). Since then, Mr. Davies has pretty much ignored Mr. Ross, in spite of the enormous number of long comments Mr. Ross plonks down below each article that Mr. Davies writes on China, and over time Mr. Ross’s admiration for Mr. Davies has faded away into what seems like something very opposite.
The Ross story is funny and helps to generate articles like the Spectator’s “”Britain is a world leader in exporting creeps”, where he plays a bit role, but back to the prediction. When Mr. Pettis said that the US would be the first major economy to recover from the crisis, and China the last, for nearly two years Mr. Ross jumped up Pettis’s arse every chance he got (pardon the language, but it seemed appropriate) firing off triumphant little remarks, usually in the Financial Times comments section, taunting Mr. Pettis for so obviously failing to understand the global economy, and, to make things worse, repeating his prediction even after Mr. Ross had explained why it was so stupid. It was almost as if Mr. Pettis didn’t know who Mr. Ross was, or hadn’t read him, or didn’t take him seriously.
But by 2011-12, the US had clearly begun to recover from the crisis, private balance sheets were adjusting, and the economy began posting growth rates of 2% and more. This was also the time when a few people besides Mr. Pettis, like Victor Shih, Andy Xie, stopped becoming called “contrarian”, and suddenly everyone started to see that China hadn’t sidestepped the crisis at all, as Mr. Ross and the rest of the consensus assumed. Even extreme bulls like Andy Rothman and Stephen Roach, whose fingers for years had been tsk-tsking the whole world for not being more like China, espcially when it came to managing debt, suddenly abandoned their arguments about how China’s invulnerability was based on having the strongest balance sheet in the world and would guarantee growth of 9-10% for the next decade, and turned their fingers to tsk-tsk Beijing for mismanaging its debt. Funnily enough, Mr. Ross’s frequent and eager remindings about Mr. Pettis’s incomprehension faded around that time too. I guess by 2013 or 2014 the US was clearly in recovery mode, and China was clearly beginning the long, difficult slowdown that wasn’t supposed to happen. But the matter wasn’t completely forgotten. After he had posted another one of his long, assertive comments under a Financial Times article about China, he was asked in a very needling way by another commenter if he now recognized that Mr. Pettis’s crazy prediction was right, after all.
This was the time for Mr. Ross to man up, admit he got it wrong. and regain credibility. Did he? Not a chance. The person whose economic specialty is making accurate predictions responded by stating sneeringly that China was growing faster than the US, and this proved that Mr. Pettis was indeed wrong and he, Mr. Ross right. Because “US recovery” means that the US must have a higher GDP growth number than China, and “Chinese economic slowdown” means that Chinese GDP growth must be lower than that of the US.
If China’s reported GDP growth is higher than reported GDP growth in the US, then it follows automatically that China’s economy cannot be slowing down or wrestling with a rising debt burden, no matter what the government officials in Beijing might say, and that US growth cannot have bottomed and that the US has not begun adjusting and recovering from the crisis. OK, I don’t understand it either, but Mr. Ross snappishly declined to explain his reasoning further. This, remember, is a man whose predictions are always accurate. If China’s nominal GDP growth drops below US nominal GDP growth, like it came close to doing in the first quarter of this year, I suppose we will be taught a new set of definitions, but for now, suffice it to say, Pettis was wrong.
But as entertaining as it is when someone blusters about so miserably, this comment on Mr. pettis’s blog was not meant to be about Mr. Ross. It was written to point out that Mr. Pettis makes very bold predictions, based on his logic, understanding of debt, and historical knowledge, and these are often amazingly contrarian, even though I am never sure whether or not Mr. Pettis even knows that he is being contrarian.
I think it is time for you to make a new set of surprising predictions, Mr. Pettis, and congratulations on having gotten the last set right.
US will not recover, its economy has become zombified like that of Japan’s. Zero interest rate is sustaining zombie companies that generate no profit but continue to over-produce goods, causing a supply-glut and price deflation.
That was a nice, lengthy and needed comment on our esteemed host here. I wonder who you are? You write like someone who writes…
LOL thank you. I do write, but mostly on social issues, but I think economic issues are more interesting, or at least are becoming more interesting now that it is not all about bankers. My nom de plume is of course not my invention, and from that, and from my comments, it is probably not hard to figure out where it is that I write, but of course I would have to deny it.
Humbly humbly, prof. Pettis, am I right to see the recent fiascoes of Hanergy and Goldin as vindication of your thesis that a higher discount rate should be applied to China ?
If we cannot come up with a reasonable, and comforting, explanation, these events certainly should add a gapping risk premium.
Hey Dr. Pettis,
In reference to this article in today’s edition of FT “Renminbi ‘no longer undervalued’, says IMF” (http://www.ft.com/cms/s/0/11e96e1e-03a7-11e5-b55e-00144feabdc0.html)-
Do you think the RMB is now fairly valued? If not, what do you think is behind the change? My guess is that this development is as much political as economic, and I’m hoping you can shed some light onto what’s really going on here.
Thanks & please blog more!
If it is undervalued, it is probably not undervalued by much, but it is generally not a good idea to think of distortions in trade “competitiveness” wholly in currency terms. Other things matter as much, for example until recently low interest rates mattered more than the value of the RMB.
Hi Michael,
I hope you are well. Im wondering your opinion on hard commodity prices over the next 2 years. We’ve seen ore into the 40s this year and China GDP has gone down to 7%. Some people say Chinas GDP is inaccurate 😉 but if it does continue to decline could we see Ore into the 30s and maybe even the 20s if GDP continues lower below 5,4 %?
I have written a lot about metal prices, and while I am no longer as certain as I was in 2012 that prices would drop by at least 50% in three years, I do think that Chinese growth has a long ways down, and iron could easily break $30, but in 2012, I was pretty sure China’s adjustment had not been priced into the market, and now it might be.
Csteven,
I wanna get your take on the Patriot Act renewal that hasn’t gotten through. What do you think about it?
I actually have no problem with the NSA collecting bulk data on foreign governments, foreign officials, foreign leaders, terrorist suspects, and a whole host of other things, but there’s no reason they should be doing this on American citizens. There’s no way they’d be able to decipher all the data effectively because the noise would increase faster than the signal and I think ex-post facto use is a real threat in this regard. What are your thoughts?
More importantly, what does the new vote and the way the factions are aligning tell you about the shifts in the political system and the axis? It seems clear that the political alignment since Reagan has, for all effective purposes, broken. How do you think the new axis lines up? I have an inkling suspicion it’ll be aligned in the old Hamilton vs Jefferson way, although it may not be exactly the same. I’d like to get your take.
BTW, I suspect that you (and Prof. Pettis) are more in line with the Hamilton than Jefferson. I tend to be more in line with Hamilton as well. I really think he was one of the most brilliant geopolitical, financial, and economic thinkers in history and it’s a damn shame he’s always so glossed over. For all of the things that Marx said and gets credit for being the first to say or think about, Hamilton said all of those things with a better grasp of everything else before Marx was even born, but Europeans and socialists refuse to acknowledge this while still claiming their aura of moral superiority.
Didn’t know it was happening, years ago, and I mean many years, as a kid, I stopped watching the recent issues and took the long, over, view. This led to lots of background, trends, data, forecasts, etc….
So, have no idea and can provide no perspective on machinations and maneuvering, what’s happening an d similar.
Frankly, I do not have a problem with the Patriot Act…as long as the use is geared toward the purpose.
So this would be those related to protection of the homeland from foreign threats….including those on domestic soil with strong external drivers.
Problem is when every little, and I mean little local group, office and similar finds out about resources and modalities and wants to gain access to these. Again, I have no fear, but more care need be taken on these matters, and use of data need to be for very specific and proscribed purposes. I have not spent much time on the act, but I would probably go further than what is in the law, if not what is built out into the regulations, let alone practice (nod, nod, wink, wink, finger to lips, shhhh)
So definitely Hamiltonian, and toward self related matters As libertarian as can be….
So axis, hmmm, and this is shooting from the hip, well, you have classic liberals (William f. Buckley, a conservative); the Heritage Foundation. invisible hand (while being associated with Smith, is found throughout the movement from Axial Age to Modernity, in the great canons of philosophy) , Lassez Faire! Free markets, minimal regulations, low taxes, ease of opening businesses, etc..Then, you have liberal cosmopolitans, Jeffrey Sachs, and many internationally focused democrats….Global Governance, International Institutions, multi-lateral, etc…Then you, Westphalian Territorialists, Mearsheimer, Realpolitick, Kissinger, the Chinese Communist Party, etc….While using the memes of continental Marxian sociologists, or the critics of the post WWII era, those who helped rationalize the Soviets, the postModern predilection to equalize everything as if, we , each have our cultural limitations and handicaps, and nationalist anti-imperialists, etc…
Now do we go back to a Jefferson versus Hamiltonians. I am not so sure, but I am quite sure, that. The Jeffersonians would prefer that, to audit the Fed, restore Gold and bury their heads in the sand to the trends, effects and fly was of history that Zeihan so aptly describes (if there is an area or two I disagree with him, or think he handles too glibly, to casually).
check out span, book tv, fall of 2008, spring of 2009, there was a conference on the future of the Republican Party. It had very many useful points. The tea party is not a useful addition in many ways, they can not and will not confound the real issues for too long, b cause of acceleration in baby boom retirement, pensions, etc…. So the real issue is how true liberals (Buckley type conservatives ) have been decimated since the Reagan revolution, with the mix of business, religious, blue dog democrats and true liberals (true conservative ).
so I am not sure but I suspect if much of what Zeihan, ev n Michale, and others, including myself, have noted is true, that there will likely need to be dialogues related to what happens (if, as, while, the U.S. Retrenches in some areas, draws up its britches in others, and refocuses. For example, on an economic front for revitalization domestically, this should be an option say move for both Democrats and Republicans, withRepublicans looking at the banking, financing, and government supports n Cesar’s for such a refocus, and the democrats moving to the n Cesar’s human, human capital, and livelihoods supports to assist the economy, businesses, and families.
But that is an optimistic take. There may be some ego-maniacal, rear view mirror viewers who gain support and inhibit better trajectories, but I suspect, generally that Zeihan is correct, and it is only a matter of time.
Yea, this is where we part. Why the hell do they need every text message, all the emails, etc of everyone involved. There’s no way to even parse that information effectively. What they need is the ability to use specific facts, like the people who have large beards with basically no mustache, to narrow their targets and operate from there. The first methodology of using large amounts of data to try and parse it effectively doesn’t work. The latter works very well to narrow the sample of targets. Allowing the NSA to do the former makes us less safe.
On the Patriot Act, my main problem is how do we guarantee that the use is geared to the purpose? You’ve gotta draw a line somewhere.
I don’t know about going back to gold, but decentralizing currency issuance while eliminating the Fed could work quite well. What’s clear is the current system isn’t working and the US needs to retrench at some point to protect the domestic economy. Eliminating the Fed would cause the USD and help US trade.
With regards to national security, I think the biggest threat is the North American Drug War. The next biggest issue is water and environmental degradation. I suspect California turns to massive desalination. If we can get desalination costs to drop and build water transport infrastructure across the country, that’d really help secure our national security.
I thin we all agree the US retrenchment is obviously coming, but the real question is when it comes. When the US retrenchment does come, trading costs for the rest of the world will spike and countries relying on trade will be devastated. I also think Zeihan is one of the people who’s actually pointing to the real risks from climate change. Most people think that the climate change impact will primarily be with rising mean sea levels, but I disagree. If there are some cities that get flooded, I don’t think it’s a big deal. The real issue is what happens when weather movements and the swaths of arable land start to shift. In many of these countries, water is a real problem and these places don’t have any sort of political institutions to provide a rule of law or some stability. I don’t see how we don’t see massive resource wars and I think large population corrections are likely in many parts of the world. When you import >50% of your calories, have large cities in the middle of the desert where water is scarce, all the revenue you get comes from natural resources, repressive governments, what amounts to warlords as the real rulers, and exploding fertility rates; something bad is gonna happen. Alas, the problem is a lack of institutions, not overpopulation, as crazy as that may seem.
The biggest risk that I see from climate change is shifts in the locations of water, shifts in weather patterns where places that get most of their rainfall two weeks of the year would completely be ruined, and the shifts in the swaths of arable land.
BTW, here’s a book you might wanna check out.
http://www.amazon.com/Warlords-Inc-Markets-Warlord-Entrepreneur/dp/1583949011/ref=sr_1_1?ie=UTF8&qid=1433021789&sr=8-1&keywords=warlords+inc
Who knows what whom has…..
Social Network Analysis
Retracing steps
Building out timelines, interactions, potentials for people, groups and organizations to have cooperated, etc….
The 911 bombers were shaven, drinking alcohol and attending strip clubs.
So why do you need all the data from everyone in the country to be able to do this? You don’t need bulk collection for stuff like that. Not only do you not need it, but it’s not even helpful at getting terrorists.
There’s a lot of stuff about 9-11 and other terrorist activity that’s been ignored by other parts of the government. Bulk-collection won’t really help us very much and it’s not because of a lack of data or information that terrorist attacks have gotten through.
In streaming across a google news page prior to reading your reply, because somewhere in there, there could have been someone discussing chopping the heads of the men in blue, others who supported, offered to meet, and provided support and groups of others who were supportive, if party number 1 were also to support party number 3 on another matter, which might not have been originally notioned as important by you.
Again, it is really a matter as to how this information is segragated and that there is not a mission creep of sorts, that allows this to be used by local yocal little cops and jurisdictions, and that is a harder part, especially where there are linkages, and some self-righteous little moron, who knows its great idea to use the data for a purpose of his choosing, perhaps national guards and cops, being said same individual, who in different societal roles, my have access, then be deprived access.
But, I don’t, never intend, nor ever have had the dream to wear, or experience of wearing, women’s panty hose, am not leading the revolution from my keyboard, or responsible for any anthrax releases in support of rubies, ridges, fatwahs, fat wads, or any such other thing, so……
Frankly those who play with these things, must understand the tightwire they walk, its keeping all of the other little unimportant plebs at bey, and making sure that any data that exists is segregated and used for fighting truly bad people, in a world of much good, but very grave dangers, and potential for some really, really bad things, so….
And know, we don’t just have a value, and sacrifice everything for a supposed value in support of some Hollywood ethos that has been given to use as we all search for our inner hero.
Suvy
There has been a lot of…..ignored by…..
Uhmmmm…how would you know, because someone has constructed an argument that it has, come on, you are much smarter than that.
I have no fear whatsoever, about any of these things. Just the facts, it is a very dangeerous world. Such won’t stop me from going anywhere i want, but really it is. And a more capable human is ever more upon else.
Again, how to make sure it is used for serious matters, and not to satisfice others in society who can construct a valid ARGUMENT, but may just want to progress themselves as a voice, solve a personal problem, or a case that has been eating at them personally, etc….
Frankly, i think we are where we are at due to the success of the system, and things will change in ways that will relieve your fears and dissatisfactions. While further, feel that the US has been quite successful, both in recent conflicts and in executing the W.o.T. more generally. The one thing I have learned, each successful execution of a program generally breeds more critics than an unsuccessful one. Look at how confused many are on the state of the US vis a vis the Global Economy, even at present..
I believe that if you want to make an analogy with a company, then GDP is equivalent to turnover/sales, not earnings.
DvD: primer on banking; NO mention of foreign exchange reserves; Working Paper No. 529
Banks are not intermediaries of loanable
funds — and why this matters
Zoltan Jakab and Michael Kumhof
Dan,
What this Bank of England paper from May 2015 says is precisely what I said in February 2015 in two different parts of the comments section on the “Syriza and the French indemnity” article. There, we discussed how inherently unstable fractional reserve banking systems work to expand money / debt relative to income during good times out of mere accounting entries (in a way that is totally impossible to do with real savings) thus turning economic growth phases into euphoric speculative booms, only to contract money / debt relative to income during bad times thus turning economic recessions into depressive busts. In effect, I gave you the primer 3 months before the always helpful Bank of England. Please refer back to this discussion if need be.
As for central bank reserves, which are the main – if totally inadequate – tool by which this power of commercial banks to create money out of mere accounting entries is capped, the article mentions them. Whether these central bank reserves are in the form of domestic or foreign instruments is technically indifferent within a domestic banking system, as the multiplier effect works in exactly the same way in both cases. Where it’s not indifferent is globally, for in that case the accumulation of cross-border reserves result in a duplication of credit within the two credit systems involved.
Hi Professor Pettis,
Another great piece! Thank you!
Recently on the front page of the global editorial website, Project Syndicate (www.project-syndicate.com), there was an editorial by Stephen Roach, decrying those who decry currency manipulation: http://www.project-syndicate.org/commentary/currency-manipulation-legislation-tpp-by-stephen-s–roach-2015-05
In essence, in his view, the low savings rate in the US is the cause of an overvalued US dollar and a trade deficit, not the result of currency manipulation by China and others. After reading your writings, I am shocked to find a well-respected economist take your conclusions and reverse the cause (currency manipulation by China) and the effect (a low US savings rate). Why do you suppose he arrived at exactly the opposite conclusions of you?
Actually I think a lot of economists make the mistake of assuming that US savings are determined within the US because most economists don’t understand how the mechanism’s that force imbalances within one country to be consistent with imbalances elsewhere. In my next post I will discuss this as part of my discussion of a book on that very topic. Roach is implicitly arguing that China has a high savings rate because of the US savings deficiency, although if you asked him to state it explicitly, he would probably reject the view.
But while I disagree with him there, I am in sympathy with his annoyance at the way this debate is often conducted, in the form of accusations traded back and forth among people who have no understanding of the topic.
Of course a high US “multiple” can easily be justified.
Do not be shy, Michael. Give it a 100.
Better yet, come up with a cool name, akin Facebook. Call it “USA is awesome” factor. Or still better, give it your own name, since you have it discovered. Call it “Pettis factor”.
Who needs real jobs and fair wages like they still have in some part of Europe, anyways. This crap is soooo overrated, right?
Banking jobs and social media plus general feeling of awesomeness, and here we go. We are number 1.
When a comment replaces argument with such heavy sarcasm it usually means the commenter doesn’t have anything left to say. I don’t think Pettis has said or implied the things you say. He does have a habit of using logic to show why something foolish is foolish, but that’s just his style, and it is easy to see that it’s his style. When you have run out of arguments you don’t have to keep coming back.
The 50c you get paid for your comment will be counted towards Chinas GDP
@DerekF
Pettis basically is saying, just ignore the numbers, the USA is better just because we are awesome. How are you going to argue with that?
The hard reality even he can not argue with, is the China produces more real products and services, by far, than the USA. What he is trying to do is to somehow find his way out of it, arguing the Google is so awesome, it is hard to put a value on it. No, Michael, it is not.
Google is a helpful tool, but that is it. We in the USA are still getting most of what we really need to survive from China. And that is not going to change any time soon.
China is much more productive in real terms than the USA, and the multiplication factor must be adjusted accordingly.
“The hard reality even he can not argue with, is the China produces more real products and services, by far, than the USA”?
Ouch Johhnyboy, maybe you should listen to DerekF. The “hard reality” is that even if you ignore all of the adjustments that might reflect the value of things that are not included in US GDP, like Google, the US produces far more goods and services than China does. Read my first comment above. It is about a famous bet on whether China would produce as much in the way of goods and services as the US by 2018, and it looks like they won’t even by then.
Ouch again.
Had a refrigerator, freezer blowing cold, refrigerator getting warm……..was looking at buying a new one, actually, had two doing this at the same time, adn was looking to buy two……..open google, search……”freezer cold refrigerator warm video”…….
saved 500 1500 5000 dependent upon the refrigerator you would buy….. actually detracted from GDP but was beneficial to my personal standard of living insofar as the 1k 3k or 10k I would have spent, need not be spent, this added to my standard of living, because I am more secure in my financial position and can take that trip to Florida that i have wanted or have some extra money for the tables in Monte Carlo, dependent upon my socio-economic status.
Another example, like solar, don’t want to buy a whole system, but want to play with putting my water well pump on solar, and making sure my garden is on a water cycle every 4 hours, same google….
In fact again, I can search how to enrich my soil, google, how to companion plant, google, how to use the apple tree that puts out imperfect fruit and graft cherry twigs, and apricot twigs, and so forth on it, using the trunk and roots of the tree in place.
Finally everyone knows that China has way too much production, that India, Kenya, Tanzania, Vietnam, Indonesia, Bangladesh, Sri Lanka, Egypt, Morocco, Columbia, Nigeria, Liberia, Uganda, Burundi, Rwanda, Somali, and Ethiopia want to produce too…..are they going to forgive their pathes to industrialize or will China be successful in growing by continuing to build more and more factories, as domestic producers margins are ever more squeezed, and everyone just watches. In the US we just merely have to serve more of our own demand, to shut down growth in externally held dollars and reverse the multi-decade process begun in the ashes of WWII in the future because of the ignorance of commentators like you, and the miscalculations of strategists and politicians globally otherwise.
I have read many articles that refer to polls taken in Europe and the US in the last 3 or 4 years that show that there are many people who believe, like you, that the Chinese economy is larger and produces more than the US. They often refer back to a period in the late 1980s when many people thought the same thing about Japan. The point of these articles is usually to show how terribly uninformed people can be about even basic economic fact. Even adjusting for PPP, and as Pettis shows, this adjustment is questionable, China hasn’t caught up. Even finally if it had been “hard reality” that China did catch up in the production of goods and services, your last statement would invalidate your credibility. China is not more productive, in “real” terms or in terms as fake as you like. Because it has four times the population, it is at best one-fifth as productive, and probably much less, and even the greatest optimists don’t think China will catch up, although in the 1980s they thought Japan would.
My earlier recommendation holds, although between citing facts and being sarcastic, you’re probably better off sticking to sarcasm. Sorry for being so cold, but there are many other places where your comments might fit, like ZeroHedge.
China is not more productive in “real” terms, but its economy is larger in real, PPP, terms. That´s not even in question. Check IMF, World Bank, CIA Factbook data, they all list China as the biggest economy in PPP terms for last year. The dispute is over which is the “right” figure to compare economies, nominal GDP or PPP adjusted GDP. Those who dont understand the difference between nominal and real exchange rates, believe that nominal GDP is the right number, those who understand the difference know that PPP is the right number.
Imagine China free-floats the yuan and it rises to 4$, from 6$ now. Chinese economy measured in nominal USD would suddenly increase by 50%. But would really the chinese economy magically expand by 50% overnight? Of course not.
Or take eurozone. Euro dropped by 20% from last year. In nominal USD, eurozone GDP contracted by 20%. But did really the eurozone economy contract by 20% from last year? Of course not.
In short. PPP measures the real size of the economy, the real production, nominal GDP reflects currency fluctuations.
Of course, chinese yuan is not free-floating so the difference is not that obvious at first sight. But the principle is same.
I think you are wrong on two counts. 1st, there is no dispute at all about which is the right figure to compare, PPP or nominal. It depends on why you are comparing them. 2nd, you are wrong to say that those who “understand”, know that PPP is the right number, because those who understand really know that PPP is the right number only when comparing standards of living, and nominal GDP is the right number when comparing relative global impact. By the way you said “Check IMF, World Bank, CIA Factbook data, they all list China as the biggest economy in PPP terms for last year.” I don’t think you understand that only the World Bank computes PPP. The others simply report what the World Bank computes.
But the point Pettis makes is one you seem to miss: the PPP adjustment is only useful if the nominal GDPs are biased in a consistent way. They are not. Pettis makes this point very clear. The PPP numbers in China’s case have no value and do not represent an adjustment. If he is wrong you should explain why.
He is wrong, because he´s only focusing on debt-overhang and malinvestment in China, ignoring it in the US. And as the financial crisis revealed malinvestment in the US economy is huge, too. Nothing has changed since then. It only got worse, if anything.
So the GDP number is not perfect, but it´s not perfect in either of the country. Not in China, US, or Europe. But while not perfect, it´s the best what we have for comparison.
Nominal GDP is not the right number to compare global impact of the economy. PPP figure is. It measures the real production, how many tanks, warships, autos or satelites can a country produce, ie the geopolitical or economic impact. Nominal GDP only refects exchange rates and price level.
IMF was the first to release their PPP calculations for 2014, CIA Factbook was next, World Bank has not yet released their data for 2014. Only available are those for 2013.
Mr. Pettis,
Long-time fan of your work and have taken a lot of inspiration from your balance of payments work. Whenever I read about China’s GDP now I think about your post from a little bit ago about how debt gets accounted for in the Chinese approach (you were arguing it doesn’t properly get accounted for, or at least its different than in the US). Something that’s always bothered me about discussions around this issue is the idea that China can just step in like it did in 1999 and nationalize in some way all the bad local government and SOE debt, park it in some holding company, and then forget about it. This just cannot be true because why wouldn’t every government ever take this approach to credit busts? And the debt doesn’t just go away – it’s still there and must carry a cost – but I’m not sure how to argue why this can’t be feasible and what the costs of such an approach would be. I’m sure you have some insights.
Thanks
Several percentage points of China’s GDP can be attributed to the profits of foreign owned corporations (thus the trillions in cash stockpiles representing accumulated retained earnings). Obviously, this would not show up as Chinese household wealth but should be in order to make the comparison apt.
The Bank of England paper referenced above by Dan Berg is important (http://www.bankofengland.co.uk/research/Documents/workingpapers/2015/wp529.pdf). This paper says, correctly I think, that banks don’t create credit out of pre-existing deposits but out of mere accounting entries.
The implication is that the “quality of GDP” explanation of different multiple of asset value relative to production is only a part – possibly a small part – of the explanation. The other part of the explanation – possibly the main part – is the extent of “ex-nihilo creation of purchasing power” going into financial markets vs. going into GDP, thus pushing up asset values relative to production.
The surge in Chinese equity valuation since the Credit Suisse report also suggests this “credit creation” explanation. The total stock market capitalization in China has soared by $6Tr in the past 12 months, equivalent to 0.6x of GDP. Does that reflect a better quality of Chinese GDP? Not at all. Where did the net $6Tr purchasing power to buy Chinese stocks come from? Has the liquidity been withdrawn from bank deposits and savings products and reallocated to the stock market? No, we would have seen tensions in interbank funding markets in that case, which we have not seen. Have Chinese people and corporations sold their real estate en masse to reinvest the proceeds in stocks? No, there has not been a -$6Tr crash in aggregate real estate values and if that’s because “someone” came up with $6Tr to buy all the real estate at the price, then the question remains the same: where did the $6Tr come from? Have Chinese people and corporations suddenly saved $6Tr out of current period income? Implausible on a $10Tr annual GDP. Has the liquidity come from outside China? If I’m not mistaken, there are restrictions for foreigners to be able to invest in Chinese shares, so unlikely. So, where has the $6Tr purchasing power come from to finance the sudden buying spree in Chinese stocks? To a very large extent, it has come – and is still coming – from newly created credit out of mere accounting entries, not from real savings. As a matter of fact, the uplift in China stock market capitalization has coincided with the lowering of both interest rates and regulatory reserve requirements. Now, at about 95% of GDP, Chinese marketcap-to-GDP is about 35% below US level. But 1 year lending rates are still 5% in China vs. 0.5% in the US. Deposit reserve requirement are still 18.5% in China and can go further down. So, another big move in its equity market and China multiple will have caught up with the US without any change whatsoever to the respective biases in GDP. Can further cuts in Chinese interest rates (say to 3%) and further cuts in deposit required reserve ratio (say to 13%) achieve another big run in Chinese equity? It certainly can.
Sometimes, it is the “excess savings” argument which is advanced to explain asset price inflation relative to production and income. This is also only a part of the explanation. While the “excess savings” explanation is helpful in that it sheds light on the shifting split between labor and capital income in the context of trade globalization taking place within an inadequate exchange rate framework, it is incomplete in that it doesn’t distinguish between real savings and credit-based money created ex-nihilo, both pouring to varying extent into asset markets (as well as into consumption and real life capex to some extent). The difference is important: In the case of real savings, the extra purchasing power gained by the borrower or the equity issuer or whoever is selling secondary securities to raise cash is offset by the renunciation on the part of the investor of immediately exercising its purchasing power. In the case of credit money created by mere accounting entries, the new purchasing power is entirely incremental. That’s the only way 200% gains in 12 months are made possible, without a corresponding drop in other asset markets. It is possible to buy without paying and without someone else selling. Purchasing power is created out of accounting entries, this purchasing power is used to buy stocks, stocks rise, loan-to-value drop, stimulating both demand for and creation of new credit, meaning share price rise further, and so on so forth. When the share price increase has exhausted itself, the process is reversed. That’s the only way -90% crash are made possible. Needless to say that capital allocation decisions made under the influence of such a credit system creating money ex-nihilo rather than mobilizing real savings, and especially these capital allocation decisions made during the boom phase, have a decent chance of turning out wrong. Such credit system is simply not compatible with capitalism in the sense that it is a very inefficient “invisible hand” guiding capital allocation decisions.
This same confusion between real savings and the creation of extra purchasing power out of mere accounting entries makes the current debate about inequality very confused. Income inequality – hence the ability to save out of high income – arising out of unequal creativity, ingenuity, talent, hard work, entrepreneurship, risk-taking, perseverance is legitimately earned and thus socially justified and economically necessary as the engine of rising living standards. Inequality arising out of unequal exposure to money creation can not be considered legitimately earned and is thus socially unacceptable (exactly like income acquired via counterfeiting which is rightly deemed fraudulent and illegal) and economically detrimental as the swings of money creation during good times and money destruction during bad times create unnecessary and damaging perturbations to the allocation of resources (in the US, see for instance the real estate boom – subprime bust of 2003-2009 or the energy capex boom of the past decade followed by the bust now unfolding). In fact, the credit system in its current set-up disables the gradual and continuous balancing properties of the decentralized free markets economy. By allowing imbalances to extend far longer and grow far bigger than would otherwise be possible, the credit system makes the adjustment very concentrated in both time and amplitude. It’s what makes Great Depression possible. Inequality can only be considered healthy under neutral monetary conditions, which is far from being the case currently. This point is almost always missed in the current debate on income and wealth inequality.
To go back to the Chinese stock market surge, it may signal that – like Japan, the US, Europe and pretty much everybody else – Chinese authorities are not aiming to sustainably rebalance the economy but are in fact doubling down on money creation. For, once started, the money creation path is impossible to sustain unless ever more money is created in an exponentially rising manner. Failing to do so inevitably leads to recession at best or depression at worst. Not very appealing politically obviously, neither in democratic (to win the election) nor in autocratic (to avoid a coup d’état) political systems. We can only observe here how seemingly impossible it is for policymakers to take on board the lessons of repeated experiences and how seemingly impossible it is to resist the pressure to repeat always the same mistakes.
By the way, there is a incorrect statement in the Bank of England paper: “This, the creation of gross positions with zero net principal value (ie. the accounting entry of a loan on the asset side and a deposit on the liability side by crediting the borrowing customer account for an amount equal to the loan), but of course with a positive net interest flow to the bank over time, is precisely the meaning of bank financing, the very rationale for the existence of banks” (p.5). This is not correct. While banks have existed for several centuries before, it is only during the second part of the 19th century that they started to lend out money that was not previously deposited with them. It is historically a fairly recent innovation in banking history and not the “very rationale for the existence of banks”. I stress the point because to say that it is the “very rationale for the existence of banks” suggests that it’s the only possible way to organize the credit system. It is not. Not only it is possible, but it is also desirable for the proper functioning of the economy, to organize the banking system differently. In fact, based on their conclusion that “financing through money creation” system “have much greater effects on the real economy” than intermediation of real savings system (for no discernible benefits as far as I can tell from their paper), this should be the logical next step of the authors.
DvD: Great post; a few comments. China does not have a stock market (sm). I know, I know: Shanghai Composit etc, but describe a textbook s.m. – nothing like that exists in China. The entity we refer to as a s.m. in China is 80% govt controlled. Google Shanghai stock exchange composit index (2000-2015); from 2001 to 2006, while real GDP grew steadily from 8-9% to 12% the s.m. fell continuously.
Why is the s.m. now rising while read GDP growth is falling and is projected to continue to fall? It’s a venal way for the gov’t to bail out failing SOEs (steel, aluminum, autos, cement, glass, solar, shipbuilding, construction) and reduce local gov’t debt.
“Where did the $6T . . . come from?” Your answer: from newly created credit. Correct me if I’m wrong, but I assume you mean gov’t bank credit. (note: 1 year interest rates = 3.5%; not 5%; SHIBOR). But “credit based money created ex-nihilo” need not be bank credit; approx. $1T is margin debt with “12.8 million new accounts in 4 weeks.” (FT) Let’s call these “new accounts” households and here is a variation on an old theme – another transfer of income from households to govt. But buried herein is yet another misleading assumption: China is just another country among Countries; but China > Japan+Canada+USA+Mexico+Latin America+Europe+Russia+Egypt in population. The numbers generated by this behemoth distort our perceptions. So 3-4 million new s.m. accounts per week borrowing and investing – with govt media (I.e.all media) encouragement and 12,000 SOEs pumping and dumping quickly becomes a very large number.
Disagreements: 1) ref. inequality; see Brookings >events>June 1: “Did the Fed’s QE make inequality worse?” No.
2) “Chinese authorities are not aiming to sustainably rebalance the economy (true), but are doubling down on money creation.” (no; M2 is falling)
3) “…seemingly impossible for policymakers . . .repeat same mistakes.” You assume ignorance; I assume they know precisely what they are doing. By the way, we all think we know how this movie will end; another dangerous assumption.
There’s nothing more rigged than the Chinese stock market. There’re literally companies in there centered out of the Cayman Islands (red flag #1). On top of that, the government would come out with a “crack down” or “corruption elimination” campaign against such companies. Then, you’ll see some report coming out saying about the prospects of revenue from the aforementioned company. Then the government will say we’re going to prevent companies in business X from something which usually means the company will have no revenue. Then, the next week the company’s share price proceeds to shoot upward by 30-50% in ONE WEEK! The Chinese stock market’s completely rigged. There’s so many companies that’re frauds and I’m sure there’s way more nonsense going on that I don’t know about. I’m only saying what I’ve seen.
There is a lot be said about the integrity of money, bond, credit, stock, commodities and precious metals markets in many countries. Yes, it may be worse in certain countries than others but it doesn’t mean it’s anywhere near up to standards in the countries you may have in mind. At least that’s what the sheer number of recent or on-going probes, litigations and settlements suggest.
I mean money / credit / purchasing power creation in the broadest possible sense, ie. not just bank loans indeed but securities financing of all kind, leverage through derivatives, margin accounts, etc from all relevant sources. Some of this financing won’t show up in bank deposits, ie. won’t show up in M2 which may very well slow down simultaneously without any incompatibility.
You’re right on the level of 1yr interbank rates, was referring to 1yr lending rates for China but not appropriate if comparing to 1yr interbank rates in the US. My mistake.
Haven’t read the Brookings paper, will try to find the time. Seems hard for me to deny the effect of central banks asset purchases on asset values, ie. on wealth distribution. So, let’s agree to disagree for the time being.
Ignorance must be a fairly rare circumstance. By “impossible to resist the pressure”, i rather meant that there is tendency to lean towards the easiest measure yielding immediate even if only short term results at the detriment of sustainably addressing root causes of issues, especially if the pressure of interest groups and political competition pushes in this same direction, as it usually does. That’s what distinguishes the vast and mediocre crowd of opportunistic politicians running the “leaderless economy” from very few men and women of exceptional vision based on a deep understanding of history, profound humanism, and highest courage. These very rare persons are “the Leaders”. They are badly needed.
Balance sheets invert quickly these days.
It must indeed feel very reassuring to the many wiped out by the Chinese stock market crash that “they” know precisely what they are doing.
Sadly, “they” don’t seem to know that it is no easier to stem the chain of margin loans being called in than to stop a flamboyant tulip from fading.
The appetite for repeating the same mistakes over and over again seems insatiable. The appetite for learning the lessons of repeated experiences seems non-existent. Is it really too much to ask for it to be vice versa? Or is suspending markets and banning selling really the very best we can expect of good economic policymaking?
The question now is what would the impact be on economic and social developments or, as it is sometimes put on this blog, how will the losses be allocated, both domestically and internationally?
Michael,
There is an interesting article on China in ForeignAffairs. The “money” quote in so far as this topic is concerned is:
“China’s GDP per capita grew by a factor of 13 between 1980 and 2010. If this sounds too good to be true, that’s because it is too good to be true. China’s economy did experience enormous growth after 1980, but no economy really grows by a factor of 13 in just 30 years. China’s recorded growth is partly due to true economic progress and partly due to the monetization of previously nonmonetary relationships.”
I was wondering if you may be willing to comment.
Thanks,
SamB
Damn, Sam B, I responded, and then accidentally erased it. I’ll try again later, but it is pretty straightforward, having to do with the fact that in a rural economy a lot of work is not paid for, and so does not formally enter reported GDP.
Can you give a link?
Oops, I thought I had. So …
https://www.foreignaffairs.com/articles/china/2015-06-07/trade-and-trouble
The key point that I was hoping for your response to is his claim that China’s reported GDP growth is grossly overstated because a big chunk of it is essentially an “accounting illusion” stemming from that entry into “reported GDP” that you refer to, and once that is used up, reported growth ends up collapsing (though ACTUAL growth proceeds apace).
And if I was unclear, what would be the impact of the resulting leveling off of China’s GDP to a MUCH lower level than the one incorporated in many, many recent (and current) capacity/investment decisions.
I always wondered about the PPP adjusted GDP. Not because of the comparison between China and the US but because it devalued the fact that there is a high level of wealth distribution within Denmark. Danish, Norwegian and Swedish nominal GDP is much higher the PPP GDP because services provided in Denmark generally are more expensive then in other less equal societies.
Anyway. One point I think is missing in this debate is the market access for goods produced in the U.S. and produced in China. The market for U.S. goods is much large then that for Chinese produced goods because the Anglo Saxon cultural and economical dominance is comparable to only that of the Roman Empire. My simple point is that a good produced in the U.S. can easily directly enter the European, Indian or Japanese consumer markets; while a good produced in China ( unless it is placed in the international supply chain already) will have to face more obstacles when entering a market directly. My guess is that the natural development of the Chinese economy will enhance this point further and thus putting a cap on future GDP growth as well. Thereby hampering Chinese companies ability to service raising debt compared to the ability of US companies. Or to put it simply the U.S backyard is just that much bigger.
Not really 100% sure of where else I should post this to ask the professor and other readers, so I figured I’d just put it the most recent China focused post.
Is it reasonable to think about what’s happening with Chinese markets right now as just a debt:equity swap paid for at the expense of savers, and that when the equity bubble pops it will be essentially the same as a write-down of impaired loans paid for via a wealth transfer from households?
Several points:
1. If you think PPP-adjusted GDP comparison is useless, than why do you think that raw GDP comparison is anymore useful? Also, are you saying that PPP adjustment has no value at all for comparison? The popular explanation of PPP usually refers to the adjustment of prices. For example, if a barber charges US$40 for an hair cut in US, and another barber in China charges RMB 40, don’t they produce identical contribution (an hair cut) to the respective economy. Yet without PPP adjustment, we would never account for this.
2. You mention that US economy is more diverse than China and therefore should be valued more. Could you please let me know how is US economy more diverse? For what I understand, China produce many more products than US, except for some extremely high tech ones. So, my impression is the other ways.
3. In terms of raw GDP numbers, I would also guess that China’s GDP understate its economy in several ways. While US is extremely well developed cash-less transaction (which enables it to account for most economic activities), China is far less developed. There are likely more underground activities in China than US. So, it should not be surprised that China GDP would be higher if it is accounted as thoroughly as US.
4. Have you take the exchange rate into consideration in the comparison of US vs China economies? While US has many advantages in political stability, environment protection, transparency, it also has been consistently running a trade deficit and budget deficit. The federal debt is 18 T and counting. This let many people to believe that in the long term, US dollar will crash. While this may or may not happen, it is hard for investors (or anyone) to have confidence in a country that consume more than it produce.
Discounting GDP for mal-investment is a very misleading exercise. One that’s not needed if one defines GDP as economic activity rather than wealth creation. There are a plethora of other analysis that con be done to estimate mal-investment without futzing around with GDP.
A few thought exercises. What if a country goes on a monument building binge financed by bank loans? These monuments are beautiful, appreciated by citizens but will never generate any cash flow to cover their costs. The loans will need to be written off or bailed out by the government. It would be very dangerous to scoff at this “waste” and decide that monument building doesn’t count towards GDP just because one nation’s independence memorial appears grandiose and wasteful to non-citizens.
And it’s not just mal-investment that’s open to discounting. I hate guns and gun ownership in America. I think the chances guns are used for protection are infinitesimal compared to increased gun violence and gun owners are deluded souls with penis issues. If I could, should I exclude the mal-consumption of guns from GDP calculations? After all, drugs and prostitution are generally excluded already.
I could go on. Exorbitant funeral celebrations in African nations lasting years impoverished families and should not be counted in GDP.
Monster truck rallies and tractor trailer pulls are ridiculous spectacles… come to think of it, so are all professional sporting events.
To decide that uneconomic investment should not count towards GDP first requires us to make valuation forecasts and introduces value judgements into what societies chose to do with its resources. What if China’s high speed rails achieve nothing more than national bragging rights? Much like NASA space race. Are we to become judge and jury on what counts and doesn’t count?
To avoid introducing value judgements, it’s safest just to say it all counts. China may be mal-investing, which will lead to stagnating growth… but we will know when we get there with lower GDP growth.
Don’t make the same mistake everyone else does, Laban Yu, especially most economists. I am no wild-eyed Girolamo Savonarola demanding that if there be any sin at all in the city we should burn the city down or, even worse, that we throw away all our GDP calculations, and I can’t tell you how many economists have been horrified by this post because they think I am out to destroy the whole system by which peer-reviewed articles are published.
But I am not. I am just insisting that we understand our measuring tools and use them intelligently. A shovel is very useful if you want to dig a small hole, but if you want to communicate with your cousin across the Atlantic there’s no point eying the shovel. When I was a young banker I was forced to take accounting, a topic I hated even though our professor was brilliant, and he showed conclusively that if one of two identical companies valued inventory using FIFO and the other LIFO, these two identical companies could have radically different assets values, net worth, and P&Ls. His conclusion was not that we jettison GAAP altogether until Jesus returned to earth and gifted us with an accounting system that was fully accurate at all times. He did insist, however, that we recognize that every different inventory accounting system is systematically wrong in a very specific way, that we should always instinctively and automatically adjust the numbers in our heads when we wanted to figure out “value”, that we learn why two different systems were not comparable until adjustments were made, and that we never tried to force any accounting system to do something it couldn’t do.
He would explain very earnestly that each inventory accounting system was perfectly objective in itself, but if you thought this meant that you could directly compare the numbers of two companies that used two different inventory accounting systems, then you simply did not understand either accounting or, more generally, systems. But worst of all, he always explained with real revulsion, was when you made a small adjustment on an unrelated matter and then claimed that the two companies were now more comparable than before. Because the original difference is random, your adjustment is exactly as likely to make the comparison worse as it is to make it better.
This is LITERALLY true. There is no “accurate” measure of an economy even in theory because there is no one thing we want to measure. GDP has always been understood to be deeply flawed, from Simon Kuznets on, but it is only worthless as a measure when it is used by people who do not understand its flaws, or ignore them. GDP is a reasonable number to start with, and then depending on what you want to do, you must begin adjusting as best you can.
So GDP, even if generated by building bridges to nowhere is not zero value and should not be overly discounted.
Which economy is richer? One that borrows a lot of money, builds a bridge to nowhere, is saddled with debt that it either writes off, monetises and/ or defaults on?
Or one that can’t get organised enough to have the financing, engineering and labour to build any bridges to anywhere?
This is not an easy question to answer. Both economies end up with zero utility but one is left with the skills to build a bridge to somewhere.
This is why discounting mal-investment in GDP and over-focusing on financial wealth creation might miss out on real and substantial wealth creation not captured by returns on investment.
The two examples above may be a very rough and very unfair description of China and India’s economy.
Now neither example is optimal but for GDP calculations, I just want to know that work is being done and things are being built. To try to discount its financial value fails to capture the innate value of being able to do work.