China’s stock markets and revisiting 2011 predictions

By Michael Pettis · July 31, 2015 · Consumption, Market structure, Politics of rebalancing, Predictions · 213 Comments

I plan to post a new entry very soon but before doing so I wanted to say a few things about the stock markets, which continue to be insane (but not unexpectedly so) and then repost a blog entry that is nearly five years old. By the time I published my latest (July 17) blog entry Beijing had managed to stop the panic with the use of what I called “brute force”, by which I meant that there was never likely to be much impact from interest rate moves, regulatory changes, margin relaxation, and so on. This is because there had been such a remarkable convergence among investors, almost all of who were purely speculative, on how to interpret information, and because any interpretation was likely to be self-consciously skeptical, that any regulatory response had to be completely unambiguous.

There is nothing less ambiguous than actually buying or selling large amounts of shares. In a July 8 message to my clients, I argued that

… the only way to create a credible floor, or to create credible expectations of rising prices, is by “brute force”. Beijing must force entities under its control, or entities it can influence, to buy shares until all uncertainty is removed.

The panic could only be stopped, in other words, by very visibly forcing institutions under state control to buy heavily, and to prevent them from selling. Other forms of signaling would not work. This is indeed what the regulators did, and they did it powerfully enough that by July 9 they had arrested the panic and set the market off on another surge.

The problem with the surge was that the various “unorthodox” measures used to stop the panic created all sorts of strange convexities and implied options that could either interrupt or speed up the surge, and in a market in which there has been both a convergence of strategies and, what’s worse, a convergence in the way information is interpreted, any interruption in the surge was likely to be brutal. In this market, either we collectively agree that we have decided to buy, or we sell.

What worries me most is that many of the measures employed by the regulators to halt the panic are unorthodox enough, to put it mildly, that they can introduce all kinds of new convexities and implied options that we don’t fully understand. As we begin to recognize and understand them, however, these might be enough to undermine confidence in our widespread agreement about having reached a consensus.

There was one measure about which there is some disagreement as to its size and its importance, but this might be more than counterbalanced by the very simple and clear signal it gives:

I realize this is very abstract, but it might help make things a little clearer to consider one of the best-known of the measures employed over the desperate weekend of July 4-5. This measure is described in a recent article in Caixin, which describes a meeting held by the CSRC involving the heads of China’s 21 largest brokers: “The firms announced in a joint statement that to stabilize the stock market they would spend at least 120 billion yuan combined to buy exchange-traded funds linked to blue-chip stocks listed on the Shenzhen and Shanghai bourses. Moreover, the firms pledged to hold all stock that had been bought with their own money until the index reached at least 4,500 points.”

Why would this matter? Because if brokers are holding large amounts of shares that they are eager to sell, but cannot do so until the index hits 4,500, this creates a barrier, or at least a speed bump, at around 4,500 whose impact as the market races up is hard to determine. This acts effectively as a kind of call option that investors must give away any time they buy stocks while the index is below 4,500.

My worry, as I discussed with my clients, was that as the index approached 4,100 or higher, the threat of intense selling by capital-tight brokers at 4,500 meant that anyone buying shares was implicitly giving away a free call at 4,500, and the higher prices went, the less upside there was and the more downside.

Writing a synthetic put option

By the way remember that if you are long the underlying asset and short a call option, you are effectively short a synthetic put option struck at the same price as the call option. This means that anyone who owns shares might in fact be short a complex synthetic put option on the market. If the writer of the put can cancel the option at no cost, the rational thing for him to do would be to cancel it. In fact he can do so simply by closing out his long position and selling his shares. By the way the fact that most investors do not understand option theory is irrelevant. The option framework predicts how investors will behave as long as they understand that a lot of selling puts downward pressure on prices and a lot of buying upward pressure, and in a purely speculative market, this is pretty much the only thing investors have to understand.

I don’t know if this is indeed what triggered the selling, but on Thursday, July 23, following a string of uninterrupted up days, the market closed at a new recent high of 4,124, after which it dropped sharply every day for the next three days to close down by just over 11%, at 3,663. This is exactly what you would have expected if traders believed that the threat of significant sales when the index hit 4,500 was substantial, or at least if they believed that the market believed it.

This expectation is what matters – or, more accurately, what matters is that everyone knows that everyone else is focusing on 4,500 as a break point. There may or may not be a great deal of selling likely to occur once the index hits 4,500 as brokers are forced by their weak capital positions to sell shares, and opinions vary on this point, but in this kind of market as long as investors believe that this is enough of a possibility for a consensus to form around it, they will act as if it were true. This means, then, that they will act like they have written a put option struck at 4,500, and unless they are absolutely certain that stocks will trade up right through 4,500, they are in the position of being able to cancel their short put any time they like simply by selling their shares.

The market may or may not be thinking this way, but it has certainly acted like it might be. After those three bad days the market traded up on Wednesday by 3.4% to close at 3,789, but then lost faith again Thursday and dropped by 2.2% to close at 3,706. Today, Friday (July 31), the market opened 1.3% lower and except for a few minutes in the early afternoon it was in the red all day to finish at 3,664, down 1.1%. I expect it might make several runs at 4,500 before it breaks through.

If this model is appropriate (i.e. if enough investors believe that there is a consensus around brokers selling substantially once the index breaks 4,500), there are two obvious implications:

If Beijing wants the market to keep rising, it must either convince investors that brokers will not sell at 4,500 or it must engineer enough very visible buying that it can convince investors that buyers will bulldoze the market right through 4,500, absorbing any potential selling without a care. Brute force, in other words, is what is needed.

Once the Shanghai Composite breaks through 4,500 convincingly, the market will rise very sharply before it hits its next barrier. Why? Because the existence of the implied call option means that demand “normally” would have pulled the index above 4,500, and was only prevented from doing so by the implied call itself. What is more, the closer the market gets to 4,500, the greater the gap between the current price of the index and the price at which the index would have traded had the implied call not existed. Once the call is “cancelled”, the gap will disappear, and the market will surge.

But this is all wild speculation on my part. My main point is that the structure of investment strategies in the Chinese stock markets had always guaranteed that this would be a brutally volatile market that trades almost exclusively on “the consensus about the consensus”, and therefore prices will reflect very rapid shifts in this consensus, in exactly the way Keynes explained in his description of beauty contest strategies. The market’s mood will rise or fall rapidly, buffeted on the one hand by “brute force” buying and on the other by unexpected speed bumps structured around complicated forms of regulatory intervention, and in a speculative market it is the mood, and not fundamentals, that determines prices.

Recalling 2011 forecasts

To move away from the stock markets and onto a different topic altogether, I thought it might be helpful to reprint my blog entry from August 29, 2011. I was reading though it last week, and one of the points I tried to make at the time was that these predictions were not a set of independent predictions but were rather part of a unified set of outcomes based on the model I use for thinking about the global economy. They were, in other words, all likely to be true or all likely to be false.

Several of these predictions were extremely controversial at the time. I thought it might be useful to re-read these predictions and see which had been accurate and which hadn’t, and what this suggests about modifying the model I use to understand the global economy. Before doing so, however, because the concept of rebalancing is fundamental to understanding the adjustment China is undertaking, I thought first I would reproduce a series of short comments I made earlier this week to clients about rebalancing in China:

Does China’s demographics help rebalancing?

A client recently asked me whether there were any rebalancing benefits to the Chinese economy as ageing Chinese retirees continue to consume, or would the economy be worse off if it reduces the amount of savings that go into investment. Are the demographics favorable or unfavorable?

I think there are two useful points. First, your savings are equal to what you produce less what you consume. Once you are no longer working, your production drops to zero, and because your consumption doesn’t drop to zero, your savings become negative. Consumption is broadly a function of the size of the total population whereas production is broadly a function of the size of the working population, so that anything that reduces the working share of the total population – retirement, unemployment, children – tends to increase the consumption share of GDP.

Whether the economy is better off or worse off depends on many things. If you want maximum current welfare, the higher the consumption share
the better off you are. If you want maximum growth, the higher the investment share, the better off you are, although of course the growth represents an increase in wealth only if investment is productive – i.e. the increase in future consumption caused by the higher productivity the investment generates should be greater than the reduction in current consumption that paid for the cost of the investment (this, of course, has been one of China’s big problems).

Savings is not just household savings

Second, there is a huge amount of confusion that plagues most discussions about savings, and even economists regularly make this mistake. We confuse household savings with total savings, and explain changes in savings by assuming that there have been changes in household savings preferences.

Ask people why German savings rose in the last decade and they will give you a story about German prudence and thriftiness, but in fact the main reason German savings rose was because after growing faster than GDP in the 1990s, worker’s wages grew more slowly than GDP in the last decade. The same thing is true about China for most of the past four decades until around 2011-12. In both cases the median household share of GDP declined, and with it household consumption declined as a share of GDP.

Because most consumption is household consumption, the result is that in both countries total consumption declined as a share of GDP, which is the same as saying total savings rose as a share of GDP. What happened to household thrift didn’t matter, even though nearly every explanation of German and Chinese savings stresses cultural preferences for thrift.

Four ways to rebalance

One way to rebalance is to convince Chinese households to save less out of their income. This would make Chinese households better off in the present while making them worse off in the future if lower savings means less productive investment. In less credible countries, lower savings usually does mean less productive investment, but in highly credible countries, domestic investment is mainly a function of expected profitability (which is usually a function of expected consumption growth). In China, where domestic investment often has a negative profitability, this kind of rebalancing would make Chinese households worse off both in the present and in the future.

Another way to rebalance is to reduce the working share of population, whether this happens because the population is getting old and retiring, or there is a baby boom, or workers are being fired. In each of these cases China households are not better off because the consumption share is rising not as a consequence of rising consumption but rather as a consequence of falling production.

A third way to rebalance is to redistribute income downwards (the poor consume a greater share of their income than the rich). This would make China households better of in the present. Supply-siders will tell you that this will make them worse off in the future, but this is only true if productive investment has been constrained by insufficient savings.

Good versus bad rebalancing

And finally, by far the most powerful way to rebalance in China is to redistribute wealth from the government sector to the household sector. This would make Chinese households better off in the present.

Again supply-siders will tell you that this will make them worse off in the future, but this is only true if productive investment has been constrained by insufficient savings. In the early 1990s when China desperately needed investment of nearly every kind, productive investment was definitely constrained by insufficient savings, and so low current Chinese consumption almost certainly meant much higher future consumption. This has not been true, however, for many years.

China must rebalance, and will rebalance, but not all rebalancing is the same. China can rebalance by constraining the growth in total production more than the growth in total consumption, which is what happens with an ageing population or with rising unemployment (an economic collapse, in other words, will cause China to rebalance), or it can rebalance by boosting the growth in total (preferably household) consumption more than the growth in total production, which is what happens with wealth redistribution from the rich or from the state to median households.

With this brief explanation of rebalancing in mind, I reproduce below the forecast I made in 2011, along with some comments below each forecasts.

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Predictions of the rest of the decade

August 29, 2011

Markets have been crazy this month, but rather than try to wade through all the news, much of which doesn’t seem to have much informational content, I thought I would duck out altogether and instead make a list of things I expect will happen over the next several years. We are so caught up in noise and market volatility – as the market swings first in one direction and then, as regulators react, in the other direction – that it is easy to lose sight of the bigger picture.

My basic sense is that we are at the end of one of the six or so major globalization cycles that have occurred in the past two centuries. If I am right, this means that there still is a pretty significant set of major adjustments globally that have to take place before we will have reversed the most important of the many global debt and payments imbalances that have been created during the last two decades. These will be driven overall by a contraction in global liquidity, a sharply rising risk premium, substantial deleveraging, and a sharp contraction in international trade and capital imbalances.

To summarize, my predictions are:

BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.
Over the next two years Chinese household consumption will continue declining as a share of GDP.
Chinese debt levels will continue to rise quickly over the rest of this year and next.
Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.
Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.
If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.
Much slower growth in China will not lead to social unrest if China meaningfully rebalances.
Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.
European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.
Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.
Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.
Trade protection sentiment in the U.S. will rise inexorably and unemployment stays high for a few more years.

There is nothing really new in these predictions for regular readers. These are more or less the same predictions – based largely on historical precedent and the logic of the global balance of payments mechanisms – that I have been making for the past five or six years (the past 11 year, when it comes to the breakup of the euro), but I thought it would be helpful, at least for me, to list them.

Note that although at first glance some of these predictions seem unrelated to others, in fact they all flow from the same basic balance of payments and balance sheet frameworks. To explain each in greater detail:

There has been no decoupling of developing economies, or more narrowly the BRICs, from the developed world. All that has happened is that the transmission from one to the other has been delayed.

Since most global consumption comes from the U.S., Europe and Japan, the collapse in their demand will ultimately be very painful for the BRICs and the rest of the developing world. The latter have postponed the impact of contracting consumption by increasing domestic investment, in some cases very sharply, but the purpose of higher current investment is to serve higher future consumption. In many countries, most notably China, the higher investment will itself limit future consumption growth, and so with weak consumption growth in the developed world, and no relief from the developing world, today’s higher investment will actually exacerbate the impact of the current contraction in consumption.

This delayed transmission, by the way, is not new. It also happened in the mid-1970s with the petrodollar recycling. Economic contraction in the U.S. and Europe in the early and mid 1970s did not lead immediately to economic contraction in what were then known as LDCs, largely because the massive recycling of petrodollar surpluses into the developing world fueled an investment boom (and also fueled talk about how for the first time in history the LDCs were immune from rich-country recessions). When the investment boom ran out in 1980-81, driven by the debt fatigue that seems to end all major investment booms, LDCs suffered the “Lost Decade” of the 1980s, especially those who suffered least in the 1970s by running up the most debt.

This time around a huge recycling of liquidity, combined with out-of-control Chinese fiscal expansion (through the banking system), has caused a surge in asset and commodity prices that will have temporarily masked the impact of global demand contraction for BRICs. But it won’t last. By the middle of this decade the whole concept of BRIC decoupling will seem faintly ridiculous.

July 31, 2015 comments: I don’t have much to add to this except to say that I expect before the end of the decade or very soon thereafter to see a wave of sovereign defaults or debt restructuring in Latin America and elsewhere through the developing world.

By 2013 Chinese household consumption will still not have exceeded the 35% of Chinese GDP reached in 2009. In fact it will probably be lower.

For much of the past decade there has been a growing recognition that Chinese growth has been seriously unbalanced, as Premier Wen put it, and that at the heart of the imbalance has been the very low consumption share of GDP. In 2005, when consumption hit the then-astonishing level of 40% of GDP, there was a widespread conviction in policy-making circles that this was an unacceptably low level and that it left Chinese growth much too dependent on the trade surplus and on increases in domestic investment. At the time the former seemed a more dangerous risk than the latter – although even then massive overinvestment was China’s true vulnerability – but I think by now there is a rapidly developing consensus that investment, and the unsustainable concomitant increase in debt, is China’s biggest problem.

That is why Premier Wen listed the need to raise the consumption share of GDP second in his speech last March before the unveiling of the new Five-Year Plan. This time, the message seems to be, they are serious about doing it.

But I remain very, very skeptical. Low consumption levels are not an accidental coincidence. They are fundamental to the growth model, and the suppression of consumption is a consequence of the very policies – low wage growth relative to productivity growth, an undervalued currency and, above all, artificially low interest rates – that have generated the furious GDP growth. You cannot change the former without giving up the latter. Until Beijing acknowledges that it must dramatically transform the growth model, which it doesn’t yet seemed to have acknowledged, consumption will continue to be suppressed.

July 31, 2015 comments: I think I underestimated the speed with which financial repression would be eliminated. In 2010-11, China’s nominal GDP growth rate was roughly 18-19%, but in 2012 it began its dramatic decline to roughly 5-6% today. Because the financial repression tax is broadly a function of the gap between the nominal GDP growth rate and the nominal lending rate, and because the collapse in nominal GDP growth also meant a collapse in the gap between the two, the once-enormously-high financial repression “tax” dropped sharply – it is probably zero or even slightly negative today. The financial repression tax was the single greatest cause of the consumption imbalance, and so with its collapse, the imbalance stopped getting worse, and consumption bottomed out as a share of GDP in 2011-12.

In the rest of 2011 and during all of 2012 Chinese debt levels will continue to rise very quickly, in spite of attempts to slow the growth in debt.

The attempts to rein in debt growth will fail because they address specific areas of debt and not the overall tendency of the system to generate debt. So although there may be more pressure to rein in local government borrowing, for example, this will probably fail, and if it succeeds it will only be because other entities, most probably locally-controlled SOEs, are enlisted to fill in the gap. My guess is that next year the general alarm among investors will have switched from local government debt to SOE debt, not because the former will have become manageable, but rather because the latter will surge, albeit in not-always-transparent ways.

With consumption growth constrained and the external environment unsound, increasing investment is the only way to keep GDP growth rates high. China funds almost all of its major investments with bank debt, and it long ago ran out of obvious investments that are economically viable – at least investments that are likely to be generated by what is a distorted system with very skewed incentives – so increases in investment must be matched by increases in debt.

To the extent that investments are not economically viable, this means that the value of debt correctly calculated must rise faster than the value of assets. By definition this results in an unsustainable rise in debt.

July 31, 2015 comments: I don’t have much to add to this. Currently the reported nominal growth in credit is around 12%, and in fact is probably higher. Reported nominal GDP growth is around 5%, but the growth in debt servicing capacity is probably lower. The unsustainable increase in debt continues to be China’s greatest economic vulnerability.

By 2013-14 Chinese GDP growth will slow sharply, and by 2015-16 predictions of a sustained period of growth rates at 3% or lower will no longer seem outlandish.

I don’t expect a significant growth slow-down until after the new leadership takes power in late 2012, but my guess (and hope) is that by 2013 the stubborn refusal of consumption to rise as share of GDP, and the continuing surge in debt, will have convinced all but the most recalcitrant that China needs a dramatic change of policy. The longer we wait, the more debt there will be and the more pressure there will be on Beijing to use household wealth transfers to service the debt.

Why do I say we will be talking about 3% growth soon? Two reasons. First, I am impressed by the bleakness of historical precedents. Every single case in history that I have been able to find of countries undergoing a decade or more of “miracle” levels of growth driven by investment (and there are many) has ended with long periods of extremely low or even negative growth – often referred to as “lost decades” – which turned out to be far worse than even the most pessimistic forecasts of the few skeptics that existed during the boom period. I see no reason why China, having pursued the most extreme version of this growth model, would somehow find itself immune from the consequences that have afflicted every other case.

Second, I just use a very simple calculus. Remember that rebalancing is not an option for China. It will happen one way or the other, and the sooner the less disruptive. And for China to rebalance in a meaningful way, consumption growth is going to have to outpace GDP growth by at least 3-4 full percentage points (and even then, at that rate, it will take China over five years to return to the 40% that was not long ago considered astonishingly low).

During the boom of the last decade consumption has grown at a very sharp 7-8% annually. If consumption growth remains at that level, China can slowly rebalance with GDP growth of 4-5%. But historical precedent (along perhaps with common sense) suggests that if GDP growth drops so sharply, from 10-11% to 4-5%, it will be incredibly difficult for household income and household consumption growth to be maintained. In that case a 2-3% drop in household consumption growth may be a fairly conservative estimate, and as the growth rate declines, GDP growth will also decline with it. I discuss this more in a WSJ OpEd piece last week.

July 31, 2015 comments: I don’t have much to add to this.

The decline in Chinese growth will fall disproportionately on investment and, because of this, it will severely impact the price of non-food commodities.

In the past, as the consumption share of GDP declined sharply, the investment share rose. By definition as China rebalances, this process must reverse. This must mean that consumption growth will speed up (relatively, at least) and investment growth decline even if overall GDP growth remains unchanged. Of course if GDP growth drops, as it absolutely must, investment growth must drop even more.

The implications are inescapable, although I think many people, especially in the commodities sector, have missed them. If GDP growth drops by X%, investment growth must drop by substantially more than X%. This is what rebalancing means.

July 31, 2015 comments: In a 2012 blog entry I went into much greater detail on why I expected hard commodity prices to fall and argued that by 2015 most metal prices would be down by at least 50%.

What happens to real interest rates will determine when the process of Chinese adjustment begins. In fact there is a chance that we may see growth in China slow significantly in 2012, perhaps even to 7%, although I suspect that it will probably be in the 8-9% region.

This is a bit of wild speculation on my part, but depending on what the PBoC is allowed to do with interest rates, we may see the beginnings of an adjustment as early as next year. In the past year the PBoC has raised interest rates by roughly 125 basis points. Obviously, as I have argued many times, this has not been nearly enough given the much higher increase in inflation and it is part of the reason why the domestic imbalances have seemed to have gotten worse in the past year, not better.

But I expect that inflation will begin to decline soon, and it may even drop quite sharply. In that case what will the PBoC do to interest rates? If they can refrain from lowering them, the higher interest rates will reduce overinvestment while putting more wealth into the pockets of household deposits. This will both slow growth and speed up rebalancing.

Will it happen? I have no idea. What the PBoC does to interest rates is likely to be the outcome of a struggle in the State Council between policymakers that are worried about growth and those that are worried about imbalances. If the PBoC can hold off the former, and especially if wages continue rising, we might begin to see Chinese rebalancing taking place a little earlier than expected. Of course this must, and will, come with much slower GDP growth.

July 31, 2015 comments: In fact the PBoC was able to keep from lowering interest rates and GDP growth did indeed begin to drop in 2012, while consumption bottomed out as a share of GDP around that time.

Growth rates of 3% will not necessarily lead to social and political instability. Most analysts argue that China needs annual growth rates of at least 8% to maintain current levels of unemployment. Anything substantially lower will cause unemployment to surge, they argue, and this would lead to social chaos and political instability.

I disagree. The employment effect of lower growth depends crucially on the kind of growth we get. The problem is that China’s current growth model encourages a heavily capital-intensive type of growth – wholly inappropriate, in my opinion, for such a poor country.

But since rebalancing in China requires less emphasis on heavy investment and more on consumption, and since rebalancing also means a sharp reduction in free credit provided to SOEs and local governments and cheaper and more available credit for efficient but marginal SMEs, a rebalancing China would presumably see much more rapid growth in the service sector and in the SME sector, both of which are relatively labor intensive. Much lower growth, in that case, could easily come with minimal changes in overall employment.

That is why Japan is a useful reminder of what can happen. After 1990 GDP growth collapsed from two decades of around 9% on average to two decades of less than 1% on average, but there was no social discontent, and unemployment didn’t surge. Some analysts credited Japanese lifetime employment or invoked the natural docility of Japanese people (a bizarre argument at best) to explain the lack of social upheaval, but for me it was because Japan genuinely rebalanced in the past two decades.

Before 1990 GDP growth sharply outpaced consumption growth, whereas after 1990 their positions were reversed – consumption growth sharply outpaced GDP growth. In that time the Japanese savings rate declined sharply, the household income share of GDP rose sharply, and Japan became less dominated by the industrial giants that were almost synonymous with Japan of the 1980s.

So as I see it the Japanese didn’t react to Japan’s “collapse” with outrage or horror largely because Japan didn’t really collapse in any meaningful sense. Japanese standards of living on average continued to rise after 1990, and on a real per capita basis probably only a little slower than they had before 1990. It was the state sector that bore most of the brunt of the slower growth, and this shows up as the explosion in government debt. Households were fine because although the GDP pie was growing at a much slower rate after 1990 than before, their share of the pie was growing after 1990, whereas it shrank before 1990.

I think the same might happen, or at least could happen, in China. It depends in part on how resistant the elites are to the process of rebalancing, which almost by definition means eliminating the distortions that had benefitted them for so long. As Jeffrey Frieden points out in his brilliant Debt, Development and Democracy (1992), the elites that benefit from economic distortions are traditionally the ones most likely to prevent necessary adjustments, and if they actually run the whole show, adjustment can be incredibly painful and disruptive.

If I am right, and China begins to rebalance (and it has no choice but to rebalance unless it has infinite borrowing capacity and the world has infinite appetite for Chinese surpluses), then the debate must shift from economics to politics. We need to understand how and under what conditions China’s elite will permit an elimination of the distortions that benefitted them. For example, under what conditions will the export sector and its defenders allow the RMB to rise, or will SOEs and provincial governments tolerate an increase in interest rates, and so on?

July 31, 2015 comments: I continue to believe that a rebalancing China can manage GDP growth rates of 3% without a social breakdown because household income growth will continue at levels not much below current levels. This is till a controversial argument but a lot less controversial today than in 2011.

Because of its rapidly rising debt burden, the only way for China to manage a smooth social transition will be through wealth transfers from the state sector to the household sector. In the past, Chinese households received a diminishing share of a rapidly growing pie. In the future they must receive a growing share. This will probably be accomplished through formal or informal privatization.

The right way to engineer the transition to a system in which household wealth isn’t used to subsidize growth is to raise wages, raise the value of the currency, eliminate SOE monopoly pricing, and raise interest rates. The problem is that all of these have to adjust so far that to do so quickly would lead to massive financial distress. It would also lead to rising unemployment and, with it, declining consumption, so that the rebalancing would occur through low consumption growth and perhaps negative GDP growth. No one wants this outcome.

Doing so slowly, however, so as not to cause financial distress and a surge in unemployment will result in worsening imbalances over the medium term. It will also lead to a continued building up of debt – and I think we only have four or five more years of this kind of debt build-up before we hit the debt crisis that every other investment-driven growth miracle country has faced.

So what can Beijing do? They’re damned if they go slowly and they’re damned if they go quickly. There is however an alternative solution that is relatively easy (easy economically, not politically). It is to increase household wealth through a one-off transfer from the state sector. The state can privatize assets and use the proceeds either to increase household wealth directly (gifts of shares, improvement in the social safety net, etc.) or indirectly (clean up the banking system and pay down debt).

Right now it is hard to find anybody who really thinks Beijing will engage in a massive privatization program, but this is the only logical alternative I can come up with, and it is the least painful. So my guess is that in two or three years privatization will become a very popular topic of policy discussion.

July 31, 2015 comments: I went into greater detail on my reasoning in the section above on demographics and rebalancing.

European politics will become much more difficult and disruptive. The historical precedents are clear. During a debt crisis the political system becomes fragmented and contentious. If the major parties don’t become radicalized, smaller radical parties will take away their votes.

Remember that the process of adjustment is a political one. We all know someone has to pay for the massive adjustment countries like Spain must make. The only interesting question is about who will be forced to take the brunt of the payment – workers in the form of unemployment, the middle classes in the form of confiscated savings, small businesses in the form of taxes, large businesses in the form of taxes and nationalization, foreigners, or creditors.

Deciding who pays is a political process, and because the stakes are so high it will be a very bitter process. This means, among other things, that politics will degenerate quickly, and of course if Europe doesn’t arrive at fiscal union in the next year or two, it probably never will. This conclusion is also the reason for my next prediction.

July 31, 2015 comments: I don’t have much to add to this.

Spain will leave the euro and will be forced to restructure its debt within three or four years. So will Greece, Portugal, Ireland and possibly even Italy and Belgium.

Once the market determines that debt levels are too high, then debt levels become too high, and without a deus ex machina the results are predictable. All the major economic agents begin to behave in ways that worsen the debt crisis until finally the country slides into default. Businesses will disinvest, creditors will demand shorter and riskier maturities, workers will strike, politicians will shorten their time horizons, and banks won’t lend.

In that case, with incentives lines up so that all the major economic agents worsen the debt problem, debt must rise faster than both GDP and the country’s debt-servicing ability. The worse the debt level gets, the faster debt rises relative to GDP. What’s more, the only strategies by which Spain can regain competitiveness are either to deflate and force down wages, which will hurt workers and small businesses, or to leave the euro and devalue. Given the large share of vote workers have, the former strategy will not last long. But of course once Spain leaves the euro and devalues, its external debt will soar. Debt restructuring and forgiveness is almost inevitable.

July 31, 2015 comments: Debt has indeed continued to rise at an unsustainable pace and I do not expect any change soon. It is still too early to say whether or not then other part of this prediction, that of a multiple euro exit, will turn out to be correct, but I expect it will. The underlying argument is that remaining within the euro will cause enormous economic disruption and unsustainable increases in debt, and that ultimately voters will choose to leave. Because I expect the economic disruption to drag on for many more years, peripheral Europe will continue to face one choice or the other.

Unless Germany moves quickly to reverse its current account surplus – which is very unlikely – the European crisis will force a sharp balance-of-trade adjustment onto Germany, which will cause its economy to slow sharply and even to contract. By 2015-16 German economic performance will be much worse than that of France and the U.K.

If Germany does not take radical steps to push its current account surplus into deficit, the brunt of the European adjustment will fall on the deficit countries with a sharp decrease in domestic demand. This is what the world means when it insists that these countries “tighten their belts”.

If the deficit countries of Europe do not intervene in trade, they will bear the full employment impact of that drop in demand – i.e. unemployment will continue to rise. If they do intervene, they will force the brunt of the adjustment onto Germany and Germany will suffer the employment consequences.

For one or two years the deficit countries will try to bear the full brunt of the adjustment while Germany scolds and cajoles from the side. Eventually they will be unable politically to accept the necessary high unemployment and they will intervene in trade – almost certainly by abandoning the euro and devaluing. In that case they automatically push the brunt of the adjustment onto the surplus countries, i.e. Germany, and German unemployment will rise. I don’t know how soon this will happen, but remember that in global demand contractions it is the surplus countries who always suffer the most. I don’t see why this time will be any different.

July 31, 2015 comments: There was always the possibility that rather than adjust internally Europe would be able to postpone adjustment by forcing its internal imbalances onto the rest of the world, but I really thought this would be so irresponsible, and unacceptable to the rest of the world, that it couldn’t happen. In fact it did. Europe is running enormous trade surpluses as countries like Germany, rather than force its demand deficiency onto its European partners, has forced the whole European area into demand deficiency which it hoists onto the rest of the world. This is not a solution but only a temporary postponement of the solution, and its only effect will be to derail the US recovery and to make Japan’s and China’s adjustments much more difficult.

As the U.S. fights over the fiscal deficit and whether or not it is the right way to expand domestic demand, more and more politicians will focus on the expansionary impact of trade protection. There will be an increasing tendency to intervene in trade – in fact I think of quantitative easing as a policy aimed at trade and currency imbalances as much as one aimed at domestic monetary management.

As unemployment persists, and as the political pressure to address unemployment rises, the U.S. will, like Britain in 1930-31, lose its ideological commitment to free trade and become increasingly protectionist. Also like Britain in 1930-31, once it does so the U.S. economy will begin growing more rapidly – thus putting the burden of adjustment on China, Germany (which will already be suffering from the European adjustment) and Japan.

Trade policy in the next few years will be about deciding who will bear the brunt of the global contraction in demand growth. The surplus countries, because they are so reliant on surpluses, will be very reluctant to eliminate their trade intervention policies. Because they are making the same mistake the U.S. made in the late 1920s and Japan in the late 1980s – thinking they are in a strong enough position to dictate terms – they will refuse to take the necessary steps to adjust.

But in fact in this fight over global demand it is the deficit countries that have all the best cards. They control demand, which is the world’s scarcest and most valuable commodity. Once they begin intervening in trade and regaining the full use of their domestic demand, they will push the adjustment onto the surplus countries. Unemployment in deficit countries will drop, while it will rise in surplus countries.

July 31, 2015 comments: As the US recovery continues to be weakened by trade war, I continue to expect the trade environment to get worse. Three days ago the Financial Times published an alarming article about the falling volume of world trade in which it said “The problem has been getting worse for some time. Trade bounced back fairly well in 2010 after the global recession but it has disappointed ever since, growing by barely 3 per cent in 2012 and 2013. Now it seems the world cannot manage even that.” I expect trade will be a major topic in the upcoming presidential elections and Americans will increasingly (and probably rightly) question the value of its openness to trade in a world in which every major economy is attempting to export its excess savings and its domestic demand deficiency onto the US.

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213 Comments

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Mike M. July 31, 2015 at 11:15 am

I think the synthetic put becomes increasingly less IN the money and its value FALLS as the index approaches 4500 (i.e. it’s the gamma/convexity that is rising, not the value of the option itself). This doesn’t mean your logic as to how investors are likely to behave is wrong in any way though.

Reply
- Michael Pettis July 31, 2015 at 11:36 am
  
  Sorry for the slip-up, but of course you are right and I have corrected it.
  
  Reply
cjared July 31, 2015 at 2:26 pm

Thank you for the review.

On your last point, “US recovery continues to be weakened by trade war”… Can you elaborate on this, please?

Outside of the press hype, have the numbers been down? Or just shifting around? Has North America been importing less? Or is it still around 10% of GDP? Are North American exports still around 6% of GDP? North America does not depend on exports to sustain it’s economy, and imports lower consumer prices. All good assuming a low unemployment rate (and high participation rate). Baby boomers are in their sixties now, the oldest turning 70 this year. North America will struggle with it’s participation rate moving forward one generation. And the unemployment rate is dropping.

…so… weakened by trade war?….

Reply
- G Stegen August 2, 2015 at 6:14 pm
  
  Cjared:
  You asked: ‘ “US recovery continues to be weakened by trade war”… Can you elaborate on this, please?’
  I offer the following to elaborate on this topic.
  
  In the balance of your comment you state:
  
  “All good assuming a low unemployment rate (and high participation rate). Baby boomers are in their sixties now, the oldest turning 70 this year. North America will struggle with it’s participation rate moving forward one generation. And the unemployment rate is dropping.”
  
  This quote suggests you believe the US is producing all that it can (no output gap) and therefore the trade deficit represents excessive US consumption (consuming more than it can produce) as opposed to insufficient US production (producing less than it can while continuing to consume at a higher rate. I would strongly disagree with this conclusion, and I believe the vast majority of economists agree that US economic growth has been and is primarily demand constrained, not capacity constrained. Bits of evidence:
  • Labor. low labor participation rates, relatively high unemployment (especially when considering discouraged workers that have dropped out of the labor force, involuntary part time workers, and underemployment), larger increases in low value added versus high value added jobs.
  • Low or moderate industrial capacity utilization. Many thousands of US factories closing down in the last 15 years. Reduced investment in new US factories due to lack of (profitable) demand. A number of bankruptcies of US manufacturing companies. Many US based companies are either 1) accumulating cash; 2) moving new or increased production to foreign countries; and/or 3) buying back stock. These show that there is capital available for investment, but that companies are not finding enough profitable investments in US based production to absorb the amount of capital available. It seems safe to assume that the lack of investment is primarily related to weak demand.
  • QE and zero interest rates. The major monetary stimulus over the last 7 years is primarily an attempt by the Fed to stimulate demand (consumption and or investment demand). It seems clear that the Fed believes there is inadequate demand. If the economy were near full capacity this massive monetary stimulus would be expected to result in high inflation rates, which clearly has not happened.
  • Essentially all products are in ample if not oversupply conditions. All major commodities, industrial products, and consumer products seem to be in ample supply. Are there shortages of anything? Nothing of much significance that I know of.
  
  Based on the above, inadequate demand is the primary reason for the slow US recovery. So, what does this have to do with the trade deficit and the statement about the ongoing “trade war?” Exports represent foreign demand that is being satisfied by US based production while imports represent US demand that is being satisfied by foreign sources. The trade/current account deficit represents net US based demand that is not being satisfied by US based sources. Therefore, based on the presumption of an output gap/demand shortage the current account deficit results in a reduction in us GDP and GDP growth, i.e. an increase in the trade deficit tends to weaken the recovery and a reduction in the deficit tends to strengthen the recovery. There is a worldwide problem of excess production/excess savings. The ongoing trade war (or savings war) represents attempts by a number of countries (and the Eurozone as a group) to export their excess production/excess savings. The methods used are many and vary from country to country as Pettis has written about a lot. To the extent they are successful they increase the trade surplus of the exporting country and tend to increase the trade deficit of the deficit countries; e.g. the US, reducing the effective demand for US made products and hence slowing the rate of economic recovery.
  
  You state: “North America does not depend on exports to sustain it’s economy…” This claim is not really true. North America depends on many pieces and part to sustain the economy, and exports are an important part.
  
  You state: “imports lower consumer prices.” This is a primary benefit of free trade. If the counterparty spends their export earnings then trade stays balanced and both parties benefit. However, if the counterparty does not spend their export earnings the full benefits do not happen. If the persistent surplus countries (China, Germany, etc.) were to reduce their current account surpluses by spending their excess export earnings the trade deficits of the US and other deficit countries would drop proportionally. The resulting increase in effect demand would stimulate these economies and increase their GDP growth rates, i.e. strengthen their recovery from the financial crisis and ensuing recession. The resulting increased production and jobs in the US would tend to offset the likely rise in some import prices that would affect US consumers.
  
  Reply
  - cjared August 4, 2015 at 1:24 pm
    
    First, my numbers of 6% & 10% are very much “back of the envelope”… but I imagine not that far off…and I welcome correction. And if you parse the North America’s exports most are inelastic, and Europe plays the largest consumer role. If you exclude exports that turn around and are imported back, such as CPUs…. then what importance do manufactured exports really have to North America?
    
    Of course I am a big fan of Prof. Pettis. I lived through the hyperbole surrounding Japan not that long ago. I lived in Japan for part of the period just after the savings & loan crises / real estate bust. Plus ca change.
    
    Still, if we widen the definition of trade beyond aggregated invoices that flow through customs then the picture changes somewhat. But there is still no trade war unless trade numbers are declining. I see imports into NA only increasing. How can we be at “war”?
    
    Reply
  - csteven August 5, 2015 at 10:14 pm
    
    Excellent, and entirely correct response. This failure to cycle also ensures that global trade will diminish as Zeihan has decided. This failure to recycle is what drove the twin towers, deficits (trade and budget), nd lessened the potential of all economies, but for the commodity dependent economies, and the shallow percentage of each economy that is based in finance around equity markets (and other markets). This is what each of us who saw the GFC coming new, and thus why we were much more able to read the fallout that would accompany the GFC. While many of us never thought that China would go to the excesses it has in the aftermath, although we new it would stimulate, the further tends were predictable.
    
    Reply
Will July 31, 2015 at 2:46 pm

I apologize if this question doesn’t make sense, but is it possible that the Chinese government is using the stock market – intentionally or not – to transfer wealth to households? Because the government-controlled entities keep buying, and because a huge part of the market is made up of retail investors, as the market hovers slightly below 4500, the government-controlled entities hold an increasing percentage of shares and the Chinese households hold an increasing amount of cash. If so, how do you think would affect the rebalancing process?

Reply
- John August 1, 2015 at 8:25 am
  
  “and because a huge part of the market is made up of retail investors,”
  
  It’s not. Retail investors make a small portion of the market. A tiny amount of Chinese households are invested in the stock market (compared to the USA). If anything, it just got some wealthy Chinese even wealthier (insider selling while it was allowed plus those who were in the know).
  
  Reply
Complex Velocity July 31, 2015 at 2:53 pm

I think the economy turning towards consumption for stability must allow innovation driven by control of profits on a personal level. How they balance capitalist drivers within China transforming will be a huge wild card.

If the gambling fever within the population can drive betting on one’s self and idea’s are born in times of crisis this can propel the transformation instead of top down solutions leaving the majority hoping the investments in solar power or construction, bubble investing is all they have. The leaders must provide an open platform for this innovation, become ” angel investors ” for those who will drive technology forward knowing many projects will ebb and flow, some will fail others will become a foundation for great things ahead. Innovation must be transfered along with profit potential.

The batton must be passed now as every downturn always brings innovation within a capitalist society. It is the mind set of control and support that must also change because China can’t continue down it’s path of top down wizard behind the curtain pulling all levers as the transfer of innovation from the top down has been met with graft, accounting fraud, so by the time it hits the population the expectations and value are lost and the feeling of being let down by corruption has most feeling like they have no voice or future that is no different than most hurt by this construct.

If China does not release control on many levels including voting or giving people a voice in future generational opportunity, they will be crushed on all sides by this ill fated attempt at a consumer driven economy. They must put wealth into the population with renminbi revaluation upward, they must let the dreams of the younger generations drive growth at this point everyone will buy into the future no matter how bad things become in the short term or medium term.

It must happen now, you will soon see a massive deflation wave wash over the globe causing massive uncertainty and if the PBoC still operates as it has in the past the wreckage of what’s coming will cause long term embedded distrust as the proof will be before the people as promises are not met and the top down methods of suppling answers and safety will also be lost. The push back is coming from trade partners and China will be hit very, very hard by this. The tariffs ( tax ) China adds onto imports are being questioned and these will be broken as negotiation by countries needing job growth will force many changes upon long standing luxuries China has enjoyed up until now.

With so many things changing at warp speed as deflation runs wild once again the real question is how disorderly the financial system unwinding becomes as many things are totally out of control of the PBoC and it’s abilities to weather this global storm will have a profound change within the existing system.

Reply
abee crombie July 31, 2015 at 4:36 pm

Great post once again and thanks for reminding us how prescient your calls have been. It has really shaped my thinking. But one aspect you dont spend much time on is how authorities will respond to this lower growth, and when I say authorities I mean mostly monetary and fiscal policy. It seems one of the great areas on misunderstanding today is the divergence between asset prices and economic growth.

If growth is going to slow in China, in EM and eventually blow up in Europe, it seems the only tool we have left is QE and monetary games. It sucks if you are Greece or Venezuela and cant print a currency the world wants but otherwise it seems like the problem is also the solution. Any thoughts on what are the 2nd round effect if your predictions play out fully would be appreciated.

Reply
- Michael Pettis July 31, 2015 at 4:59 pm
  
  Thanks, AC. I think we are going to relearn that a lot of what we think of as economics is really politics. I am not sure what the authorities will do because ultimately their response will be the outcome of a political struggle, and about political outcomes I can’t really do much more than guess. My goal is to try to figure out logically what are the various paths, and perhaps work through their consequences. In the end, there has to be a redistribution of income downwards, because without redistributing income there will not be sufficient demand to justify raising capacity. But income can be redistributed downwards in many ways. The most common ways tend to be political redistribution, sovereign defaults, inflation, or war. We should hope and work for the first of these forms of redistribution, but I guess we will get one or the other.
  
  Reply
  - Bill Rich July 31, 2015 at 9:36 pm
    
    Redistrubtion downward in China means redistribution from the powerful to the people. The powerful also happened to be those close to, or are, decision influential and makers. Will these powerful willing to distribute their own financial resources to the people consciously ? PRC isn’t (or never had been) a communist country anymore.
    
    Reply
    - johny August 4, 2015 at 8:51 am
      
      ” The people” will never ask if the powerful are willing to redistribute. They never are.
      Which does not mean they can not be forced.
      
      Reply
  - abee crombie August 1, 2015 at 10:02 pm
    
    Redistribution of wealth is a topic d’jour but I am not convinced it is the solution to a demand deficit in the world. Seems to me politicians are woefully incapable of making such decisions. The political example set by socialist countries (Brazil, France) has no credibility and the capitalistic side (US, Germany) seem to believe in more a tickle down policy which doesnt seem to be working either. China might be the only place that could actually do it right but the way their own economic machine is set up currently, as you mention, means that it is unlikely they will be able to pick all the slack on their own. It will probably take another crisis (in asset prices) that will trigger a new way of thinking. Until then I dont see how policies really change (aside from China where you know their long term goal but not really sure how they will achieve it).
    
    As an aside, I’m not sure if you caught it, but Russell Napier had an interesting note out saying he thinks that current BoP system is over, now that China is selling reserves and that this will serve to raise interest rates in the US. link text
    
    Reply
    - Michael Pettis August 2, 2015 at 11:31 am
      
      There is a lot of confusion about the impact of PBoC purchase of USG bonds and US interest rates, AC, and the Napier piece repeats some of these, and other, confusions. It refers, for example, to EM as the global engine of growth, and while this was a common mistake when I wrote the predictions, I didn’t think analysts still believed it. I think it also confuses foreign appetite with central bank appetite. If central banks begin to sell USG bonds because other investors in their countries are taking money out, the net effect is probably zero. These investors are taking money out of EMs and putting it into safer developed markets, mainly the US, so all that is happening is that non-central-bank flows into the US are replacing central-bank flows into the US.
      
      The fact that these new flows are more likely to go into risky assets than into USG bonds has only a minor impact, mainly to tighten the credit spread, because when foreign investors buy risky US assets, the seller of those assets must do something with the money, and ultimately either he pays down debt or he buys USG bonds or their equivalents. Remember that only one of two things is likely to happen. Either foreign current account surpluses decline, or they don’t, and if these are counterbalanced with capital flows into the US, then either the US current account deficit declines, or it doesn’t. In the latter case there is no net impact. In the former case, the decline in the US CAD will only matter if it is large enough to set off a significant increase in growth, such that the Fed decides to raise rates. There is so much excess capacity and excess savings in the world, however, that I don’t think this will happen for a while.
      
      Reply
- John August 1, 2015 at 7:19 am
  
  “My worry, as I discussed with my clients, was that as the index approached 4,100 or higher, the threat of intense selling by capital-tight brokers at 4,500 meant that anyone buying shares was implicitly giving away a free call at 4,500, and the higher prices went, the less upside there was and the more downside.”
  
  Took me awhile to figure out the “giving away calls” part but eventually I got it. Thanks for the options practice!
  
  I do wonder why in such a speculative situation with a clear strike price would one consider buying common shares at all.
  Wouldn’t it be better to buy calls and sell calls (rolling it forward)? This way you are also not in a net short position
  and can’t be blamed for anything.
  
  Reply
Suvy July 31, 2015 at 6:21 pm

Just a note, when you say BRICS, what you really mean are BRCS minus India. India is a energy importer with a domestic demand driven economy that’s had a fall in input costs stemming from the collapse of commodity prices.

As for trade war, it’s already here. I ran into some Bernie Sanders supporters and discussed various issues with them. Needless to say, we agreed on 80-90% of the issues that were on the table and the rest of the issues were primarily minor disagreements. There’s (far) more agreement between the “radical libertarians” and the “radical progressives” than there is between the “mainstream Democrats” and “mainstream Republicans”.

The biggest issues we discussed were trade, inequality, and foreign policy. We seemed to be in virtual agreement on most of these issues. The quibbles came with regards to health care where they favored single-payer, which I’m vehemently against. I favored disaster health insurance (low premium, high deductible which is happening with the ACA) with mandatory health savings accounts for regular expenses–Rand Paul has been advocating for something like this. With regards to tax policy, I thought a flat tax, at say 15-20%, with an exemption for the first $30-50k which again the other side had little problem with.

The new axis is developing and the old political structures are well on their way to being broken down. The ideologies have started to change while Republicans are campaigning on what were traditionally Democratic issues and vice-versa. The old elites are in the process of being purged and I suspect the process will only accelerate. All of us also supported the taxation of US assets abroad along with the need to break the cartels, like the big banks. We seemed to be on the same page with regards to decentralization, except for health care apparently. So yea, the changes are here and it’s changing quite suddenly.

What you said about elites controlling the system and the inflexibility that’s reflected in giving the elites so much control is exactly the problem throughout the world. The old elites need to be purged across the entire world, and they will eventually be. In the US, this process is well underway.

Reply
- Suvy July 31, 2015 at 6:26 pm
  
  *There’s more agreement between “radical Republicans” and “radical Democrats” than there is between the “radical progressives” and “mainstream Democrats” or the “radical Republicans” and the “mainstream Republicans”.
  
  I myself was very pleased after the conversation. I’ve got old friends who also support Bernie Sanders and it’s great news to hear that both fringes are based in similar ideas. I’d rather vote for Bernie Sanders or Elizabeth Warren than I would Hilary Clinton. I’d also much rather vote for Rand Paul or even Donald Trump than I would for Jeb Bush.
  
  Reply
John August 1, 2015 at 8:20 am

My executive summary of this most brilliant post by Prof. Pettis is:

Long USD, short everything else.

Reply
Alex August 1, 2015 at 12:20 pm

These revisitations are always entertaining and enlightening – thanks. I know this blog usually avoids questions about asset prices, but especially given the discussion of non-food commodities, and of Chinese stocks, I wondered if you wouldn’t mind speculating on what sorts of assets would do *well* in the environment you predict. Hyun Shin had a nice paper in 2013 you probably read about the second phase of (excess) global liquidity being driven by emerging market bond issuance (the first phase was driven by global bank leverage). But if Europe falls apart, and the US recovery is thereby derailed, and Abenomics goes into tailspin; man, where the heck will you put your money?? Bit of a gauche question, I know; but I do think answering it helps elucidate the predicted shifts.

Shin’s paper
http://www.princeton.edu/~hsshin/www/FRBSF_2013.pdf

Reply
SL August 1, 2015 at 5:40 pm

Another great article. Thank you.

What is your opinion on the massive capital outflows happening in China right now? It seems to be slipping under everyone’s radar but with the stock market debacle and the economy slowing, I think it should be seen as an important piece of the puzzle.

Reply
- Michael Pettis August 2, 2015 at 11:17 am
  
  The outflows have been there for a long time and probably picked up in Q2, and they are putting a great deal of pressure on the banking system, but they are definitely not under everyone’s radar. Most China analysts have been discussing the rising outflows since 2010-12, and the whole SDR negotiation is probably about reversing the capital account deficit
  
  Reply
Stan August 1, 2015 at 7:25 pm

@ Alex

I think better question is “where the heck” (corporations) ” will put” their money. They have accumulated over
several T’s in overseas profits. Will they put it in M & A or in economically viable investments? Will they need tax encouragement from Congress ? Will they ask Mr. Elon Musk for an advice?

Reply
John August 2, 2015 at 8:23 am

I do apologize for posting another one! (no need to post it if it’s too much).

Following what Prof. Pettis wrote about Europe, here is a table of Euro current account balances with the rest of the world:

http://ec.europa.eu/eurostat/statistics-explained/index.php?title=File:Current_account_balance_with_the_rest_of_the_world,_2004%E2%80%9314_(%C2%B9)_(EUR_billion)_YB15.png&oldid=241472

The numbers speak louder the words.

1. Germany’s surplus is shockingly high for so long.
2. Can easily see how from 2013 Spain and Italy turn positive. Now this is where it’s interesting:
3. It’s not really the US with its flat deficit, it is in fact the UK who has seen it’s deficit skyrocket!

My question for the readers: considering the UK is not the US (pardon Mr. obvious here) and that it’s not the one with the reserve currency, can it simply decide it had enough and push it back on the eurozone? If so, how? Thanks.

Reply
- Michael Pettis August 4, 2015 at 2:41 pm
  
  In addition, John, commodity producers saw their surpluses contract or their deficits widen, and effectively ended up absorbing much of the shift in the European current account. Because it is almost arithmetically impossible for them to do so to the same extent, continued large European surpluses will be absorbed with much greater difficulty. I think at some point the UK will push back, and the sooner the better. Check out UK growth and trade in the 1920s and 1930s to see a similar story.
  
  Reply
Vinezi Karim August 3, 2015 at 9:19 pm

Michael predicted in 2009 & repeated in 2011 that: “The US will be the first major economy to emerge from the global crisis”
Michael again stated in 2013 that (see item 13 in linked page): “The US…xxxx.. tends to adjust fairly quickly and I expected that this time would be no different. Although this was another one of the predictions that seemed to cause a lot of surprise and disbelief when I first proposed it in 2009, and even two years ago, I am pretty sure that by now no one is surprised by the claim that the US is in the process of recovery…..”

http://blog.mpettis.com/2013/09/revisiting-my-2011-predictions/
———————————-

(I) Unemployment Rates
http://data.bls.gov/timeseries/LNS14000000
US Unemployment 2008: 5% of Labor Force (Pre-crisis)
US Unemployment 2009: 10% of Labor Force (CRISIS)
US Unemployment 2015: 5.3% of Labor Force (Is this recovery?)
Improvement since crisis low point: 4.6 Percentage Points

(II) Participation Rates
http://data.bls.gov/timeseries/LNS11300000
US Participation rate 2008: 66.1% of 15+ population
US Participation rate 2009: 65.5% of 15+ population
US Participation rate 2015: 62.6% of 15+ population
Deterioration since before-crisis high point: 3.5 Percentage Points

(III) Workers to Adult Population Ratio
http://data.bls.gov/timeseries/LNS12300000
US Employment to Population Ratio 2008: 62.5% of 15+ population
US Employment to Population Ratio 2009: 59.4% of 15+ population
US Employment to Population Ratio 2015: 59.3% of 15+ population
Deterioration since before-crisis high point: 3.2 Percentage Points

This suggests that much of the the unemployment rate “improvement” in the last
7 years is largely because of workers who have become so discouraged that they
have given up actively looking for work, and are, therefore, not being counted
in the active labor force anymore (i.e. a reduction in participation rate).

(IV) Labor Force Numbers
http://data.bls.gov/timeseries/LNS11000000
US Labor Force 2008: 154.0 Million (Employed plus actively looking for work)
Therefore, using (I), 154.0*0.950 = 146.3 million working & 7.5 million looking for work.
US Labor Force 2009: 154.5 Million (Employed plus actively looking for work)
Therefore, using (I), 154.5*0.900 = 139 million working & 15.5 million looking for work.
US Labor Force 2015: 157.1 Million (Employed plus actively looking for work)
Therefore, using (I), 157.1*0.947 = 148.7 million working & 8.6 million looking for work.

Here are the data on actual workers employed as a confirmation double-check:
http://data.bls.gov/timeseries/LNS12000000

NOTE CAREFULLY: The number of actual workers in 2015 is only slightly higher than in 2008, by around
2.5 million over 7 long years. From the historical trend determined by demographics, we know that
about 1.5 million people should have been entering the workforce EVERY YEAR under normal circumstances.
Therefore, we should have seen the number of workers rise by 10.5 million or so over this 7-year period.
This implies that massive additional unemployment of about 8 million is currently being disguised as
“voluntary non-participation” (i.e. reduction in participation rate) for statistical purposes.

From these data, we can conclude that the “fairly quick” recovery that Michael predicted for the US
is still nowhere in sight even after 7 long years. The US economy is now trapped in a low-level equilibrium
with high hidden-unemployment. Unless the rising debt-load model that the US has been using for the last 35 years is CHANGED, I fear that true recovery may never come. In fact, this is why the CBO and the IMF are independently projecting that the US growth rate has settled into a lower equilibrium and will not be able to average more than 2% over the next decade.

What are the various views (whether optimistic, pessimistic or realistic) on this issue?

Reply
- Claire August 4, 2015 at 5:45 am
  
  Does it make sense to compare current data to 2008 (which was the peak of a market) instead of a more typical year (or a moving average or whatever)?
  
  As a side note, I actually think that the number and wages for illegal immigrants or jobs (e.g. people paid under the table) would probably provide a better indicator, as that market must be pretty ruthlessly efficient in balancing labour supply and demand (and could perhaps explain some of the “high hidden unemployment”–I don’t know). I don’t know if anybody collects stats on that, though.
  
  Just an off-beat thought.
  
  Reply
  - Vinezi Karim August 4, 2015 at 5:42 pm
    
    ^^Claire WROTE: “Just an off-beat thought…”
    ———————–
    
    What is your projection (or guess) for the trend in participation rate for the NEXT 7 years?
    https://goo.gl/RzdbcP
    
    Will the graph (i) keep going down, or (ii) flatten out, or (iii) climb back up again?
    
    Reply
- Suvy August 4, 2015 at 1:59 pm
  
  I think the workforce/population ratio is actually fine if you adjust for demographic shifts. 2% GDP growth/year is a lot and I don’t think people realize how much even 1% GDP growth per capita is.
  
  Reply
  - Vinezi Karim August 4, 2015 at 5:00 pm
    
    ^^SUVY WROTE: “I think the workforce/population ratio is actually fine if you adjust for demographic shifts…..”
    ———————–
    
    The Federal Reserve agrees with you and is asking people not to panic……
    https://fredblog.stlouisfed.org/2015/05/labor-force-participation-is-a-trend-or-a-cycle-at-work/
    
    However, if this demographic argument from the Fed is true, then we should be able to see STEEPER drops in participation rates for Japan/Korea which are either older or/and aging much faster than the US. So do we? See for yourself……
    
    http://data.worldbank.org/indicator/SL.TLF.CACT.NE.ZS/countries/JP-KR-US?display=graph
    
    Reply
    - Vinezi Karim August 4, 2015 at 5:57 pm
      
      Just for fun, I have added Spain to that graph. Now we can compare the trends in participation rates between US, Japan, Korea *AND* Spain…..
      http://goo.gl/t2nv7N
      
      Can someone explain why the participation rate is collapsing in the US, while it is more or less steady in Spain? Here are the demographic pyramids for:
      (a) United States
      http://populationpyramid.net/united-states-of-america/2015/
      (b) Spain
      http://populationpyramid.net/spain/2015/
      
      Reply
    - Suvy August 4, 2015 at 7:34 pm
      
      As I said below, this comment can be ignored. My first comment makes no sense and is retarded.
      
      Reply
      - johny August 6, 2015 at 9:10 am
        
        Suvy
        My favorite passage is, speaking of “protection” the USA provided for China:
        “He (general MacArthur ) explained he would drop between 30 and 50 atomic bombs- strung across the neck of Manchuria, and spread behind us, from the Sea of Japan to the Yellow Sea-a belt of radioactive cobalt-for at least 60 years there would be no land invasion of Korea from the North. The Russians, he claimed, would be intimidated by this and do nothing. He continued to seek authority to deploy the bomb. ”
        http://b-29s-over-korea.com/Why-Truman-Fired-General-MacArthur/Why-Truman-Fired-General-MacArthur.html
        Go ahead at try to spin this, how those actions would amount to protection of China.
      - Suvy August 6, 2015 at 9:51 pm
        
        Can you not read? I never said the US was protecting China directly or with special regard to China; I said the US is guaranteeing safe shipping and protection of trade for every country in the world with the trade networks being the world’s oceans.
        
        The global financial system IS the global security apparatus for trade. That doesn’t mean the US is “protecting” every country (although this is what it can amount to indirectly).
    - Dan Berg August 5, 2015 at 8:23 pm
      
      Vinezi: I think you should choose your gerunds more carefully; collapsing? 0.5% / yr. after the worst economic crisis since the ’30s is collapsing? That’s how people describe the Chinese stock market. You seem to partially answer your own question my referring to Spain’s demographics, which is contracting; smaller denominator.
      
      Reply
      - Vinezi Karim August 6, 2015 at 8:42 pm
        
        I don’t know what a ‘gerund’ is, so I won’t quibble about things of which I have no knowledge. However, when you say that the decline of participation rates has something to do with “the worst crisis since the 30s”, you should know that the Federal Reserve is saying something else altogether. According to the Fed (quote):
        https://goo.gl/Lkca7D
        
        “One major concern since the start of the recent recession has been the labor force participation rate. The graph above shows a clear and continuing decline. However, when you reveal the full sample, as shown in the graph below, you can see the decline started BEFORE the recession and the current level is not the lowest in postwar history. It appears, then, at least part of the current evolution of labor force participation has to do with a longer-term trend….”
        
        In other words, the Fed is saying that the collapse (oops, sorry) or “clear and continuing decline” in the participation rate has little to do with the crisis and is merely a continuation of a “longer-term trend”.
        
        Regardless of the finer points, I have two broad questions for you:
        1) Can you find another country in which the participation rate has declined as dramatically as it has in the US in the last 7 years? Surely, if this has something to do with the global crisis, there must be at least one country with a similar trend somewhere. If you cannot find another country with a similar trend, what do you think makes the US so exceptional in this matter?
        http://goo.gl/q36P3X
        2) What is your view of the future trend in the US participation rate? Over the next few years, do you expect the trend in the graph provided by the Federal Reserve to:
        https://goo.gl/Lkca7D
        (a) Keep up the current downward trend and decline further.
        (b) Flatten at the current level.
        (c) Reverse direction and go back up again.
        
        Please let me know your thoughts.
  - Vinezi Karim August 4, 2015 at 6:51 pm
    
    ^^Suvy WROTE: “…..2% GDP growth/year is a lot and I don’t think people realize how much even 1% GDP growth per capita is.”
    ———————————————-
    
    POPULAR STATEMENT: Japan has been in ‘horrible stagnation’ for 24 years.
    
    1) Average GDP growth over 24 years: 1.1%
    http://goo.gl/j4QX3r
    2) Average population growth over 24 years: 0.1%
    http://goo.gl/OI0cTK
    3) Average GDP per capita growth over 24 years ((1)-(2)) = 1.0%
    http://goo.gl/RZkt4r
    
    So are you okay with per capita GDP growth in “dynamic, flexible, innovative US” being the SAME as in “stagnant, rigid, copycat Japan” from here on? But then where is the advantage of all that “dynamism, flexibility and innovation”?
    
    If the US grows at 2% over the next 20 years, then the only real difference between the US and Japan (of the past 20 years) will be the higher population growth (or better demographics) in the US. Given that much of this higher population growth (or better demographics) is attributable to Mexican immigrants, we come to a very strange conclusion that may be written in equation form as follows:
    
    “Dynamic, flexible, innovative US” = “Stagnant, rigid, copycat Japan” + Mexicans
    
    Do you disagree? Please let me know your thoughts.
    
    Reply
    - Suvy August 5, 2015 at 9:47 am
      
      The US has more Asian immigration than Hispanic immigration. Source:
      http://fivethirtyeight.com/features/immigration-is-changing-much-more-than-the-immigration-debate/
      
      The proportion of foreign born Mexicans peaked in 2006-07 and is currently less than the percent of foreign born Mexicans in 1990. Source:
      http://fivethirtyeight.com/datalab/immigration-isnt-driving-hispanic-population-growth/
      
      Reply
    - Jonathan Vause August 5, 2015 at 12:23 pm
      
      Assuming your numbers are right (I’m not saying they aren’t) the US still has the advantage that the higher growth rate makes debt easier to service – Japan looks in more trouble than the US in that regard, even if standards of living are improving at similar rates
      
      Reply
    - Dan Berg August 7, 2015 at 8:17 pm
      
      Vinezi: “continuing decline” is not the same as “collapsing.” You contribute significantly to this blog; you dont want to start sounding like Johny.
      I have no idea what future participation rates will be; my guess is (b) – level off – as the economy strengthens, chinese wage rates rise, immigration slows.
      
      Reply
      - Vinezi Karim August 8, 2015 at 10:00 pm
        
        I don’t know who this ‘Johny’ is, so I won’t quibble about the voice-patterns of people with whom I am not familiar. But surely, the issues you mention, viz., (i) Strength of Economy, (ii) Rate of Immigration, (iii) Wage growth in China are ALL factors in the UK as well.
        
        So then the question becomes this: Why are we not seeing a similar collapse in the participation-rate in the UK?
        
        In fact, this brings us back to the first question I asked in my previous comment: Can you find a single other country in which a similar collapse of participation rate has happened? If not, then what is it about the US that makes it so EXCEPTIONAL in this matter?
        
        We note that a rapid, continuous long-term decline in the participation rate, in general, is an indicator of deteriorating demographics. So in Japan for example, we should expect to see such a decline over the long-term, and this is precisely what we do see:
        http://goo.gl/swqPWh
        
        Note carefully that Japan’s rapid demographic descent began in the mid-nineties and, exactly as expected, the participation rate also begins its rapid descent at around that time. But, surely, the US is known to have the BEST demographics amongst all developed countries. So why should there be a collapse in participation-rates– and the word ‘collapse’ is used advisedly– at a speed that only matches the collapse that Japan, with its horrible demographics, saw from the mid-1990s onward (see above-linked graph again to compare the speed of the collapse). Note further that the indicated graph is from the Worldbank database and ends in 2013; according to the Federal Reserve, the participation rate in the US from 2013 to present has fallen EVEN further:
        https://goo.gl/Lkca7D
        
        In summary, all things indicate that this is clearly an unemployment disaster that the USG is trying to sweep under the carpet by artificially collapsing the NON-HEADLINE participation rate in order to cosmetically improve the HEADLINE unemployment rate. This is a sleight of hand. Note that analysts who are unaware of the collapse in the non-headline participation rate are CELEBRATING the drop in the HEADLINE unemployment rate, which is exactly what the USG wants them to do…
        http://goo.gl/BlsYKM
        
        Michael clearly has spectacular insight into China’s economy and I am convinced that all his prognoses for China will turn out to be 100% accurate. When it comes to the US, however, Michael seems to suffer from a ‘blind spot’. This is the only explanation I can find for why he feels that the US will recover (quote) “fairly quickly, as it always does”. The most common reason for the development of such ‘blind spots’ is what is known as being ’emotionally invested’. It is possible that Michael’s background makes him incapable of being as neutral while analyzing the US economy as he is while analyzing China’s. This phenomenon of ’emotional investment’ is a common aspect of human nature and just requires some work to overcome. Therefore, if Michael makes the effort of emotionally distancing himself from the subject at hand, I am sure that he will be able to see the situation in the US just as clearly as he sees the situation in China. If the blog participants here wish to assist Michael in this process, they should reduce the levels of sycophancy often seen here and make an attempt to stick to the facts on hand.
      - Laurent Harvey August 9, 2015 at 11:30 am
        
        Yeah agree that Americas massive decline in the participation rate is cause for concern. They do have stats on the age groups (eg 15-24) and it does show although people are reaching retirement age, people from most of the age groups are dropping out of the workforce and surprising there is some resilience in the over 60 age group not declining as fast as once thought. Some people say this is because they need the money so the elderly are staying in the workforce.
      - Vinezi Karim August 9, 2015 at 7:50 pm
        
        ^^L.Harvey WROTE: “Yeah agree that Americas massive decline in the participation rate is cause for concern…”
        ———————————-
        
        ‘Cause for concern’ is putting it mildly. In the comments above, one participant insists that a 0.5%/yr drop in the US participation rate is not really a “collapse”. To appreciate the scale of this issue, let us look at the expected long-term decline in the participation rate of Japan that is being caused by its well-known demographic deterioration:
        http://goo.gl/swqPWh
        
        We can clearly that after Japan reached its demographic tipping point in the mid-nineties, the participation rate there has declined exactly as predicted by demographic theory. The total decline is 4.5% (percentage points) over 18 years. This is about 0.25%/yr.
        
        Let us summarize as follows:
        1) The participation-rate in the country with the WORLD’S WORST demographic profile (i.e. Japan) is declining by 0.25%/yr.
        2) The UK, with an average demographic profile, is not showing any specific decline pattern in its participation rate.
        3) The participation-rate in the country with the developed WORLD’S BEST demographic profile (i.e. US) is declining by 0.5%/yr.
        
        This is more than a matter for concern. This is a matter that should trigger fear.
      - Laurent Harvey August 10, 2015 at 1:40 am
        
        Yeah America does have problems. I mean if they had true unemployment at 5.26% (current) with a healthy participation rate since 2008 you’d think we would see some proper wage inflation but we haven’t and it’s stayed anaemic. The fed does know this. If they really believed the unemployment number they would have raised rates already. Record household net wealth has people like Stanley Druckenmiller calling for rate hikes yet the employment picture is still fragile and so the Fed feels caught between a rock and a hard place.
      - Vinezi Karim August 10, 2015 at 11:26 pm
        
        L. HARDY WROTE: “Record household net wealth has people like Stanley Druckenmiller calling for rate hikes yet the employment picture is still fragile and so the Fed feels caught between a rock and a hard place.”
        ——————————-
        
        You have hit the nail on the head. Please see my comment below on the need to now abandon Friedmanite ideology.
        
        1) The Old Keynesian ideology of the post-war period believed that it was impossible to have high unemployment AND high inflation at the same time. This was the prevailing theory from 1945 onward.
        2) The stagflation of the 1970s, however, placed that ideology into question. The simultaneous occurrence of high inflation and high unemployment in the 1970s placed the fed, as you say, “between a rock and a hard place”. They did not want to raise interest rates to kill inflation because they feared an increase in unemployment, but they could not lower the interest rate to reduce unemployment because they feared a rise in inflation. They were caught in a trap.
        
        3) This trap discredited the Old Keynesian ideology and led to it being replaced by the new ideology of Monetarism (or Friedmanism) after 1980.
        4) The new ideology worked wonders. Inflation was killed and, after a brief downturn, employment rate rose very well. Problem solved, everybody said during the 1980s & 90s.
        
        5) But look at what is happening now: Yes, there is no inflation in prices of goods & services (house rents, product-price) as there was in the 1970s, but there is now massive inflation in prices of assets (house prices, stock-price). The asset bubbles of 2000 & 2008 are all back in full strength. House prices have crossed their previous bubble peak and stock-prices, despite the gloomy global situation, are in the stratosphere. This is why Stanley Druckenmiller is calling for rate hikes in order to contain these dangerous asset bubbles.
        6) But this conflicts with the ‘wealth effect’ of Friedmanite theory. Why should there be high real unemployment, when asset prices are in outer space and household wealth is on the moon? This contradicts this prevailing theory.
        7) So, as you correctly point out, the Fed is ONCE AGAIN in a quandary. They do not want to raise rates to kill the asset bubbles, because they fear a worsening of the employment situation, but they cannot continue with monetary stimulus because they fear a worsening of the asset bubble.
        
        8) If you carefully compare the quandary of the 1970s in (2) to the current quandary of the fed in (7), you will see that in a way we are back in the 1970s situation. Just as the Old Keynesian ideology was discredited in the 1970s, the current Friedmanite ideology should now be discredited. We need a NEW economic ideology that explains all the current facts and provides a clear plan to bring America out of the current mess.
      - Laurent Harvey August 12, 2015 at 1:15 am
        
        Cool, glad we are on the same page. Will a new economic ideology come? Everyone at the fed is so old and they all believe monetary policy is such a big driver and it is their go to thing (Like Jordan in the Chicago Bulls). But the problem is Jordan is now 42 and isn’t hitting the jumper like he used too. A complete move to Austrian economics would be a massive change but I can’t see them ever adopting this approach as this goes 180 degrees in the opposite direction and there are no Austrian believers there.
        
        I would love a change in ideology but I think it will be more of the same. When the next crisis hits, QE4 will be bigger than QE3 and it will be a bigger version of 2008 except in harder circumstances with higher debt and already low rates.
        
        Ray dalio (Runs the worlds largest Hedge Fund) said he’s worried it’s 1936 and when they raise rates it will trigger a stock sell off like 1937. I wonder if in fact it’s more like 1926. America had a nasty 2 year depression in 1920 where the new fed finally began easing and the economy grew again. Every book or article I’ve read said the roaring 20s was more an asset roaring rather than a Main Street (real economic) roaring. Although stocks were going through the roof, the average man on the street who wasn’t investing stocks didn’t feel like everything was that rosy. I keep thinking that today feels similar- a nasty depression in 1920-21 (like 2008) then easing in the early 1920s (like 2009-2014), massive increase in asset prices globally in the 1920s (like 2009-2015) and an eventual worldwide depression 8-9 years later in 1929 ( Could be like 2016 or 2017). Hmmm
    - Vinezi Karim August 13, 2015 at 12:20 am
      
      ^^L.Harvey WROTE: “A complete move to Austrian economics would be a massive change…”
      ———————————
      
      The Austrian ideology deals with the causes of high inflation or hyper-inflation. The problem today, however, is one of very low inflation or deflation. Therefore, the Austrian ideology has nothing to offer right now.
      
      Remember that while Peter Schiff (the loudest Austrian in America today) was correct in predicting the financial crisis, he was completely wrong on the inflation aspect. If you recall, he was all over the media in 2006 screaming about how the US was going to become the next Zimbabwe (hyper-inflation). Events proved him wrong on that aspect, as the fear now is that the US might become the next Japan (persistent deflation).
      
      In the future, however, if there is a problem of hyper-inflation, then, perhaps, people would take another look at the Austrian school.
      
      Reply
      - Laurent Harvey August 13, 2015 at 3:18 am
        
        Yeah I don’t think there will be any move toward Austrian economics any time soon. I would say that atleast they put a larger emphasis on debt and how debt restricts growth than modern day Keynesianism. People like Krugman want to increase public USA debt to gdp to 130% and believes it isn’t a problem. He also openly admits that he didn’t see the housing bubble coming..
        
        I believe the 2 biggest factors globally is the record household debt and public debt combined with slowing demographics. Most mainstream economists barely mention this and focus on credit acceleration and fiscal policy.
      - Vinezi Karim August 13, 2015 at 5:44 pm
        
        ^L. Harvey WROTE: “I believe the 2 biggest factors globally is the record household debt and public debt combined with slowing demographics.”
        ————————————–
        
        Speaking of demographics, it is widely known that the US has better demographics than ‘aging’ Europe. What this means is that there will be more workers (or tax payers or producers) per retiree in the US than in Europe in the years to come.
        
        We often see Americans thumbing their noses at Europeans at international conferences on this issue, because this fact is taken to mean that the US has a brighter future (or is in less trouble) than Europe.
        http://www.econdataus.com/workers.html
        
        This demographic fact, while unquestionably true, has a very important caveat: The cost of healthcare as a % of GDP.
        http://goo.gl/aFvHxn
        
        What this means is that while the US may have fewer retirees per worker (good), it will have much higher public healthcare (‘USG Medicare’) costs per retiree (bad). Conversely, while Europe may have more retirees per worker (bad), they will have much lower public healthcare costs per retiree (good).
        
        If we compare the two (see linked data above), we see that the two opposing factors cancel out each other. Therefore, it appears that the US & Europe are quite similar in their future financial outlook, despite the clear difference in demographics.
        
        Do you disagree? Please let me know your thoughts.
- Suvy August 4, 2015 at 2:16 pm
  
  I’ve actually personally known people very close to me who were out of the workforce for a decade and ended up being able to retrain and come back into the workforce. It’s mostly an issue of the KIND of jobs we’ve lost that just aren’t coming back. It doesn’t make sense to have old school industrial jobs in the US.
  
  Ignore my comment above, that comment makes no sense.
  
  Skilled labor in the US is, and has been, doing just fine. What we’re really seeing is a major class divide from the middle class and higher vs the working class and below. This has been exacerbated and manipulated into a race issue because a certain class of people were always considered a class above the poor and now they’re basically on par with them.
  
  Reply
  - Dan Berg August 9, 2015 at 5:03 pm
    
    The Department of Labor projects the rate will continue to fall through 2022 because of demographic shifts: – See more at: http://journalistsresource.org/studies/economics/workers/missing-workers-labor-force-participation-unemployment-research-review#sthash.GNeJtquW.dpuf
    I guess you are right; the rate will continue to decline (oops, collapse) through 2022; we’re doomed.
    
    Reply
    - Vinezi Karim August 10, 2015 at 1:53 am
      
      Here is a very nice article (short & clear) from The Independent newspaper that discusses this very issue of participation-rate versus unemployment rate and compares the US data to the UK data. Interestingly, they refer to it as “the trans-atlantic jobs PUZZLE”….
      http://goo.gl/53RMed
      
      As for the Department of Labor projection that the participation rate will continue its collapse through to 2002, the immediate question for the DoL is this: Why is this trend not visible in other countries? Why is this “demographic shift” not happening in France or UK? What is so EXCEPTIONAL about the US?
      
      In fact, the ONLY country that clearly exhibits a long-term decline of such magnitude in the participation-rate is an old & rapidly aging Japan with a declining population. Could that be what is happening in the US? Could the mental stress of watching the near collapse of Wall Street have aged the US population faster than mere physical years? Could the population be declining because everyone is fleeing the country?
      
      The questions are many; the answers few.
      
      Reply
      - cjared August 10, 2015 at 2:07 pm
        
        The North American bias in immigration is towards young and young families. Baby boomers, mostly born in the ten years after the end of WW2, are exiting the work force. But immigration has been cranked up for while now. There will be no long term demographic issues with North America, as there is no issue with attracting immigrants. The only issue is a moral one, is it right for North America to take the best and brightest of the world to counter balance our retiring baby boomers?
- Michael Pettis August 4, 2015 at 2:24 pm
  
  I think it would be a little strange for most economists to define “emerging” from a crisis as synonymous with achieving the same employment and GDP levels as before the crisis, especially if you believe that a crisis typically follows a period of excess. Economists, and people generally, typically would define it to mean that the collapse in growth and employment, or in asset prices, has ended and they are all beginning to trend upwards. Certainly when we say that a person is “recovering” from a heart attack, we allow him a little quiet time and don’t necessarily mean that he is racing marathons.
  
  The big debate about the US currently is whether the recovery will be derailed by weak external demand, and not whether the economy is still plunging. If for some reason you prefer to define the words “recovery” and “emerge” to mean only that the economy has passed its pre-crisis peak, that’s fine, but then you should come up with another word that means the economy has bottomed put and is beginning to climb back, and then you can simply replace my use of “emerge” and “recover” with that other word.
  
  A British economist who lives here in China (sorry, but I forget his name) was especially contemptuous, and very vocally so, of my claim that US would emerge from the crisis before China, and at first he used the same definitions as the rest of us did, but once it became obvious to even those who understood China and the global economy least that the US had bottomed out years ago and China was years away from bottoming out, he became much less vocal, and when challenged changed the definitions of words like “adjusted” to ones much closer to your own definitions, and argued that as long as reported GDP growth in China exceeded reported GDP growth in the US, this meant that the US had not “adjusted” and China had. This is I think a silly definition and forces us to discard very useful concepts in favor of much less useful ones, but I guess doing so was much more comfortable for him than acknowledging the alternative.
  
  Reply
  - Vinezi Karim August 4, 2015 at 5:30 pm
    
    The comment was not about GDP growth rates, it was about jobs. If there were 146 million people employed in 2008 and there are only 148 million people employed in 2015, then there is something very, very wrong. This is especially scary when we consider that the US population has grown by 18 million over that same 7 year period.
    
    If we go by GDP growth rates alone, I suppose it’s all right, but we would need to call it a “jobless recovery”. Spain, for example, has been posting positive GDP growth rates and current account surpluses for a couple of years, but it still has sky high unemployment (whether declared or hidden). Can we look only at the GDP/Trade numbers and say that Spain has “recovered” when millions of people are just miserably idling away?
    
    Reply
    - Suvy August 4, 2015 at 7:36 pm
      
      “If there were 146 million people employed in 2008 and there are only 148 million people employed in 2015, then there is something very, very wrong.”
      
      There’s a worldwide demand shortfall and the US is running persistent current account deficits stemming from geopolitical financial conditions. The global security and financial apparatus must be changed, with the most important being the monetary system.
      
      Reply
    - Claire August 6, 2015 at 3:42 am
      
      If there were 146 million people employed in 2008 and there are only 148 million people employed in 2015, then there is something very, very wrong.
      
      I still don’t understand this argument–you are cherry-picking the data by picking a particularly frothy year and using that as a “standard” for unemployment rather than an aberration. If I use the same data that you do (http://data.bls.gov/pdq/SurveyOutputServlet) and go back to 1992, can say that the general public is better off now (employment wise) than it was 20 years ago. I can further say that the unemployment rate now is roughly where it was in 1996, and that as we all know that 1997-2000 was a great boom (bubble), then this indicates a great recovery around the corner.
      
      I don’t believe this, incidentally–I am merely trying to show that picking an arbitrary date allows one to support any view I like.
      
      If we go by GDP growth rates alone, I suppose it’s all right, but we would need to call it a “jobless recovery”.
      
      I do not necessarily believe that there will be a recovery any time soon (at least not in my country), but I think every recovery starts off as a “jobless recovery” (and I remember the media touting a “jobless recovery” before every recovery since I was a teenager). I think most businesses need to see some pretty strong indications of orders before they begin hiring again.
      
      Spain, for example, has been posting positive GDP growth rates and current account surpluses for a couple of years, but it still has sky high unemployment (whether declared or hidden). Can we look only at the GDP/Trade numbers and say that Spain has “recovered” when millions of people are just miserably idling away?
      
      I’m actually a little confused by this point–there have been many, many posts on this site discussing how Spain is not recovering despite doing a lot fundamentally “correct” things because of the debt overhang (which must get settled somehow, and as so far the creditors haven’t had to eat the losses, it’s being felt via unemployment in the debtor countries).
      
      Maybe I’m missing the point of your argument, though (?)
      
      Reply
  - Jaques August 5, 2015 at 8:49 am
    
    I think that British “economist” was probably John Ross, the failed advisor to Ken Livingstone who found himself in China and for some reason being more Chinese than the Chinese in his confidence and love of the way everything was working here. He has gone a lot more quiet recently, although I am sure his single-mindedness is probably still putting bread on the table from various Chinese academic institutions…
    
    He also seemed to be trying to up his fame by picking a public fight with other academics….it seems it all backfired.
    
    Reply
- DvD August 5, 2015 at 2:36 pm
  
  So it takes a $4tr balance sheet expansion by the Fed (and a much higher number for overall financial wealth) to allow for the creation of 2.5m jobs over 7 years? That’s $1.6m money creation per job that are each paying something like $50k p.a. on average. It is immediately visible that the extra wage income generated and spent will fall way short of justifying the increase in asset value generated by such policies. A large divergence is simply created which makes the recovery intrinsically fragile and plant the seeds of the next financial deflation.
  
  Assuming (charitably) that this relationship ($1.6m of base money creation per job created) is constant as money creation expands, it would take close to $13tr extra QE to allow for the creation of the missing 8m jobs over a number of years. In total, that would be money creation of about $17tr or about 100% of GDP to go back to a “normal” level of under-employment of about 5%. And we keep hearing that there is no better idea than this? That would, at the minimum, be very surprising.
  
  It seems to me much more accurate to say that little efforts have been made to find a better solution to the global twin issues of excess under-employment and excess debt than monetary creation at the various domestic levels. It has also not been fully understood that the same excess monetary creation played a crucial role in the period of excess leading to the 2008 crisis from which it is now so long to recover (despite the fact that this was already the second very visible iteration of this pattern after 1995-2002). We keep going around in this vain circle. The monetary tools are by nature expedients aiming at redistributing the symptoms of unemployment and debt differently, they are not solutions aimed at correcting the root causes. The monetary tools have had mediocre outcomes (we should not exclude the possibility that the 2015-2008 comparison could be a fair peak-to-peak comparison, we will only know that in 12 months) and perhaps they have had only temporary outcomes (hence the question “will the US recovery be derailed by weak external demand?”). This would be logical in a situation where every monetary zone / country is trying to use these monetary tools at the same time, thus neutralizing each other, while the global labor arbitrage – and thus the global demand shortfall – continues. The exclusive focus on these monetary expedients means that precious time has been wasted in the past 7 years (and in fact for much longer) and we are still ice-skating on a very thin layer of ice, some more happily than others. The great rebalancing has not occurred. May be Europe is a bit more unhelpful and China a bit less but basically global imbalances are still there unaddressed. For the simple reasons that no policymaking body – and certainly not the G20 which have been created for this specific purpose – has sought to address them. Trade wars are avoidable … if we are seeking to avoid them.
  
  Reply
  - Dan Berg August 5, 2015 at 9:17 pm
    
    DvD: you seem to believe that the Fed “expands its balance sheet” or “creates money” and $4T of cash flows to workers; divide one into the other and come up with some absurd number. The stuff workers use to buy coffee is not some fraction of the Fed’s balance sheet, but wages – which are paid by companies out of profit or borrowed from COMMERCIAL BANKS – they “increase the money supply.” But of course they haven’t been doing that recently (long story).
    
    Reply
    - DvD August 6, 2015 at 4:35 pm
      
      No Dan, it is not me who believes QE is “helping main street”. It is the Fed chairman. And yes, by “helping main street”, i understand primarily facilitate job creation through some “transmission mechanism”. So, to assess the validity (or lack thereof) of that claim, it seems to me acceptable, at least in first approximation, to relate the size of the monetary stimulus to the number of jobs created over the period (7 years is long enough for the “transmission” to have occurred). You may find that “absurd” but then you should at least provide a better way to assess the claim. Sadly, you haven’t done that. Perhaps next time?
      
      To be more precise, wages are paid out of gross profit (net profit is what’s left after wages and other costs have been paid). For a gross profit (or value added) to exist in the first place, companies have to be able to sell their products to “somebody” at prices higher than input costs. Which means that “somebody” is paying for these products with income – either from labor or from capital – or borrowed funds. So, wages are paid out of value added, which only exists because “somebody” has spent his / her labor or capital income or has gone into debt to buy something at a certain price. What it comes down to is to see how the value added split between labor and capital income has evolved and how total credit outstanding relative to GDP has evolved under QE (total credit outstanding here should include central bank liabilities since the financial sector has deleveraged by selling assets to the Fed and should also add back the $2.5tr of corporate debt erased by the Fed between the first and second quarter of 2014 due to a change in statistical methodology so that the comparison is on a like-for-like basis). You will see, it is very illuminating. Please note, you may find some of the numbers “absurd”. May be because they are.
      
      Reply
      - Dan Berg August 7, 2015 at 4:21 am
        
        Before 2008 when someone said “simulative monetary policy” one assumed with a lag interest rates falling, equities rising, investment rising, jobs created: yes?
        Given the liquidity trap, the above no longer holds. Yes?
        Banks do not lend reserves. The massive increase in reserves is NOT an increase in the money supply, as in “simulative monetary policy” in the first paragraph. Yes?
        To create jobs the US needs fiscal stimulus (not the Fed’s job), which cannot happen for political reasons. Bernanke has said publicly that the various QE would do little, but little is better that zero. Yes?
      - DvD August 7, 2015 at 10:28 am
        
        So, now it seems you agree that QE has had a mediocre outcome and that there are most likely better ideas than this.
        
        The US has run a permanently stimulative federal budget since 2008 and the deficit is still close to 3% of GDP last time i checked, much higher that the level reached at equivalent time in previous cycles. Federal debt has skyrocketed since 2008 and is already on an unsustainable trajectory. You have to take that into account before concluding that “the US needs fiscal stimulus to create jobs”.
        
        It is the combined effects of highly stimulative monetary policy and stimulative budget policy that have been disappointing over the past 7 years. The question you have to answer is why? That’s what i mean by “precious time has been wasted over the past 7 years”. Before there is a collective acknowledgement of the largely ineffective impact of domestic monetary and budget tools, before there is a reasonably well established understanding of why, we can’t move forward towards sustainable solutions. For the time being, the constant reference to “structural economic reforms” is invariably accompanied by a complete lack of specifications about what these might be (for instance Stan below). When you press for more clarity, you quickly realize that “structural reforms” means different things to different people. Eight years after the freezing of the US inter-bank market, there is still no clarity of thinking about what exactly needs to be done.
      - csteven August 7, 2015 at 1:10 pm
        
        Mediocre result……and ramifications, conditions without the policy that at least has had a mediocre result, then some result, not in the negative.
        
        What of the potential result, and while still running this deficit, the resultant impact of a vastly different set of circumstances globally, compounding…..
        
        hindsight is better than 20/20 within the confines of our philosophical blinders, as we conjecture on is’s, never elucidating the global might have beens, likely to have beens etc
      - Vinezi Karim August 10, 2015 at 10:19 pm
        
        ^^ Dan Berg WROTE: “Before 2008 when someone said “simulative monetary policy” one assumed with a lag interest rates falling, equities rising, investment rising, jobs created: yes? Given the liquidity trap, the above no longer holds. Yes?
        ———————————————
        
        Ben Bernanke says no.
        
        Here is his verbatim quote (see link in comments below for the whole speech): “As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero–its practical minimum–monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken.”
        
        Ben Bernanke ADDED: “So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities”
        
        In other words, once the fed funds rate reaches zero, monetary stimulus to boost aggregate demand and the economy CAN still be applied by means of Quantitative Easing (QE). This is what Bernanke said in 2002; and this is exactly what he did after the crisis.
        
        In other words, QE is just unorthodox monetary stimulus. If you feel it hasn’t worked, please take it up with Big Ben.
    - Stan August 6, 2015 at 6:06 pm
      
      Thank you Mr. Dan Berg for bringing a common sense to these discussions. In 2008, US household debt was 12.68 trillion now is 11.85 T. That is reduction of 6.5% . Consumption of US economy is about 70% of GDP. The average income growth during the period 2001- to now for bottom 90% is negative. So clearly shows that Fed or inflation, or even President cannot reverse the trend as Prof Pettis states w/o structural economic reforms.
      
      Reply
      - Dan Berg August 7, 2015 at 7:57 pm
        
        “It is the combined effects of highly stimulative monetary policy. . .” NO! This is where we fundamentally disagree. Re-read last post.
        “. . .and stimulative budget policy . . .” NO. (all from FRED, St. Louis Fed): From 2011 (3.9T) to 2013 (3.8T) federal govt total expenditures FELL; from 2013 to 2014 increased back to 3.9.
        Finally, the federal deficit (% gdp) is rapidly disappearing: from 9.79 to 2.79.
      - DvD August 8, 2015 at 4:59 pm
        
        Are you saying that $4tr of liquidity injections over the 2008-2014 period was not very effective on the real economy because of a $0.1tr temporary reduction in Federal expenditures between 2011 and 2013 due to debt ceiling constraints, themselves prompted by the fact that Federal debt has been increasing at the unsustainable pace of ~ $1tr p.a. vs annual GDP growing by ~ $0.5tr p.a.?
        
        Let’s recall that the problem to solve is to achieve a so called “beautiful deleveraging”, meaning a deleveraging which is neither deflationary (debt default) neither inflationary (pay down debt in highly depreciated currency). Therefore, any potential solution has to be likely to satisfy the condition that total credit outstanding grows more slowly than nominal GDP for sustained period of time. Unchecked fiscal expansion does not satisfy that essential condition and is therefore unlikely to be a valid solution.
        
        Let’s also recall that the Federal Debt / GDP is by nature a cyclical ratio. A Federal deficit of -2.9% of GDP 6 full years after the trough in the economy is rare enough that it can not really be deemed overly restrictive.
      - Vinezi Karim August 10, 2015 at 10:53 pm
        
        ^^ Dan Berg WROTE: ““. . .and stimulative budget policy . . .” NO. (all from FRED, St. Louis Fed): From 2011 (3.9T) to 2013 (3.8T) federal govt total expenditures FELL; from 2013 to 2014 increased back to 3.9.”
        ——————————————
        
        Fiscal (or Budgetary) stimulus is determined by the extent of the fiscal (or budgetary) deficit (as % of GDP). It is not dependent on the absolute size of the budget. The ‘stimulus’ part comes from the fact that the government is borrowing ‘excess’ private saving and CONVERTING it into additional aggregate demand by ‘deficit spending’. As long as the government borrows and spends, it is a Keynesian fiscal stimulus. Therefore, fiscal policy has been hugely stimulative since the crisis, as you can see in the graph below….
        https://goo.gl/muscUH
  - csteven August 7, 2015 at 1:06 pm
    
    The 4 trillion wasn’t spent for Job creation.
    DvD, I generally enjoy your posts, but this one, merely illustrates your preferences, and how those preferences drive your review, rather (merely) than being a balanced analysis, within the confines of the philosophy you’ve accepted.
    
    Reply
    - DvD August 9, 2015 at 1:33 am
      
      I know the $4tr was not aimed primarily at job creation. Actually, it is a rather recurrent theme of my comments over many of Michael Pettis articles that money creation is not the solution to the twin issues of excess debt and excess under-employment and i have tried to outlined alternative ideas. The Fed chairman, however, has several times stated that QE is aimed at “helping main street”, by which i indeed understand facilitating job creation in the context of falling employment ratios unexplained by demographics, as recalled by Vinezi Karim. Currently, the Fed is also making an explicit connection between payrolls development and its upcoming attempt at starting to normalize monetary policy. So, whether it is my preference or not and whether you like it or not, this connection between unconventional monetary policy and job creation has been made. For obvious demagogic reasons. Given that this claim has been made (again, not by me), my earlier comment was simply saying that the fact that it took $1.6m of base money creation per job created showed how inefficient this method had been given that these jobs are paying ~ $50k p.a. on average.
      
      Then, since neither you nor Dan apparently believe that QE is to facilitate job creation, can i please ask what you think the purpose of QE was? It is likely we can agree that QE1 was to prevent a financial and banking markets collapse. But, clearly, that was no longer the case thereafter and as late as 2014. So what exactly was the purpose then according to you?
      
      Thank you
      
      Reply
      - cjared August 9, 2015 at 12:44 pm
        
        I suspect that QE has done an amazing job at generating jobs. QE itself was not directly invested in “jobs” of course. But QE has effectively forced rates down by “re-flating” (is that a word?) the money supply that collapsed by a corporate borrowing/lending collapse.
        
        How does that create jobs? Well… the evidence is everywhere. In the old economy (pre-crisis)… what did investors do? What did Pettis do on Wall Street? Bonds. Lazy investing. I don’t blame the bond investors, they had good returns, little risk or effort required to make the investment.
        
        Where is money going now? Can I just buy bonds and expect a good return? All around me I see investors active again, insurance companies building rental apartment buildings for example, not just recycling portfolios, but building new. This generates jobs… and frankly hasn’t been done since the 70s. This is an example of an investor that needs a long duration asset to match long duration liability.
        
        But… shorter duration investments are also in demand… venture capital is everywhere. And people are keen, you can’t just stick money in the bank and do nothing. This investing generates jobs. Witness Silicone Alley, Beach, Valley.
      - Dan Berg August 9, 2015 at 5:28 pm
        
        The Fed has gone to enormous lengths to explain what they are attempting to do with QE; Kenneth Rogoff , who is very concerned about high and rising debt, also recommends intelligent fiscal stimulus – I simply agree with that. Even in the absence of stimulus, unemployment rate is glacially declining; a declining participation rate is a concern, but a crisis? At least you have stopped equating QE and monetary stimulus; that will improve your digestion.
      - Vinezi Karim August 9, 2015 at 7:02 pm
        
        DvD WROTE: “Then, since neither you nor Dan apparently believe that QE is to facilitate job creation, can i please ask what you think the purpose of QE was? ”
        ———————–
        
        Here is the explanation from Big Ben himself:
        http://goo.gl/ybVU6z
        
        EXCERPT: ” As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero–its practical minimum–monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.”
        
        EXCERPT: “So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities”
        
        Not surprisingly, Herr Krugmann DISAGREES with Big Ben:
        http://krugman.blogs.nytimes.com/2010/07/14/nobody-understands-the-liquidity-trap-wonkish/
        
        Note that Bernanke (right-tilt) is a Friedmanite, while Krugman (left-tilt) is a Keynesian. So this is merely a continuation of the Maynard v/s Milton fight of the 1970s.
      - Vinezi Karim August 10, 2015 at 1:15 am
        
        ^^Dan Berg: “Even in the absence of stimulus, unemployment rate is glacially declining; a declining participation rate is a concern, but a crisis?”
        ——————————-
        
        The problem is that the unemployment rate is *NOT* declining. It is merely being made to *LOOK* like it is declining by the US being the only country in the world that has collapsed its participation rate.
        
        In other words, if the participation-rate in the US had stayed as steady as it has in ALL other developed countries, the unemployment rate today would still be about 10% — almost the same as it was in 2009. The 5.3% unemployment number that they are showing the public today is almost entirely dependent on the drastic reduction in the participation-rate.
        
        The way to visually grasp this would be to go to the FRED St. Louis Federal Reserve database and look at these THREE curves together…….
        http://goo.gl/9zT6oi
        
        This is statistical juggling pure and simple. When other governments wake up and see what the US is doing, they will also start to do the same thing and then we will see a ROSY picture of fast declining unemployment rates everywhere. It looks good for now, but reality has a way of re-asserting itself in a brutal fashion.
      - DvD August 10, 2015 at 9:06 pm
        
        Thank you Vinezi Karim for responding with value added comments.
        
        Bernanke’s famous November 2002 speech “Deflation, making sure it doesn’t happen here” has provided the exact menu of measures that have been implemented by the Fed in response to the 2008 deflationary bust. Of course, by the time these measures became necessary, it was hard to ignore that excess monetary creation in 2002-2007 under Greenspan-Bernanke had been instrumental in the debt deflation event of 2008. Not for the rigorous Princeton Professor, however, and this unfitting reality was simply ignored for a much less academic “when in trouble, double” approach. Which makes it very convenient as we can now compare the results from the factual experiment to the predictions.
        
        The clear empirical results are that the increase in money supply from these actions has been accompanied by a less than proportional increase in nominal production and spending (and by a much less than proportional increase in full time jobs, as already discussed) and by a more than proportional increase in asset values. Why?
        
        And the US still has essentially 0% CPI inflation. Why?
        
        And, unlike in the 1950’s which Bernanke uses as an example in the speech, there is no deleveraging whatsoever this time while the lower interest cost should have freed up some cash for principal amortization. Why?
        
        And is it more likely that the divergence thus created between asset values and economic flows ultimately backing them up is reconciled through an acceleration in economic expansion or via a financial crash?
        
        The honest post mortem on the theories presented in the speech now that they have been tested in real life is a meagre “it would have been worse without that”. Better than nothing, for sure. But far far away from what is necessary to resolve the twin issues of excess debt and excess under-employment. To reassure Dan, which was apparently running out of relevant arguments, the search for better solutions is quite stimulating and doesn’t lead to any digestive trouble whatsoever.
      - Vinezi Karim August 11, 2015 at 11:55 pm
        
        ^^DVD WROTE: “The clear empirical results are that the increase in money supply from these actions has been accompanied by a less than proportional increase in nominal production and spending (and by a much less than proportional increase in full time jobs, as already discussed) and by a more than proportional increase in asset values. Why?”
        ————————–
        
        Up to 2008, Friedmanism worked like this:
        1) Recession hits. Job Losses. Investment plummets.
        2) Fed lowers interest rates.
        3) Asset prices climb.
        4) Households feel rich.
        5) Households borrow, banks lend.
        6) Households spend, spend, spend.
        7) Demand rises. Companies hire and invest.
        8) Jobs created. Unemployment drops.
        9) Economic boom. GDP up, up, up.
        9) Asset prices develop nosebleed.
        10) Fed raises interest rates.
        11) Asset bubble bursts.
        12) Goto (1).
        
        After 2008, Friedmanism fails. Here is why:
        1) Recession hits. Job Losses. Investment plummets.
        2) Fed lowers interest rates.
        3) Asset prices climb.
        4) But households too scared by 2008 to borrow.
        5) Banks also too scared by 2008 to lend.
        6) So households do not spend, spend, spend.
        7) Demand does not rise. Companies do not hire or invest.
        8) Jobs not created. Real unemployment stays high.
        9) Economic gloom. GDP flat, flat, flat.
        9) Even so, asset prices still develop nosebleed.
        10) Finally giving up, Fed raises interest rates.
        11) Asset bubble bursts.
        12) Goto (1).
        
        If you compare the two, you will see that the transmission steps of (4),(5)&(6) have failed. This is the end of monetarist ideology. Just as the old Keynesian ideology was discarded due to stagflation in the 1970s, it is now time to discard Friedmanite ideology and rid ourselves of this pernicious doctrine of the ‘wealth effect’. We need a revolution of new ideas. In fact, America needs a new Milton Friedman right now.
Koru August 4, 2015 at 5:05 am

Thank you for the post, very nice review. Two questions that might seem obvious but would love some clarification nonetheless:

1. Why is consumption the only path towards rebalancing for China? Is it possible to find productive investment opportunities outside of infrastructure (such as Tech, Healthcare, Education) to slowly wash out bad loans? Perhaps better investment and orientation towards higher value add exports that depend less on labor costs can at least be combined with some form of wealth transfer back into the household sector.

2. Per your earlier comment, understand this may be more political than anything else. But economically, what does government aim to achieve or what could they hope to achieve in supporting the stock market? Is the primary purpose to engineer a positive wealth effect (though household participation in the stock market doesn’t seem high enough for that to have an effect) or to create an additional source for SOE financing?

Reply
- Michael Pettis August 4, 2015 at 2:12 pm
  
  1. Yes it is possible in principle, Koru, and many analysts say that this is “all” Beijing has to do, but it is extremely difficult to transform the financial system in such a way that it will be able to do so. Remember that the more productive uses of capital are more likely to involve small and medium enterprises and less likely to involve the SOEs and state sectors, the reverse of the existing practice, and to change this is politically difficult. At any rate I cannot think of any country that has been able to do so in a reasonable amount of time, except perhaps Chile in the late 1970s and early 1980s, and it required a banking collapse collapse to pull it off.
  2. I think there were supposed to be three benefits of a strong stock market — a positive wealth effect, SOE deleveraging, and a market for privatization. The first was always unlikely, I think, and the second two didn’t in fact occur. They were probably planned for later this year or next year when the markets were expected to be even higher, but I am just guessing.
  
  Reply
Claire August 4, 2015 at 5:23 am

By the way remember that if you are long the underlying asset and short a call option, you are effectively short a synthetic put option struck at the same price as the call option. This means that anyone who owns shares might in fact be short a complex synthetic put option on the market. If the writer of the put can cancel the option at no cost, the rational thing for him to do would be to cancel it. In fact he can do so simply by closing out his long position and selling his shares.

I’ve been thinking about both this and Pettis’ previous blog entry for the last couple of days. As usual, all thatcomes out of this are more dumb questions, but if somebody who understands markets better than I do has a lot of patience and would like to humor me:

1. If the market is to be propped up until the index hits 4,500 and I were one of the brokers stuck holding these stocks (or even somebody speculating on the brokers being stuck on holding these stocks), wouldn’t I buy the “least overvalued” of these stocks and not touch the other stocks that make up the index? In other words, isn’t the correct bet to only look within the universe of stocks within this index and make the relatively safe bet that the strongest underlying companies will get bid to the moon to force the overall index higher because nobody would want to buy the weaker ones?

2. In a similar vein, shouldn’t this policy basically crater all of the stocks that do not comprise the index that has gov’t support to 4,500? The government has basically selected a small group of winners but afforded no protection to the losers.

3. If I were running one of the “winners”, would I not then use my shares to buy other, stronger, non-guaranteed stocks? They may be overvalued, but probably not as much as my shares.

4. Alternatively, what prevents me from issuing shares or using my shares as currency to improve my balance sheet? (Why should I not, basically, short my own shares/take the other side of the government’s call option, and then keep doing so until I have a solid balance sheet)?

5. I don’t understand how Beijing’s actions suggest that the country will allow a rebalancing. It seems to me that their policies in propping up the markets are doing the reverse–basically committing public funds to back up SOEs and the “vested interests” who own the shares. Am I missing something?

Reply
- Michael Pettis August 4, 2015 at 2:05 pm
  
  1. It is hard to know which is the least undervalued or the most undervalued, especially in a speculative market which, by definition, doesn’t trade on fundamentals.
  2. Yes, and a lot of recent trading has consisted of trading based on perceptions of government targeting.
  3. Again, in a speculative market, it isn’t clear that under- and over-valuation has much meaning. The entire market can be overvalued.
  4. This is what some of the SOEs were supposed to do before the panic, but they never got around to doing so. In the current market, of course, they can’t really issue, and probably wouldn’t be allowed to.
  5. No. In fact since 2011-12 you can describe policy as alternating between stepping on the rebalancing accelerator and subsequently panicking about credit growth, and stepping on the rebalancing brakes and subsequently panicking about slowing GDP growth.
  
  Reply
  - Vinezi Karim August 4, 2015 at 8:53 pm
    
    ^^Michael Pettis WROTE in the comment section: “5. No. In fact since 2011-12 you can describe policy as alternating between stepping on the rebalancing accelerator and subsequently panicking about credit growth, and stepping on the rebalancing brakes and subsequently panicking about slowing GDP growth.”
    —————————————
    
    This dual-fear “accelerate, brake, re-accelerate” pattern is similar to what is happening in the US.
    
    1) The Federal Reserve expands its balance sheet (unconventional monetary easing) to stimulate job creation. Everyone then grows alarmed at the size & speed of the expansion of the balance sheet and so they slam on the brake.
    2) Next they keep looking at the trends in job creation. When they realize that the trends are not getting any healthier, they panic in the other direction and step on the accelerator once again and re-expand the balance sheet.
    
    Here we can clearly see this repeating {accelerate, alarm, brake, panic, re-accelerate} pattern (expand graph to see all years):
    http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
    
    In fact, just as in many other countries, there is now complete panic setting in amongst US policy makers. Nobody know what to do next. Even though they try to put up a brave face, the reality of the mood is one of all encompassing, debilitating & abject fear. The anger in the US about trade imbalances & globalization, which Michael accurately describes, is merely a triggered physiological response to this desperate fear.
    
    The rebalancing process in the US is going to be very difficult. Yes, Michael is correct that China’s rebalancing is going be much harder; but that does not mean that the rebalancing in the US will be a cake-walk.
    
    Reply
    - Suvy August 5, 2015 at 1:01 pm
      
      It depends on how you see the job trends and who you are. As I’ve said, skilled labor has done great and even today, most firms are having difficulty finding skilled labor. What’s really happened is that the working classes have gotten crushed, even though there’s mobility for most of them. So many of the groups of those working classes (not all) are trying to turn a class war into a race war, as Marx tried to do.
      
      I remember when I went to some small towns not too long ago to meet up with a bunch of old friends who were all meeting over there. Let me tell you that the working class people in those kinds of towns are the most racist people I’ve ever met. Honestly, there’s a part of me that doesn’t even want to help these people. They seem so ignorant and many of them are straight up dumb. The only people in that town that treated me with any semblance of respect were people from out of town (I was there on a holiday weekend so there were a decent amount of people from out of town).
      
      There’s one key factor: human capital. Those with human capital are able to do fine. Those without it are gonna get crushed.
      
      Speaking of which, I get really angry when people call Donald Trump racist when the immigration position of someone like Bernie Sanders or even Hillary Clinton is FAR more racist than Trump. Trump (correctly) pointed out the current problems with immigration coming from the trade routes on the Mexican-American frontier, but Trump also states that he has no problem (and wants to encourage) Hispanics who want to come to the US to work legally. Sanders explicitly says that he wants to prevent Hispanics from coming into the US because they’ll depress wages.
      
      Yet I always hear how Trump is more racist than Sanders. I’m just gonna start assuming that these same people who argue for “equality” are retards while saying shit like this are retards. This is also why I’m against “democracy” when used naively. It allows the racist bigots of a certain class to portray these “capitalists”, “entrepreneurial classes” or “financial classes” as evil because they wanna give people who would otherwise have no chance a shot in hell while painting themselves as morally superior. Usually, the capitalist classes have the least to gain by bigotry. It’s the “boorish proletariat”, as Keynes duly pointed out, that’s really against truly liberal principles and will gladly and willingly choose to oppress those who have no voice and they’ll do this in the name of “equality” or “democracy”.
      
      Reply
  - Claire August 5, 2015 at 10:21 pm
    
    Thank you for the reply.
    
    So long as there is an option on the share prices, then, would it make sense for the banks to start writing off some of the non-performing loans that they have just rolled over or otherwise refused to acknowledge? (Presumably, to some degree the government would actually want to encourage some write-offs as well).
    
    Once again, thank you for all of the thought-provoking blogs entires (and discussions).
    
    Reply
Claire August 4, 2015 at 5:38 am

As the US recovery continues to be weakened by trade war, I continue to expect the trade environment to get worse. […] I expect trade will be a major topic in the upcoming presidential elections and Americans will increasingly (and probably rightly) question the value of its openness to trade in a world in which every major economy is attempting to export its excess savings and its domestic demand deficiency onto the US.

Michael,

One of your key points over the years has been that “growth miracle” countries should structure their debt to be anti-cyclical. I’m curious if you’ve ever thought about how to structure trade agreements to make them anti-cyclical as well (for example, to stablize against demand contraction)? If so, what would such an agreement between (for example) all of the EU members look like?

This may be a dumb question–I’m still new at this (although I gotta admit that your blog is providing quite the education.)

Reply
- Michael Pettis August 4, 2015 at 1:59 pm
  
  Actually I would say all countries, especially those with with weak financial systems, should try to embed counter-cyclical structures into their balance sheets, Claire, but I am not sure how you would structure trade agreements that way, although it is an interesting exercise to think about trade and pro-cyclicality. I suppose one good idea — and the Chileans and Norwegians seem to have done this successfully — might be for countries whose revenues are heavily commodity dependent to create reserve funds that receive revenues according to a formula that is positively correlated with commodity prices and which at some low price point begin dispersing funds. This acts automatically to counterbalance the impact of changes in commodity prices with the fiscal balance.
  
  Reply
johny August 4, 2015 at 8:43 am

“The deficit countries control demand, which is the world’s scarcest and most valuable commodity.”
First of all, the deficit countries do not “control demand” any more than a substance addicted person can control his addiction.
Second of all, demand is definitely not the “world’s scarcest and most valuable commodity”. Extending this logic just a bit further, next thing Michael will say, the USA actually makes a great favor for China by graciously agreeing to consume what China is producing. When, and not if, the adjustment in China comes to completion (that is where Michael absolutely correct), it is developed countries like the USA will have to get used to paying MUCH MORE for all the products and services they will be forced to produce themselves and which they are getting now from countries like China. NO more enjoying the results of slave labor and neglecting environment pollution which happens far away from the USA shores.
Do you still think it is developed countries that hold all the cards, Michael?

Reply
- meofios August 4, 2015 at 11:17 am
  
  instead of saying demand is too scarce, how about say the world is drowning in overcapacity and overproduction. But i guess mainstream economists do not believe there is such a thing as overproduction.
  
  Reply
  - Michael Pettis August 4, 2015 at 1:42 pm
    
    I am not sure there is a significant difference between saying demand is scarce or supply is excessive. When consumption is constrained and savings forced up, the result is usually that demand is less than it might have been and supply is more than it might have been.
    
    Reply
    - meofios August 5, 2015 at 11:40 am
      
      surely, there is some difference between not enough demand and overproduction. For example, china produce more cement and steel it can consume. But there is no reason why Chinese people should consume all this cement and steel just because china is capable of producing so much cement and steel, it’s just malinvestment, not that there is too little demand for cement and steel in china.
      
      Reply
    - johny August 5, 2015 at 3:23 pm
      
      Yes, Michael.
      ” It is just beyond your grasp” is a very mature argument.
      My point is that when adjustment in China comes to an end and if the deficit countries like the USA will be producing their own products and services, the unemployment in the USA will go down, but the prices will go up.
      And that is one of the reasons the US policy is reluctant with cutting itself off from China.
      Instead of responding in such infantile way, you could address the issue straight on.
      What is your reason the USA tolerated the status quo for so long? I did not read THAT in your posts.
      
      Reply
      - Suvy August 6, 2015 at 10:11 pm
        
        Why would you say that in such a situation lower unemployment would lead to higher prices? That’s wrong. Higher prices depend on many factors, including input costs and global commodity prices. In a world of no demand with collapsing excess capacity and commodity prices, how are you gonna get inflation? It doesn’t make any sense.
        
        Simply put: inflation comes when you have falling production and rising consumption. If you have less people unemployed while commodity prices are collapsing, what you’ll see is a rise in production and even though real consumption could rise, nominal consumption doesn’t have to (or it’s rise would be severely limited).
        
        I don’t think you fully understand how you get rising prices. There’s a lot of other things going on that just can’t be ignored. You can’t ignore shifts in input costs, supply-side structures, and capital structures of economies when you’re talking about inflation.
- Dodgson August 4, 2015 at 12:17 pm
  
  Ha ha I have read Pettis long enough to know he answers most questions, and he is willing to respond to disagreements, but he always ignores disagreements with lots of capital letters from people who don’t understand the issues very well. Pettis may have been among the first in recent years to argue that trade imbalances are driven mainly by distortions in the surplus countries that force the surpluses onto deficit countries, but by now his argument is very accepted, and you should at least understand why before you disagree. I don’t fully agree with him, and think he de-emphasizes distortions in the deficit countries, but you definitely don’t understand why he might be wrong. And if you should out that nobody put a gun to the American consumer’s head and forced him to buy a flat screen TV, then you definitely do not understand the argument at all. Also, if you don’t understand why the European trade imbalances were caused at least partly by German policies that screwed the rest of Europe, then you don’t understand trade very much and should read his brilliant post from earlier this year on Syriza and the French Indemnity of 1873. I am not trying to be rude, but Pettis is widely considered to be one of the most brilliant economists alive on trade, and unless you think you are too, you should ask rather than announce.
  
  Reply
  - johny August 5, 2015 at 3:31 pm
    
    Ha Ha Dodgson,
    so what exactly China do to “force the surpluses onto deficit countries”? Threaten the USA with war if Unites States refuse to accept Chinese good and services?
    You are wrong if you think I did not understand Michael argument about imbalances.
    My point is that it USA could if it wanted to relatively easy to protect itself against inflow of Chinese goods. Raising tariffs, subsidizing the USA industries, etc.
    It is a conscious choice, a policy matter, that the USA government persue and it always takes two to dance in this case. So unless you can exactly explain how China ” force the surpluses onto deficit countries” which implies the deficit countries refuse it, but China overpowers them, can you please stop pretending you understand more than the others?
    Pettis covers only one side of the issue and ignores the rest. Then complains when someone suggests constructive criticism. I had professors like him. Nothing new here.
    
    Reply
    - Suvy August 6, 2015 at 2:25 pm
      
      You wanna know how China forces the US to run current account deficits? It’s really this simple: China has capital controls, the US doesn’t. The US has absolutely no control its current account deficits in the current financial system (it can’t because the reserve currency makes capital controls impossible). China has very strict capital controls and a fixed currency regime, so they must necessarily buy US assets as necessary to maintain their peg (or the peg must shift, but that risks instability in the banking system so moving the peg really isn’t an option).
      
      Reply
- JohnWarberg August 4, 2015 at 1:19 pm
  
  Johny: If you read “Internal and external balance” at
  http://blog.mpettis.com/2015/06/internal-and-external-balance/
  you’ll see why Pettis is right and you are not.
  
  When you say “Extending this logic just a bit further, next thing Michael will say, the USA actually makes a great favor for China by graciously agreeing to consume what China is producing,” the word “graciously” is gratuitous and not very well-mannered in a blog usually reserved for adults, so you won’t be angry if I say that this statement, “it is developed countries like the USA will have to get used to paying MUCH MORE for all the products and services they will be forced to produce themselves and which they are getting now from countries like China”, besides being a little infantile, shows a completer lack of understanding. Even if you were right about the MUCH MORE I don’t see why in a world in which every major central bank is trying to get inflationary traction you would even bring this up as an argument unless you simply don’t understand what a world of weak demand, or excess supply if you prefer, means for prices.
  
  Reply
  - johny August 5, 2015 at 3:36 pm
    
    JohnWarberg,
    Much of this seems to be a little above your grasp.
    Read more slowly.
    It is a common logic that if you, as a business, have to pay more in salaries and clean up the environmental mess your factories make, you have to pass the costs to the consumer. What does it have to do with inflationary policies of the CB?
    
    Reply
    - TonyS August 5, 2015 at 8:55 pm
      
      And you think inflation reflecting the true costs of production is bad for the US why? Isn’t inflation exactly what the US would want given its debt position?
      
      Reply
- JohnWarberg August 4, 2015 at 1:34 pm
  
  “Do you still think it is developed countries that hold all the cards, Michael?
  Pettis said “deficit” countries, not “developed” countries, which are not the same at all, and yes, in trade disputes during times of weak demand, deficit countries are in stronger position. Have you read any history at all of periods like thew 1930s or 1880s?
  
  “First of all, the deficit countries do not “control demand” any more than a substance addicted person can control his addiction.”
  I would say that the real “first of all” is that the statement “NO more enjoying the results of slave labor and neglecting environment pollution which happens far away from the USA shores” shows a kind of stupidity in a discussing why surplus countries have surpluses. Pettis has explained how both the Chinese and the German surpluses are the results of policies that relatively lowered household income, and whether you agree or disagree (and by “you” I mean the general you, not you personally, because you clearly don’t understand) if you think that this has anything to do with the idiotic Fox news cliches of slave labor you are obviously in way over your head.
  
  Reply
- Michael Pettis August 4, 2015 at 1:52 pm
  
  No I don’t, and I didn’t say they did. Much of this seems to be a little above your grasp, Johny. Read more slowly,.
  
  Reply
- Suvy August 4, 2015 at 2:07 pm
  
  The deficit countries certainly do control demand today. The US actually does do China a favor. China’s got a lot of issues and the US does almost every country a favor by providing a global security and financial apparatus. If the US stopped protecting and enforcing world trade, China would be the first country to get hit hard. China imports most of its food and energy through the South China Sea (and the Straight of Malacca, I think, but I could be wrong here). It’s the same thing with being the world’s reserve currency.
  
  People talk about China’s naval power, but I’m quite sure China isn’t even the strongest naval player in its region and if China had a legitimate conflict with Japan over turf, China would be crushed. Without the US, China’s input costs spike and a major source of the market for Chinese producers completely disappears, not to mention that their financial system could start having real issues.
  
  Reply
  - johny August 5, 2015 at 3:41 pm
    
    “US does almost every country a favor by providing a global security and financial apparatus”
    Suvy, are you trying to make people laugh? I mean we do need a comic relief once in a while in our life, I just did not think I will find it on this blog.
    So the USA goes out of its way, spends money and takes risks, just to provide global security and financial apparatus to other countries? How about you fix my car or a roof in my house, I will write you my own IOU and then claim I gave you a favor by allowing you to work for me?
    I find this blog more and more entertaining.
    
    Reply
    - Suvy August 5, 2015 at 7:26 pm
      
      Who do you think protects trade? What do you think is the world’s reserve currency? What does the world’s reserve currency mean in terms of the payments system? Please get a basic understanding of things before accusing others of being stupid.
      
      Reply
    - csteven August 7, 2015 at 1:46 pm
      
      Johny
      
      There is a great deal of development need globally.
      Without over-priveaging elites, and of inability to change course, China has degraded itself terribly.
      
      As to US, of course they police the entire global trade system. Provide protection for shipping, and architecture for finance and the reserve currency.
      
      There are many things it can and will do.
      
      Just because someone has overbuilt to excess, you imagine that because the world is fundamentally challenged that many important developing countries of the world, would not cooperate with the country that created the first global multi-lateral system in the world, working to mitigate everything from food scarcity to disease control, while providing decades of stimulus for development, via running current account deficits to enable countries to follow export led growth models as the US recedes from ensuring the global system functions for all. If the US were to begin to limit use of the dollar, failed to provide protection and security to global shipping (it can still provide protection for its own; and new partners).
      
      This is what is always wrong with posters like you (and post-modern thinkers):
      
      I have a value
      We all want value (as if value can be achieved)
      Value not achieved
      
      Those doing most toward achievement of value are stymieing achievement of value.
      The loudest believe that x is stymieing achievement.
      
      People do and will feel that.
      Feeling equates to truth.
      Thus unable to analyze value free.
      
      The US will have plenty of development partners as it recedes from unconditional support, and sole payment for ensuring the global system; look how many have done well under it. Have done better, have been able to achieve levels of industrialization and advancement in a world slowly and imperfectly moving itself from a condition of mass serfdom.
      
      Reply
  - johny August 5, 2015 at 4:02 pm
    
    Right. Global security.
    Both China and Russia are extremely happy that the USA is protecting them from foreign invasion. So who is it exactly that going to invade Russia or China again? Ukraine and Japan?
    
    Reply
    - Suvy August 5, 2015 at 7:28 pm
      
      China is happy. Do you think China can protect its own trade? Have you bothered to look at how much of China’s energy inputs come via the South China Sea?
      
      When did I say the US is protecting China and Russia against invasion? Global security threats aren’t limited to invasion. Why would you think global security threats are limited to invasion? It makes no sense.
      
      Reply
      - johny August 6, 2015 at 7:08 am
        
        Suvy,
        are you a physiologist who can examine the state of China happiness? B y what measure do you think Chinese are happy with “protection” they get from the USA? Is it a reason they increase they own military spending? Because they are so happy and reliant on the USA “protection”?
        please enlighten me on how exactly the USA protects Chinese trade. I did not see any reports China energy inputs are under attack, but it is possible I have missed something.
      - Suvy August 6, 2015 at 10:59 am
        
        Bretton Woods and the entering of China into the global trading system in the 80’s. The US protects everyone’s trade, which is really a side effect of the financial system.
      - Suvy August 6, 2015 at 11:36 am
        
        *70’s not 80’s.
        
        What does it mean to be a reserve currency Johny?
        
        Keep in mind that China is surrounded by hostile countries like Japan, Vietnam, South Korea, Taiwan, Indonesia, Malaysia, and India, some of whom have nuclear capabilities.
        
        You do recognize that ~60% of China’s defense spending goes towards internal security, don’t you?
        
        As for “US protection”, as you like to call it, many countries in the world are reliant on US protection. BTW, just because energy inputs aren’t currently under attack doesn’t mean its not an issue. All of the disputes for turf in the South and East China Seas are really resource disputes, so I think it’s clear how China feels about security risks with regards to its energy inputs.
        
        Chinese geography really places a lot of limits on China’s options with regards to military and geopolitics. When you’re surrounded by countries that’re all openly hostile to you or have a history of being openly hostile towards you (ex. Russia), you end up with lots of constraints in military policy.
    - Suvy August 5, 2015 at 7:29 pm
      
      BTW, the risk of China and Japan going to war isn’t a trivial one. If they did and Japan won, China would run the risk of being invaded and even falling apart. What do you think happened in China 100 years ago? Basically that.
      
      Reply
      - johny August 6, 2015 at 8:05 am
        
        Right Suvy.
        Japan, who by its own constitution is prohibited from even having a real military will go to war against China.
        if I remember correctly, the USA kind of tried engage China once during Korean War. Results?
        “The situation in Korea was becoming precarious. Chinese troops were surrounding and overpowering many of our marine units, especially around the Chosen Reservoir. Weather at 20 below was taking it’s toll. Soon the Eighth Army was in full retreat with a real catastrophe in the making.”
        http://b-29s-over-korea.com/Why-Truman-Fired-General-MacArthur/Why-Truman-Fired-General-MacArthur.html
        And to top it off, China has nuclear weapon. Nough said.
      - Suvy August 6, 2015 at 10:58 am
        
        Japan is probably the #2 naval power in the world and has a very sophisticated military. Just because there’s limits on military spending (limits now basically being disregarded).
        
        BTW, the idea of saying that because you have nukes that it eliminates the risk of war is foolish. If you nuke the other guy, the other guy nukes you and depending on the degree of damage, you end up dead. You’re better off losing a war than you are nuking the other guy. To say that China has a nuclear weapon so “Nuff said,” doesn’t really say anything. Launching and missile capabilities matter a lot too, and in some cases they could become constraints.
        
        BTW, the US is already arming countries like South Korea and Vietnam with missile defense systems.
        
        When did I ever say the US should engage China? What the hell dude? I never even referred (or was referring to) the Korean War. Why would you think I was referring to the Korean War?
      - Suvy August 6, 2015 at 9:57 pm
        
        China Nuclear Warhead Arsenal: 230
        China Ballistic Missiles With Range >7,000 km: ~40
        American nuclear warhead arsenal: 7200
        American Ballistic Missiles With Range >7,000 km: >400
  - Claire August 5, 2015 at 10:30 pm
    
    If the US stopped protecting and enforcing world trade, China would be the first country to get hit hard. China imports most of its food and energy through the South China Sea (and the Straight of Malacca, I think, but I could be wrong here). It’s the same thing with being the world’s reserve currency.
    
    I think your favorite author would point out that this dependence on the US is a “bad” thing, as it creates an incredibly fragile system–especially if the US feel compelled to slowly withdraw from the rest of the world (I think Michael mentioned this likely US withdrawal before in an earlire post: http://blog.mpettis.com/2014/09/how-much-longer-can-the-global-trading-system-last/ )
    
    Reply
    - Suvy August 6, 2015 at 6:44 am
      
      It’s a real problem for China and China is fragile geopolitically. China has a lot of problems and I suspect China really turns toward internal issues over the next few decades. China’s “rising dominance” is kind of a joke.
      
      However, I do see ability for China in the next few generations to really be a success. The elements are there and if they can hold through this sharp population decline, I think China could end up much better off.
      
      Reply
      - Claire August 7, 2015 at 4:55 am
        
        China has a lot of problems and I suspect China really turns toward internal issues over the next few decades.
        
        I am not sure if it’s even possible for them to turn towards internal issues–in fact, I think that the US, becuase of its geographic isolation for most of its history, is one of the very few countries that ever had the luxury of “turning inwards”. And even it lost this luxury once it became too big (post WWI? WWII?) with respect to the rest of the system.
        
        But going back, by “protecting everybody’s trade”, the US has basically suppressed the natural volatility in the system, which reduced prices and risks. I understand the short term benefits (and “short term” is measured in generations in this case), but once this stops, the imbalances caused by this suppression are going to swing violently to the other direction and volatility should pick up–big time, I think.
        
        The elements are there and if they can hold through this sharp population decline, I think China could end up much better off.
        
        At the risk of coming off like a bit of a jerk, you are basically saying that if China can handle huge amounts of short term volatility, then they should be able to handle longer term amounts of lack of volatility. That seems a little obvious, no?
      - Suvy August 7, 2015 at 2:31 pm
        
        China’s definitely turned inward before and China usually has turned inward when Eastern and Southern frontiers are under Chinese control.
        
        With regards to the US protecting everyone’s trade, that had far more to do with beating the USSR by bribing countries into an alliance structure. It worked great, but now the system no longer makes sense.
        
        At the risk of coming off like a bit of a jerk, you are basically saying that if China can handle huge amounts of short term volatility, then they should be able to handle longer term amounts of lack of volatility. That seems a little obvious, no?”
        
        I guess that’s a way of looking at it, but sometimes the obvious needs to be stated. Far too many people gloss over what’s right in front of their face instead of first looking at it and taking it at face value.
  - csteven August 7, 2015 at 1:34 pm
    
    Read Zeihan, excellent set of very logical conjectures.
    The world is in for a rude awakening.
    
    Those from a Libertarian to Marxian perspectives, to say nothing of the dull-minded, political actors that invade finance and economic blogs, should they live a few decades as history is written, will be cowering in, peering around, corners, wandering if anyone remembers how nonsensical their vitriol was.
    
    It is one of the more masterful, and grounded, set of predictions, forecasts that i have read.
    
    Thx, I retract my assertions previously. While still liking Kaplan, his persepctives are more grounded in the was, than the is, and will be, but I still enjoy his take. With Ogilvy, have you noticed how Zeihan’s old group is starting to more decidedly take a future orientation, and well more organized at that. I still see their economics lacking, however.
    
    Reply
Mike August 4, 2015 at 6:24 pm

Professor Pettis, a recent university graduate here. A short while ago I discovered your blog and have been trying to catch up on past posts ever since. You seem to have a grasp of economic history that most mainstream economists don’t share. I’m curious, apart from your own well regarded books, have you ever given a suggested reading list for beginners in past blog posts or interviews? If not, would you consider doing so in the future? Thank you for sharing your non-consensus views.

Reply
Vinezi Karim August 4, 2015 at 7:44 pm

I realize that co-relation is not the same as causality, but the following does make one wonder:

1) Michael predicts in 2009 that the US will be the first to recover.
The Federal Reserve responds by inflating its balance sheet by another 1 Trillion$.

2) Michael predicts in 2011 that the US will adjust fairly quickly as it always does.
The Federal Reserve responds by inflating its balance sheet by yet another 1 Trillion$.

3) Michael confirms in 2013, claiming that the consensus now supports his original prediction, that
the US economy is back on its feet again.
The Federal Reserve responds by inflating its balance sheet by still another 1 Trillion$.

The Federal Reserve balance sheet, following historically unprecedented unorthodox policies, including zero interest rates for 7 long years, now stands at an astonishing 4.5 Trillion$ (expand following graph to include all years available):
http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

As I said, I realize that co-relation is not the same as causality, but even so, just to be on the safe side, perhaps it would be best for Michael to stop cheer-leading the US economy. I don’t think Federal Reserve can go on expanding its balance sheet at this dizzying rate forever.

Reply
- John August 5, 2015 at 4:56 am
  
  1. The USD is a global reserve currency.
  2. The FED has simply satisfied the *global* demand for money (risk avoidance) following the crisis using financial products.
  3. There is no indication that it is the FED itself behind the growth in the USA.
  4. Real GDP ex. energy and food is similar to pre. crisis.
  5. Prof. Pettis already wrote clearly about the short-comings of GDP calculation including some great examples.
  6. Regarding employment, as you have already been replied to: it makes no sense to compare to a peak of a multi-decade financial bubble. In addition:
  – the crisis might have simply quicken a trend in the labor market market which is obvious for many years before 2008. That is, even without a crisis the labor trend would continue.
  – Possible skills gap.
  – Some would say benefits after the crisis gave people less incentives to work etc. but this is all speculation of course. Look at long term trends and consider that these few years are just short trend.
  – and last but not least, the numbers are continuously improving.
  
  Reply
- johny August 5, 2015 at 3:49 pm
  
  To Michael the USA balance sheet does not seem to correlate that much with a state of its economy. As long as he personally enjoys all the real things made in China and can play with his Google Search, he is happy.
  
  Reply
  - Fendy August 6, 2015 at 9:20 am
    
    Its hard for you to say anything that doesn’t make you seem an idiot, isn’t it? It’s not just that you don’t understand any of it, but rather your attempts to sound clever in exactly the same way as all the other trolls who have the sheer balls to discuss economics in the comments on Fox and Yahoo websites. Do you realize that what seemed clever when you were in 8th grade, and the butt of the jokes from all the clever kids, isn’t clever today? Is that why you hate smart people even as you try to be one of them?
    
    Reply
Giancarlo Bergamini August 4, 2015 at 10:00 pm

Savouring Prof. Pettis’ posts is but one of the few comforts left in my old age. What a pity when I’m confronted with a passage I don’t understand, such as the following :
“One way to rebalance is to convince Chinese households to save less out of their income. This would make Chinese households better off in the present while making them worse off in the future if lower savings means less productive investment […] In China, where domestic investment often has a negative profitability, this kind of rebalancing would make Chinese households worse off both in the present and in the future”
Shouldn’t it be the opposite, at least “in the present” ? Sorry, other than realising that China’s excess savings are not owned by households, the rest of the above reasoning I’m unable to grasp. Can someone help this cognitively impaired reader ? Thanks a lot.

Reply
- DvD August 5, 2015 at 2:40 pm
  
  That’s also my understanding. If domestic investment is not productive, then less investment / savings today doesn’t necessarily lead to a worse off situation in the future.
  
  Reply
  - Claire August 5, 2015 at 10:44 pm
    
    If domestic investment is not productive, then less investment / savings today doesn’t necessarily lead to a worse off situation in the future
    
    If potential future purchasing power gets expended today on something that does not pay for itself, then you have essentially wasted your ability to consume or invest in the future, and therefore you are worse off than if you simply did nothing.
    
    That’s my understanding, anyway.
    
    Reply
    - DvD August 7, 2015 at 12:55 pm
      
      If the investment doesn’t pay for itself, ie. has a negative return, then clearly you are right that you are worse off in the future for having made that particular investment. Correspondingly, not making that investment in the past would have made you better off today. That’s what many oil & gas companies managements must be thinking at the moment. Or US households that lost their investment in the subprime crisis. Or Chinese households that lost all their equity and sometimes more in the recent equity market boom-bust. That’s the problem of making investment decisions in a completely distorted environment where prices have lost their signaling function about real supply-demand dynamics due to excess monetary creation. The world is risky – uncertain – enough that it is totally unhelpful and ultimately self-defeating for policymakers to increase that uncertainty further by interfering with the processing and interpretation of price information by the multitude of participants. Declining consumer prices (deflation) means something. You can not simply suppress it and “make sure it doesn’t happen here” even if you are a Princeton professor or a Fed Chairman or a BoJ Governor or a Chinese Premier or whoever and you just feel like it.
      
      It not always possible to be so clear-cut, however. Some investment projects might have a positive return but below cost of capital. Are they unproductive? They make you better off in the future but worse off than an alternative investment that could have been more profitable. Some investment projects don’t lend themselves easily to a precise return computation. A public works program including roads, tramway lines and a university campus, for instance. Sometimes you just can not conclude, or at least not with great precision. That’s what i meant by saying “does not necessarily lead to a worse off situation”.
      
      In any case, it does make that passage of Michael Pettis article difficult to understand.
      
      Reply
      - Giancarlo Bergamini August 8, 2015 at 1:28 pm
        
        Many thanks, DVD, for addressing my doubt. Maybe my perplexity stemmed from my understanding that prof. Pettis’ hypothesis was that the portion of households’ income that was detracted from savings would end up as consumption (which would arguably make them better off in the present, as implied in the third rebalancing option). On the other hand, the passage that prompted my perplexity becomes less obscure if it implies that households increase their investment (in lieu of their consumption). The hospice is waiting for my call…
      - DvD August 9, 2015 at 1:36 am
        
        Clearly, the hospice can wait a lot longer…
- johny August 5, 2015 at 3:53 pm
  
  Giancarlo Bergamini, you are not a cognitively impaired reader.
  That passage the way it is written indeed makes no sense whatsoever.
  
  Reply
  - Fendy August 6, 2015 at 9:23 am
    
    It does, Johnny, and most people seem to get it, but I think it might be a little tough for you to get. And someone like you shouldn’t use the word “indeed”. It comes across as jarring and much too expensive a word for you to afford.
    
    Reply
Laurent Harvey August 5, 2015 at 4:57 am

Hi Michael,

Another classic piece of China and world economic analysis, really liked the extra notes and points from 2011. In 2011 you wrote that China would only have 4 or 5 years left until they reach the debt capacity that growth miracles invariably reach which would mean 2015/2016. Do you still think that timing is about right, maybe the debt capacity has already been reached and we are starting to see the fallout in real estate/markets or is that debt capacity still yet to come in 2015/2016?

Also, I was looking over some old internet news reports of Japanese investment into American realestate in the early 90s and after continuously going up by 10-30% in the late 80s, suddenly (maybe 91 or 92) it halved and remained depressed as a Japan entered the lost decade. Could this happen with China as they also have been increasing RE purchases in so many countries (Canada, USA, Australia, England)?

Reply
- johny August 5, 2015 at 3:54 pm
  
  Michael will revise his predictions again, do not worry. Every time he is wrong on timing, he will adjust a timeline to make it look right.
  
  Reply
  - Ge. Forsmith August 6, 2015 at 9:08 am
    
    Nice quip, Johny. I have read lots of Pettis’s work, including his books (three, which I think are all of them), and I was curious to know if you are saying this as someone who strongly resents his betters, or do you have concrete examples of major predictions that Pettis got wrong and subsequently “adjusted” to make him look right?
    
    For someone who reads the Pettis blog, and takes advantage of his courtesy to participate in discussions with some very smart people, even if you were right, your comment is a petty and nasty, and very childish. Aside from the fact that I can’t think of any economist who has a better predictive track record, and often with very non-consensus predictions too, I wonder if you would even be able to tell whether or not his predictions were correct. I don’t mean to be offensive, but from your comments I get the impression that a lack of courtesy might not be your biggest weakness. A very weak grasp of basic economics and history, and very poor logic, combined with an inferiority complex that makes your resentment of smart people somewhat stronger than your curiosity to learn from them, are probably bigger hurdles for you to overcome.
    
    By the way, where is it that you have listed the predictions you have made? I am curious to see if my assessment of your understanding of economics is correct.
    
    Reply
  - Ge. Forsmith August 6, 2015 at 9:26 am
    
    I know some of Pettis’s critics have had to “adjust”. When Pettis predicted that China would have a decade of average GDP growth between 3-4% at first every one said this was crazy, but now that it looks less crazy I know one person in my country (Australia, and he unfortunately he was deputy governor of our central bank) who disagreed strongly in 2011 and 2012 with Pettis’s analysis.
    
    He has now taken to arguing that Pettis is wrong (implying that he, in a breach of logic, must therefore be right) because when Pettis said “a decade”, he originally meant 2010 to 2020, and because it is now too late for his prediction to come true, he has had to change it. Even if our central banker had been correct, this strikes me as a trivial ground for criticism, especially when the debate between them was not about the timing of the slowdown but about how sustainable the Chinese development model and whether there would even be a slowdown of anywhere near that extent. Pettis argued that it was not sustainable and there would be, and his opponent argued that is was fully sustainable and there wouldn’t be.
    
    But I don’t think he was correct. I first read this “prediction” by Pettis in 2009 or 2010, I think, and the disagreement by our former central banker in 2011 or as late as 2012, and even though he has been challenged several times to cite the article in which Pettis said that the decade of 3-4% average growth would run from 2010 to 2020, he has never done so.
    
    In all the articles of that period I read, Pettis has always said that the decade of slow growth would begin “once rebalancing began”, always adding, in everything I have read anyway, that rebalancing would probably not begin until a new leader had stepped in. This seems to have been a truly remarkable prediction at the time.
    
    Reply
    - JohnWarberg August 6, 2015 at 9:27 am
      
      Mr. Foresmith, I assume you mean Stephen Granville. Am I right?
      
      Reply
  - csteven August 7, 2015 at 2:05 pm
    
    Michael is too nice for posting your garbage. You realize that most of us would not be so kind. But keep going, you serve to illustrate a small sub-set of the viewing population with political intentions unrelated to economics, at each post, and why so many in the world are so blind as to what is coming. Frankly, most market actors would probably prefer that you and others stay ignorant.
    
    Reply
Todd G August 5, 2015 at 6:19 am

Great read, as always. I was a little surprised to see this:

“I don’t have much to add to this except to say that I expect before the end of the decade or very soon thereafter to see a wave of sovereign defaults or debt restructuring in Latin America and elsewhere through the developing world.”

Do you include the bigger countries like Brazil and Russia in this prediction? That seems like serious business. I was under the impression that they were in better position this time around, given their reserves & lower debt/GDP levels (at least, compared to the last time they experienced defaults). What happened? Are you expecting defaults and 90% currency devaluations again?

Reply
- Claire August 5, 2015 at 10:40 pm
  
  That seems like serious business. I was under the impression that they were in better position this time around, given their reserves & lower debt/GDP levels
  
  FWIW, the Real has already dropped by over 50% to the USD over the last five years (roughly from 1.5 to 3.5, if I remember).
  
  Having said that, I think (but then, WDIK?) the main point is that so long as the structure of Brazil’s debt is pro-cyclical, there is no reason to believe that this time around will end very differently than any previous time.
  
  Reply
  - Suvy August 6, 2015 at 3:00 pm
    
    Brazil is a major commodity exporter that’s highly reliant on cheap capital. Brazil does have some advantages in the sense that its fertility rates have fallen and there’s a rising middle class with human capital, but it’s economy isn’t well diversified enough yet. Those flips between what effectively amounts to fascist governments followed by socialist governments for centuries really fucked Brazil (and Latin America) up.
    
    In my eyes, the problem was/is the nationalism and nation-states of Latin America. What the Latin American economy needed was an empire instead of idiots like Peron thinking they’re great and using Nazi Germany or Fascist Italy as role-models. Why the hell would you wanna be like mainland Europe?
    
    As for mainland Europe and the “European dominance” since 1800 or so, I don’t know if I necessarily agree with the most common narrative. In my opinion, the three strongest world powers in 1880 were the British Empire, the US, and Japan. When Japan crushed Russia in the Russo-Japanese War, I think that was really the nail in the coffin to the European dominance story. I also don’t know if its fair to consider Russia as European because Russia is Asian in many, if not most, ways. I’m also pretty sure that by ~1820, the US navy could’ve beaten many, if not all, of the navies of the European powers excluding the Royal Navy. Even in the War of 1812, the American navies inflicted losses on the Royal Navy that Napoleonic France and its allies were never capable of. It’s also not fair to treat the British Empire as purely European because the British were heavily reliant on the loyalty of Indian troops and the goodwill of Indian rulers to maintain their key possession: India.
    
    Sorry for the seemingly tangential rant, but the standard narratives about the greatness of mainland Europe and the apologist narratives for empire and the colonial period are wrong in many respects. I just don’t get how Latin American people look at mainland Europe, its institutions, and its ideas as something to be admired. It’s retarded.
    
    The typical example of this retarded thinking would be Che Guevara, who did more damage to Latin America than anyone else, was an absolute barbarian, was a racist pig (he hated blacks), was against free speech/free press, was against fair trials, explicitly/literally wanted to create a revolution led by hate, create a killing machine, and ruthlessly wipe out anyone that disagreed with his view points. How the hell did these people in Latin America take the ideas of Marx, Engels, Lenin, Mussolini, etc and think that implementing them was a good idea? How could any bit of what they say be good? Anyways, the problem with Latin America was taking the European approach instead of the American one: choosing nation-state over empire.
    
    Reply
  - Todd G August 6, 2015 at 3:04 pm
    
    Yeah, both the real and ruble have fallen around 50% from their peaks. I was under the impression that they might fall a bit more, but eventually stabilize at these lower levels. I wasn’t thinking of 1998 currency obliteration scenarios.
    
    I was also under the impression that, since Russia and Brazil have large FX reserves now, they’d be able to make the counter-cyclical moves necessary to prevent 1998 style blowups (to counteract, as you say, the pro-cyclical nature of the debt)
    
    Reply
    - Suvy August 6, 2015 at 10:05 pm
      
      The Ruble is probably gonna continue to tank. The RCB has ~$350 billion of FX reserves, but I’m pretty sure that $150-200 billion of those aren’t very liquid. If this pressure keeps up, Russia could be in trouble. With that being said, I think this is a great opportunity for the US to destroy nuclear weapons across all countries together.
      
      The US should find a country like Russia on the edge and provide Russia with a bribe of say $500 billion over the course of a 10 year period to remove 75% of American and Russian nuclear stockpiles and destruction of all of the Russian nuclear launch sites. The US should be doing this to countries like Pakistan, Russia, China, and Israel (maybe France too).
      
      Financial crises like these are a real opportunity to bribe and manipulate foreign governments. The problem is that our entire foreign policy has been basically run by idiots and we’ve got retarded opinions regarding “moral” issues of American Empire. I don’t understand why the US doesn’t use explicit bribes more often towards governments to get them to do stuff. It’s way better than spending the same amount of money on weaponry and unnecessary foreign occupations.
      
      Reply
      - csteven August 7, 2015 at 2:16 pm
        
        As to Brazil and Russia……
        
        have you seen these on Saudi….if Saudi, then….!?!?!!?
        
        http://www.telegraph.co.uk/finance/oilprices/11768136/Saudi-Arabia-may-go-broke-before-the-US-oil-industry-buckles.html
        
        http://money.cnn.com/2015/08/06/news/economy/saudi-arabia-oil-deficit/
        
        http://www.forbes.com/sites/timtreadgold/2015/08/06/saudi-arabia-might-just-have-blinked-in-the-oil-war/
      - Suvy August 7, 2015 at 3:36 pm
        
        No surprise here. I basically view Saudi Arabia, ISIS, and a lot of these other states as warlord regimes. They’re run by either explicit thugs or non-explicit thugs by extracting rent via commodity extraction and export while filling power vacuums. When these regimes go bust, really crazy shit could happen.
        
        With that being said, I think we could see a recreation of some kind of a Turkish Empire. Turkey is already expanding into the Middle East and I think it continues. In response, I suspect we’ll see the creation of a Persian Empire and maybe even an Israeli Empire, whether formal or informally.
        
        If our foreign policy is sensible, crises like this afford us an opportunity to have a major sway over by bribing governments that desperately need cash. It’s a problem in today’s world when empire has such a bad name. Empire doesn’t have to be rent-seeking imperialism.
    - Claire August 7, 2015 at 4:43 am
      
      ooops! Sorry–I probably shouldn’t have replied to your original post…And so I am now going to compound my mistake by replying to your next one as well 🙂
      
      was also under the impression that, since Russia and Brazil have large FX reserves now, they’d be able to make the counter-cyclical moves necessary to prevent 1998 style blowups (to counteract, as you say, the pro-cyclical nature of the debt)
      
      I run myself into circles thinking about the debt problem, but I’m currently leaning to the opinion that it’s impossible to counteract the pro-cyclical nature of the debt in general after the fact, because the debt is in itself very distortionary. I think for the most part you can really only make debt “anti-cyclical” by embedding the “anti-cyclicality” of it at the time it is issued (LOL–maybe Michael’s website should be http://www.hedgeyourdebts.com)
      
      But ok, let’s say that Brazil’s $400bn (or whatever) in reserves is enough to fend off a declining currency and enable Brazilian businesses to pay down their debts or swap their debts for locally denominated ones or whatever. That will work once, but once Argentina and all the other neighboring countries implode, then Brazilian businesses will be uncompetitive with their higher currency (and too many businesses facing insufficient demand) and blow up anyway, I think.
      
      So I guess I’m curious how it would benefit Brazil to sell their FX reserves (ie, a currency that other countries sort of want) to buy Reals (a currency that nobody wants) in order to increase their unemployment by making their exports more uncompetitive (I am being very lazy and assuming without looking it up that a disproportionate amount of Brazil’s exports are commodities which could be purchased anywhere–this might be a very incorrect assumption)?
      
      I hope that even if my conclusion is wrong, the logic at least makes sense and the question is the “correct” one to think through…
      
      Reply
      - Vinezi Karim August 9, 2015 at 8:10 pm
        
        ^^CLAIRE WROTE: “….So I guess I’m curious how it would benefit Brazil to sell their FX reserves (ie, a currency that other countries sort of want) to buy Reals (a currency that nobody wants) in order to increase their unemployment by making their exports more uncompetitive…..”
        ———————-
        
        Brazil is not “defending” its currency this time. They are letting it go down in an orderly fashion. They intend to keep their Forex Reserves mainly intact. Reuters reported: “Brazil’s Real Drops to 12-Year Low; but Brazil has no plan to use its international foreign-exchange reserves, Planning Minister Nelson Barbosa told reporters after President Dilma Rousseff’s weekly cabinet meeting in Brasilia.”
        
        Have you thought about this global issue from the other side?
        
        If all currencies are sharply dropping w.r.t. King Dollar, then what does it mean for the US? In general, a strengthening dollar leads to two things:
        1) A larger current account deficit
        2) Lower inflation (or disinflation)
        
        As we know, the USG/FED is right now worried about two things:
        1) Inadequate aggregate demand, a part of which leaks out through the current account deficit.
        2) Inadequate inflation, which makes debt deleveraging more difficult.
        
        Clearly then, the rising strength of the Dollar would make the job of the USG/FED much MORE DIFFICULT. In fact, what the US needs right now is a WEAKENING dollar, as that would reduce the current account deficit and stoke some inflation.
        
        Do you disagree? Let me know your views.
      - Claire August 10, 2015 at 5:47 pm
        
        Vinezi Karim: I don’t think that the US is going to have a happy, post-WWII-like growth any time in the future. For what little it’s worth, I don’t even believe that the US is going to be better off economically speaking ten years from now than it was ten years ago (although since I don’t do this for a living, or even for a hobby, my opinions are worth exactly nothing).
        
        However, I also don’t see which countries are going to recover from this before the US does. Just picking through the G7, I don’t see any of Japan, Germany, Italy, France, Spain, or Canada recovering faster (at least not without going through absolute hell first). Similarly, I don’t see Australia, Brazil, Argentina, Korea, or Turkey going anywhere soon.
        
        Michael’s explained how China can rebanlance and actually slow its economy down while having its average citizen better off, but I don’t understand why all the people who have benefited from this lack of balance would suddenly decide to sacrifice their wealth for the benefit of the general population. So I don’t have a whole lot of hope for China any time soon (although I agree with Suvy that in the long run, that country might do very well, there are some pretty big short-term hurdles they have to get over first).
        
        So to say that the US is gong to recover first isn’t necessarily cheerleading–perhaps it is, rather, a reflection on the rest of the world being a complete an utter mess, with nothing in sight to change the situation anytime soon.
        
        Those are my thoughts, anyway.
      - Vinezi Karim August 12, 2015 at 1:09 am
        
        ^CLAIRE WROTE: “However, I also don’t see which countries are going to recover from this before the US does. ”
        ———————————
        
        George Harrison says: Bangladesh, Bangladesh.
        https://www.youtube.com/watch?v=4EJvizCVEyc
        
        Net commodity importer. Strong remittances.
        Low external debt, largely held by multilateral & bilateral agencies.
        Low short-term debt. Good reserves.
        Low overall debt-loads. Modest inflation.
        No asset bubble. No credit bubble.
        Low fiscal deficit. Low current account deficit.
        Healthy savings. Healthy consumption. Healthy investment.
        GDP growth driven primarily by internal demand.
        Healthy demographics. Stabilizing population.
        Plenty of sources of growth on supply & demand side.
        Export exposure to Europe/US limited to basic clothing,
        which will always be purchased regardless of state of world economy.
        ———————————
        
        ^CLAIRE also WROTE: “So to say that the US is gong to recover first isn’t necessarily cheerleading..”
        ———————————
        
        My original comment was NOT about denying that the US might be the first to recover. That may well prove to be true. My original comment, if you read it carefully, stated that to say that US will “recover quickly, as it always does” was way off the mark and hence a form of cheer-leading.
        
        The US may well be the first to recover; however, it will not happen “quickly, as it always does”. This is going to be a long war. This ain’t no blitzkrieg, so don’t expect a France-like quick surrender– this is all I wanted to say.
      - Claire August 12, 2015 at 7:06 am
        
        Further to my thoughts about the US not having a happy future (and to be clear, I actually disagree with the vast majority of this article–it still makes for an interesting read, though)
        
        http://www.theatlantic.com/magazine/archive/2015/07/world-without-work/395294/
      - Suvy August 12, 2015 at 10:18 pm
        
        Vinezi,
        
        Bangladesh doesn’t have healthy demographics and has an exploding population. I’m also pretty sure there’s a lot of emigration from there to the Eastern parts of India.
        
        Basically any place in the Ganges Basin is something we have to be careful about. Even in the case of India, the South and West (primarily the regions that don’t speak Hindi) are doing quite well and will continue to do so. They have rising education levels, a rise in human capital, fertility rates that’ve dropped to below the US, and they all have relatively low development levels. Most of the areas in the Ganges Basin (including Bangladesh)? Not so much.
        
        I think there’s a real chance of South and West India to just break off from the rule of New Delhi and the idiots of the North. The problem with India since independence has been the parliamentary democracy bullshit wherein the idiotic Northern states would use “democracy”, their superior populations, and their backwardness to impose their will on areas that actually wanna take up sensible policies. Anyways, that’s a different rant for a different day, but I don’t think India in its current form can hold together. There’s no way the Northern Hindi speaking states should be ruling Telangana, Tamil Nadu, Andhra Pradesh, Maharashtra, Kerala, Goa, and the rest of South and West India.
        
        Bangladesh also has horrible geography that limits trade and population movement while allowing for high fertility rates. Small shifts in the monsoon cycles could mean Bangladesh gets flooded or could mean that Bangladesh starves (seriously). Either way, Bangladesh is not the next new thing.
      - Vinezi Karim August 13, 2015 at 12:34 am
        
        ^Claire WROTE: “Further to my thoughts about the US not having a happy future (and to be clear, I actually disagree with the vast majority of this article–it still makes for an interesting read, though)”
        —————————————–
        
        https://en.wikipedia.org/wiki/Luddite
      - csteven August 13, 2015 at 1:42 am
        
        Vinezi and Claire:
        
        The difference is this….
        
        the US is nearly the only source of demand for those seeking to follow export led development.
        
        The commitment of the US to an open market in the face of what has occurred recently, and demographic trends (aging, spending power, the ability/proclivity of different generations to save or consume or to have the power/desire to consume alters,….)
        
        The world economy doubled during the 1998-2008 period, and the pace of growth has slowed, while China expended a considerable amount of firepower, causing the cost of everyones development, including their own to be expensive, while such a process led investment around the world, contributing to global growth, and the short-term evolution of a global middle class to seem to occur, while bringing forward demand, in much the same way as Michael suggests for China. That will lead to lower growth moving forward…..
        
        this is because countries structure their economies to create surpluses, tying up their surpluses in liquid assets, that enable them to rationalize money growth via asset bloat, and over-development of associated areas of economies in the process…
        
        It is likely that Shale Oil, a great boon for the US, also was important in averting the unraveling of globalization during this time, via a shrinking current account deficit, leading to the ability of the US to still continue to splurge externally, otherwise.
        
        Now, the situation will not be pretty for anyone moving forward…..the baby boomer retrenchment (globally).
        
        The over-growth of the 2000’s (demand forward)
        
        The over-development in productive capacity (the fall in prices, the competition for rationalization of investment in productive capacity (AIIB), and the grave need of developing countries to continue to develop (SSA, SA, SEA, MENA, LatAm, etc).
        
        The US while challenged has options for retrenchment and special relationships.
        The period since the fall of the wall is not long.
        NA has self-sufficiency (with little efficiency improvements) in Oil and Gas; the US is the Saudi Arabia of Coal (per capita basis).
        the US has cheap options for transportation of goods.
        The US has plenty of land, is a swing producer in global food markets, controls large swathes of the high seas and has deep and long-lived (financial and human) capital (markets).
        
        Machines.
        In the frame that has existed, which will be challenged by forces domestically, machines can lead to the dystopian future of the Atlantic article, and Vinezi hyperventilating.
        
        The can also facilitate regional production on a vastly greater scale in an era of abundant and cheap natural resources, of the overcapacity exists of previous false expectations.
        
        Plain and simple, more people need to move into a position aside the US as a global demand provider for global development to proceed apace (even at a slower pace); despite bubbles, financial crisis, growing debt, etc….
        
        China and global dialogues on China have made this place for China far more difficult. 10 years from now they will still trying to use their aging, over-developed, industrial plant, after extension of the charade, made distrustful, a population that benefited from the globalization system, and needed to move into a place that enabled others to do the same, of the advancing material capabilities of states and individuals, even those who reside in decidedly undeveloped locales.
        
        The rest is at most, worry of my parochial interests related to my desire to maintain or advance my personal portfolio, etc…
        
        Regardless as to what happens of that, the longevity and place of America in the system ensures the best of even a very bad world; and better in a better.
      - Vinezi Karim August 13, 2015 at 4:34 am
        
        ^Suvy WROTE: “Bangladesh doesn’t have healthy demographics and has an exploding population.”
        ————————————
        
        George Harrison disagrees with you.
        http://goo.gl/NPmoLl
        http://goo.gl/1lxJFi
        http://goo.gl/rPXvaw
        https://goo.gl/P0g3eN
        
        ————————————
        Suvy WROTE: “Either way, Bangladesh is not the next new thing.”
        ————————————
        
        Maybe not, but at least they have god; which is more than what we can say for the communists in the east and the capitalists in the west.
        
        For a generation now, the race has been about ‘fast engines’; but now that we are about to enter into a long rough patch, the race will hence be more about ‘shock absorbers’. For the past generation the ‘stars’ were the ones who could move super-fast; for the next generation the ‘stars’ will be the one who can take the most pain. When the global terror comes, a clear distinction will be made between those who are happy with 3 meals a day and those whose happiness is dependent upon the endless acquisition of shiny things. The former will manage to hang-on in contentment, whilst the latter will be cast into the outer darkness where there is much weeping and gnashing of teeth.
      - Suvy August 13, 2015 at 3:59 pm
        
        Vinezi,
        
        1.5% population growth is quite a bit for a developing country wherein trade and development costs are through the roof. Fertility rates are currently at ~2.2 or so, which I think is the key number to pay attention to. Bangladesh’s fertility rate is still above replacement and most of the country is still agrarian.
        
        Just a note, many of those who are “happy with 3 meals a day” are agrarian societies that’re highly sensitive to shifts in the global climate patterns. Places like Bangladesh could either be completely wiped out in floods or by famine, which could lead to war. The current population growth rates in the Ganges Basin along with the kind of environmental degradation we’ve seen there make the place very fragile. I’m also worried about water constraints on agriculture because even basic infrastructure like working irrigation systems in places like Bangladesh or North/East India are a real problem.
        
        I’d actually argue that the most fragile places in the world are the places who “are satisfied with 3 meals a day”. The situations in most of those places aren’t robust and the slightest shift in climate patterns could easily devastate those populations.
      - Vinezi Karim August 13, 2015 at 7:04 pm
        
        ^Suvy WROTE: “1.5% population growth is quite a bit for a developing country…xx..Fertility rates are currently at ~2.2 or so, which I think is the key number to pay attention to…”
        —————————
        
        Here are the actual data:
        http://goo.gl/qnGZo2
        
        —————————
        ^Suvy WROTE: “Just a note, many of those who are “happy with 3 meals a day” are agrarian societies….”
        —————————
        
        There are plenty of people in California who would be “happy with 3 meals a day”, but California is not an agrarian society. I think you might be confusing a physical state with a state of mind.
        http://goo.gl/QoUGwB
        
        —————————
        ^Suvy WROTE: “I’d actually argue that the most fragile places in the world are the places who “are satisfied with 3 meals a day”.
        —————————
        
        Are we to presume, then, that the most robust of places in the world are the places whose “happiness is dependent upon the endless aquisition of Shiny Things”?
        https://goo.gl/zi2UQi
        
        —————————
        ^Suvy WROTE: “The situations in most of those places aren’t robust and the slightest shift in climate patterns could easily devastate those populations.”
        —————————
        
        And where does god fit into this theory of yours? Or have you no need of such a hypothesis?
        http://goo.gl/LJC7QG
      - Suvy August 14, 2015 at 7:08 am
        
        I’m not confusing a physical state with a state of mind. What I’m saying is the people that’re satisfied with little are, ironically enough, the ones who tend to be the first in line to die.
        
        Where does God play (I’m gonna assume you meant God, not god, as the latter would make no sense)? God is the root of our consciousness, but we’ve gotta be careful mixing spiritual and physical domains. The concept of God is what separates humans from robots, but a more “virtuous” lifestyle doesn’t necessarily mean your culture will survive. To cite Hindu tradition, we are in the Kali Yuga.
      - Vinezi Karim August 14, 2015 at 4:49 pm
        
        ^^SUvy WROTE: “What I’m saying is the people that’re satisfied with little are, ironically enough, the ones who tend to be the first in line to die.”
        ————————–
        
        Jesus disagrees with you. He insists that the meek shall inherit the earth.
        But then again, you may be right; after all, he was the first in line to die.
      - Suvy August 15, 2015 at 7:45 am
        
        Jesus wasn’t the first. He just happened to be one of the many in line.
        https://en.wikipedia.org/wiki/Kali_Yuga
- Vinezi Karim August 8, 2015 at 1:01 am
  
  Todd G WROTE: “Do you include the bigger countries like Brazil and Russia in this prediction? That seems like serious business. I was under the impression that they were in better position this time around, given their reserves & lower debt/GDP levels (at least, compared to the last time they experienced defaults).
  —————————————
  
  Debt/GDP is not very useful, because debt is in hard-currency and GDP is on soft-currency. Instead, look for the following TWO KEY FEATURES:
  
  1) An attempt to “defend” the currency by drawing down reserves.
  2) High ratios for Short-term debt/Reserves
  
  1) So who is attempting to “defend” the currency by drawing down reserves? Some examples:
  Argentina
  Venezuela
  Mexico
  Russia
  Ukraine
  Malaysia
  Turkey
  
  2) So who has high-ratios of Short-term debt to Reserves? Some examples:
  http://goo.gl/e1qfof
  Argentina
  Venezuela
  Mexico
  Russia (No reliable reporting)
  Ukraine
  Malaysia
  Turkey
  
  Interestingly, Brazil is not trying to “defend” the Real by drawing down on its Reserves this time, even though the fall has been huge. REUTERS REPORTS: “Brazil’s Real Drops to 12-Year Low but Brazil has no plan to use its international foreign-exchange reserves, Planning Minister Nelson Barbosa told reporters after President Dilma Rousseff’s weekly cabinet meeting in Brasilia.”
  
  In addition, Brazil has relatively low short-term debt to reserves ratio. So Brazil *MAY* turn out okay in this round.
  
  Reply
Walter August 5, 2015 at 8:29 am

Professor Pettis,
Thanks for your insights, and by the way you were mostly right about the predictions made back in 2011.
China is still financially repressing its household sector, if not even more. They have cut interest rates four times since November 2014.
Two things have caught my attention:
1. Stock market
The Chinese IPO market came alive last year, and there have been 225 new IPOs (someone needs to check, if these IPOs are genuine) raising 133bn RMB ($21.5bn), according to Zero Hedge.
The IPOs market capitalisation is 754.2bn RMB ($121.6bn).
The current market capitalisation of the combined IPOs stood at 3,133bn RMB ($505.32bn), as of April 2015. Although by June 2015 (when markets have peaked), the market capitalisation of IPO could be as high as $630bn.
Secondly, the market has attracted the opening of 25m new trading accounts since last year.
Since that fall in June 2015 of 35%, retail investors (trading on margins) lost its original investment and even owe debts from their brokerages. An interesting CNBC story about a farmer losing his fortune found by clicking below:
http://www.cnbc.com/2015/07/28/chinese-farmer-invested-life-savings-in-stocks-lost-it-all.html
We probably know who has benefitted from the market rout, and they are the SOEs insiders who have cashed out their shares to transfer wealth from
2. Wealth management products (WMPs)
These are more risky investments for higher returns, and by investing in WMPs you get a typical 6% (probably lower due to interest rate cuts). In some cases, fraud has taken place. Here is one example from English Caixin.
That market is well over 17 trillion Yuan as of June 2014. According to Economist Yan Liang, about 30% of WMPs is guaranteed a return of principal. These WMPs are invested in corporate and government bonds, as well as in property investment though some are lent out to the private sector (charging entrepreneurs high interest).

Both these money-raising instruments goes back to China’s ‘investment-driven’ model and if you point out that further investment leads to negative returns than the profits made from the ‘inexperience’ household sector would result in further losses, meaning that debt pile will keep on rising.

The second thing I like to raise is your theory of rebalancing. I think that China has put too much empathise on capital investment in infrastructural development, and not into human investment.
Professor, you are also right about China seeing slower growth because the next stage should be ‘real’ empathise on R&D spending (most of it goes to building R&D facilities that are mostly empty).
Investing in human capital (talent) would take some time (going to university and all that), but the positive returns in future can be very rewarding if China can innovate and invent.
However, the Chinese government, (I fear) are ‘short-terms’ thinkers. They acknowledge the problems (as always), but won’t do anything to spur the nation to follow the path of the Koreans, Japanese, the Germans and the Americans in its next stage of economic development.
Given the level of corruption and the Chinese leadership empathizing all things ‘infrastructure’, China could risk being trapped in the ‘lower middle-income’ bracket.
Love to hear your thoughts.

Reply
- meofios August 5, 2015 at 11:50 am
  
  it’s not that chinese leaders are short-term thinkers, it’s that chinese leaders have an obsessive fear of a repeat of Tiananmen square protests, they fear that any economic slow down, each mild slow down, can potentially lead to another Tiananmen square.
  
  Reply
  - Walter August 6, 2015 at 2:50 pm
    
    Meofios
    
    If they carry on doing what they are doing it could be a whole lot worse than the Tiananmen square protests. The thing is they know that will be the end game. Hence, why the Chinese purchase so many properties in the U.S., Australia and Canada.
    
    Reply
Cypriot August 5, 2015 at 10:04 am

Prof. Pettis: regarding the lack of professional investors in China, you can add the SOE and StatePensionFund as price-insensitive buyers. They are buying their own equity in A-shares at double the cost of the same shares on the Hong Kong market. And these are cash-flow business with easy metrics, not internet unicorns.

The Shanghai and Shenzhen equity markets are totally decoupled from prices in other markets- ON THE EXACT SAME SHARES. So there is no reality in their stock market. Even CNH and CNY trade within a few basis points- we are talking 1000s of basis points in equities. – Therefore the stock market as an avenue for rebalancing is closed.

Also, the buying of shares by the state (and coerced buyers) only increases the state ownership of the economy, and lowers the privitization narrative.

Reply
Dan Berg August 5, 2015 at 9:21 pm

So where did funds to prop up the stock market come from?
“The firm (China Securities Finance Corporation or CSF) borrowed 1.22 trillion yuan (at 4.3%) as of July 13 from commercial banks either through direct interbank loans or short-term notes issued on the interbank loan market to buy stocks, according to bank sources who asked not to be named. ” (Caixin, 7/28)

Reply
luddy August 5, 2015 at 10:53 pm

It has to be an encouraging sign for the field of economics that Prof. Pettis’ theories are being validated as having real predictive power. That’s always struck me as the thing that economics is missing most, when compared to ‘hard’ sciences: the ability to put its equations and theories to use to predict what will happen if certain conditions arise. It’s pretty exciting, I think! I wonder how many other basic equalities (like the accounting identities) are lurking, that might also be brought into the mix and applied simultaneously, in (say) a big computer simulation. Good stuff.

Reply
Koru August 6, 2015 at 4:17 am

“July 31, 2015 comments: I don’t have much to add to this except to say that I expect before the end of the decade or very soon thereafter to see a wave of sovereign defaults or debt restructuring in Latin America and elsewhere through the developing world.”.

When you say closer to end of the decade, take Brazil as an example, is that primarily due to the below?
1) they have ample dollar reserves to service dollar debt for a while, and 2) unlike in the past where in the “trilemma” they chose independent policy and fixed exchange rate, and the rebalancing/correction thereafter was more violent, now they’re going with non-independent monetary policy and will raise rates with the Fed (can’t remember but think it was from a Jeffry Frieden piece – that when the gov’t wants popular support, controlling inflation becomes more politically important). As a result, they’ll have to live with rising interest rates, a probably long period of low commod prices, while trying to deleverage and grow at the same time.

Reply
Vinezi Karim August 7, 2015 at 11:08 pm

^^^DvD WROTE: “Before there is a collective acknowledgement of the largely ineffective impact of domestic monetary and budget tools, before there is a reasonably well established understanding of why, we can’t move forward towards sustainable solutions. For the time being, the constant reference to “structural economic reforms” is invariably accompanied by a complete lack of specifications about what these might be (for instance Stan below). When you press for more clarity, you quickly realize that “structural reforms” means different things to different people. Eight years after the freezing of the US inter-bank market, there is still no clarity of thinking about what exactly needs to be done.”
—————————

This is exactly correct. You have identified the key issue that America faces today. When there is no consensus as to the nature of the problem, how can there be a consensus as to the nature of the solution?

I propose the following framework:
1) From 1945-1980, during the approximate Breton Woods period, the ruling economic ideology was Keynesianism.
2) Due to the stagflation of the 1970s, however, some people began to question the prevailing theories of Keynes. Specifically, Milton Friedman rose as a towering & charismatic figure determined to discredit Keynesianism with his new Monetarist ideas.
3) After the 1980 election of Reagan, Keynesianism was pushed into the background and Monetarism (or Friedmanism) took over as the ruling economic ideology.
4) For the last 35 years, Friedmanism has been the guiding ideology of the Federal Reserve– regardless of which party formed the government. Now look at the graph below:
http://blogs.reuters.com/rolfe-winkler/files/2009/12/US_DEBT1209.jpg
5) Note carefully that during the 1945-1980 Keynesian period, the debt-load was approximately constant. Once the Keynesian ideology was replaced by the new monetarist ideology of Friedman in 1980, however, the debt-load began to rise and has been continuously rising to this day. This is unsustainable.
6) Clearly, while Friedmanism may have been an appropriate response to the stagflation of the 1970s, it has now outlived its utility and has become unsustainable (or even malignant). Therefore, just as the old Keynesianism was pushed aside in 1980, Friedmanism MUST NOW BE ABANDONED.
7) Just as the stagflation of the 1970s acted as the catalyst for the rejection of the old Keynesian ideology and the adoption of the then-new Friedmanite ideology, the current debt-mess should act as the catalyst for the rejection of the currently-established Friedmanite ideology and the adoption of a BRAND NEW economic ideology.

However, there are numerous reasons why this will be very difficult:
(A) Friedman rose as an intellectual giant of great influence and was able to not just challenge the prevailing Keynesian ideas of the time, but also propose a replacement ideology in the form of monetarism. Today, there is no such intellectual giant in sight in America. In addition, it is unclear as to what will replace Monetarism (or Friedmanism)? Would it be a return to a modified form of Keynesianism? If so, who will lead this ideological revolution? And what modifications would be made? As may be imagined, the difficulties are enormous.
(B) The old Keynesianism was essentially a government-based ideology. Therefore, once Reagan was elected on the platform of change, it was easy to push Keynesianism into the background and shift to Friedman’s monetarist ideas. Today’s Friedmanite ideology, however, is rooted not in the elected government, but in the unelected & independent Federal Reserve. Friedmanite ideology (via Greenspan, Bernanke) has now become deeply rooted in the institutional culture of the Federal Reserve and so will be very, very difficult to change. This is because no matter which party people vote for during elections, they cannot change the established institutional culture of the close-knit intellectual network at the Federal Reserve without compromising its “critical independence”.

I could be wrong. Just some thoughts.

Reply
- DvD August 10, 2015 at 9:23 pm
  
  I agree that the persistent economic and financial malaise reflects first and foremost a deep crisis in the dominant economic vulgate. Perhaps it is inevitable that the “elite” rules over the “masses” as Suvy thinks but that’s becoming a problem when the “elite” is so confused that it is incapable of leading effectively, as is the case at the moment. It is interesting to notice how the political “elite” is trying to compensate for their confusion and lack of results by a mixture of expanding demagogy and tightening civil liberties under the cover of terrorism.
  
  Reply
  - Suvy August 19, 2015 at 6:21 am
    
    So we need to chuck out the old elites, not have no elites. Class mobility is much more important than equality. In places like Europe, there’s no class mobility at all (ex. in France 60% of the wealthy inherited it, in Germany all of the largest companies/employers are the same ones as they were 100 years ago AND the top 1% of firms in size account for ~30% of the total employment and ~50% of GDP, etc.).
    
    In the US, that’s actually much less of a problem. I actually see a lot of signs in the political arena of the US. The ideas are starting to change and there’s a lot of headway going on behind the scenes. The correct ideas and solutions are slowly being brought out into the open.
    
    Reply
Vinezi Karim August 8, 2015 at 11:07 pm

Here are the 1948-2015 data on number of workers ACTUALLY employed in the US:
http://data.bls.gov/timeseries/LNS12000000

People can select to zoom into the various previous recessions/crises and compare them to what has happened recently. Here are some examples:

1) Select 1977 to 1984 window to examine the troubled Carter to Reagan transition period.
As seen in the graph, there was almost NO REDUCTION (<1% peaks to troughs) in actual number of workers employed in that troubled period.

2) Select 1987 to 1994 window to examine the troubled period of Bush Senior.
As seen in the graph, there was only a small reduction (1.7% peak to trough) in the actual number of workers employed during that crisis AND recovery to previous peak was accomplished in about 1.5 years (trough to previous peak).

3) Select the 1997 to 2004 window to examine the Internet Bubble debacle.
As seen in the graph, there was only a small reduction (1.4% peak to trough) in the actual number of workers employed during that crisis AND recovery to previous peak was accomplished in about 1 year (trough to previous peak).

4) Now select the 2007 to 2014 window to examine the recent mess.
As seen in the graph, the was a MASSIVE reduction (5% peak to trough) in the actual number of workers employed during that crisis AND the recovery to previous peak took a VERY LONG 5 years to accomplish (trough to previous peak).

Note that the LONGER it takes to get back to the previous peak, the bigger the backlog of jobs-needed (to accommodate the new additional entrants that come in during that long period) gets. This implies that the economy must now add jobs at a historically unprecedented rate for years on end to clear this huge backlog in addition to accommodating the millions of young millions who are going to come into the job market due to America's excellent demographics. Clearly, what we are facing is a VERY difficult situation. Nothing like this has ever been seen in the employment statistics in the whole of US post-depression history. People can verify this by examining the data in the above-linked graph for all the other crises/downturns going back to 1948.

Still further, when we consider that this unprecedented employment disaster has occurred even as the US government ran cumulative deficits that added about 40% of GDP to the debt load, AND as the Federal Reserve expanded its balances sheet in a historically unimaginable way by 25% of GDP, it clearly indicates that the situation today is very dire and will take a LONG TIME to fix. It is difficult to say what this "long time" might turn out to be, but it is certain that the US will not be able to "adjust fairly quickly, as it has always done".

Reply
csteven August 9, 2015 at 2:05 am

Any see the newer Victo Shih discussion of Debt on the USCBC

Reply
- Suvy August 9, 2015 at 6:32 am
  
  Word. This is sick.
  
  BTW, this may be of interest to you.
  
  Reply
  - csteven August 9, 2015 at 12:15 pm
    
    Any other books you have been reading?
    
    Reply
    - Suvy August 10, 2015 at 4:32 pm
      
      On this kind of topic, I’ve read Warlords, Inc., which is basically a collection of semi-related essays, and Thieves of State by Sarah Chayes. I like Thieves of State, but there are A LOT of other issues going on in these countries and I think Chayes just says it’s all “corruption” when I think other issues are way more prominent in the functioning of these countries.
      
      As for the rest of my reading, most of it has been with regards to history. I finished a book on colonial history that comes at colonial empire from a balance sheet point of view. As we expect, the nonsense Marxist perspective is obviously wrong, flat-out retarded, and takes away credence from perfectly functioning societies (a classic example of this nonsense would be the idea of the “Asiatic mode of production”).
      
      I’m also reading Rothbard’s A History of Money and Banking, which is actually really good. Keep in mind that I DO NOT agree with Rothbard’s political views and find him largely ignorant of critical geopolitical issues, but the data and analysis used in his books (which is a collection of large essays) is unparalleled and phenomenal.
      
      I also picked up books by a historian by the name of HW Brands called Money Men, which is about the US being a capitalist democracy. Brands claims that the US only became a capitalist country in the late 19th century after the Civil War, but I’d actually say the US became capitalist when Hamilton started to impose his system and it was the primary reason why the Union (with industry, finance, trade, and technology) crushed the Confederacy. Anyways, I ordered the book and it’s on the way, but I’ve watched a lot of his videos and I like what I see.
      
      I’m also reading history books on other aspects of history including the Ottoman Empire, British Empire, World War I, the Napoleonic Wars, the Civil War, and other stuff.
      
      Books I’ve Read or I am Reading:
      1 A Short History of Colonialism by Wolfgang Reinhard
      http://www.amazon.com/short-history-colonialism-Wolfgang-Reinhard/dp/0719083273/ref=sr_1_1?ie=UTF8&qid=1439222956&sr=8-1&keywords=a+short+history+of+colonialism
      2. A History of Money and Banking in the United States by Murray Rothbard (halfway through)
      3. Thieves of State by Sarah Chayes (read)
      4. Unfinished Empire by John Darwin (~60% finished)
      5. Ottoman Centuries by Lord Kinross (~20 % finished, long book but a pages read quickly)
      6. The Deluge by Adam Tooze (finished)
      7. Napoleon’s Wars by Charles Esdaile (absolutely excellent and also finished)
      8. A History of God by Karen Armstrong (~50% finished)
      9. Liberty and Power by Harry Watson (excellent account/description of Jacksonian America)
      10. The Wages of Destruction (barely started)
      11. All the Devils are Here by Bethany McLean (~15% of the way through)
      12. The Great Game by Peter Hopkirk (big book, but a relatively quick read, ~20% through)
      13. Lost to the West by Lars Brownworth (finished, excellent book on Byzantine Empire)
      16. The War Lovers by Evan Thomas (~20% through, quick read)
      
      I’ve picked up way more books and I’ve read a good bit for the past few years, but I can’t remember off the top of my head. I’m basically reading in a kinda scattered manner. I’d be reading more, but I’ve spent so much time doing mathematics research and traveling this summer that I’ve been busy. I’ve been out of the country, traveled basically almost all the way across the East Coast (just came back from a music festival in Baltimore), so I haven’t been able to read as much as I’d have hoped even though I’ve been reading a lot. Honestly, the math stuff I’m working on has been taking up most of my time.
      
      Reply
      - Suvy August 10, 2015 at 4:33 pm
        
        *I’ve finished Liberty and Power
      - Michael Pettis August 11, 2015 at 5:50 pm
        
        The best reading should include a lot of “scattered” reading along with at least one or two topics about which you know almost everything. This way you can accidentally make connections that aren’t the normal ones, which are what you find when you study a topic more systematically. I remember spending reading a fascinating book on the Medici banks and contemporary European banking in the midst of a sustained period of extensive reading up on option pricing and anything that seemed to come out of Merton’s 1974 paper on capital structure optionality, and a comment in the former about the correlation between economic growth on the one hand and, on the other, dodgy currency manipulation by princes who, for the most part, remonetized coins with reduced gold and silver content, made me waste a day very fruitfully as I tried to picture how to think of currency manipulation and the risk of good money going bad in optional terms, how it affected incentives, and whose incentives you wanted to change (the correlation was actually positive, and while only slightly so, and at a low confidence level, you would have expected it to be very highly negative).
        
        Maybe this is taking the metaphor too far, but it seems to me that if you know a couple of things deeply and you combine it with knowing a very wide range of things superficially, it is like creating a 3-D map by combining a large 2-D map with a few of tunnels of great depth, although of course you have to assume that there isn’t much variation in depth, which I think is often a reasonable assumption when dealing with historical events. For all the extraordinary surface diversity, people tend to organize their social needs and to respond to incentives in fairly similar ways.
      - Laurent Harvey August 12, 2015 at 1:24 am
        
        Hi Michael,
        
        I saw you haven’t been commenting for a bit but I’d really like to know your opinion on something?
        
        This is just a question to satisfy my curiosity.. In the revisiting of the 2011 forecasts you did write that China could reach debt capacity in 4-5 years (so2015/2016). I know opinions can change but I’m just wanting to know where you think China is now with regards to debt capacity? Have they reached it or are they still in the process of reaching it?
        
        Thanks heaps
      - Michael Pettis August 12, 2015 at 6:48 am
        
        Check out my blog entry about restructuring European debt restructuring. That is where I discuss a little more about how to think of “too much debt”. Sorry I cant respond, but the PBoC move on the RMB has made things pretty crazy.
      - csteven August 11, 2015 at 11:52 pm
        
        Not this topic, won’t even look at this, old hat, continuing tired memes
        
        newsflash, people will take advantage as much as they can, in as many ways as they can….
        
        than this story, I have more interest in who got the Ibrahim award this year for good governance and leaving a country without raping it, and allowing for transference of power in Africa, than this tired old story, don’t waste our time with this sort of old, of course, this is what people will do, that’s it structural, etc, don’t hold, grease payments are even able to be deducted from taxes, etc, cost of doing business….so won’t watch such, you have real areas of this topic that you can review and contribute too, this is better for hollywood plots, and part of the reason, no one looks at anything but the flashy issues that are titillating, if I want titillating, I’ll go to a strip club.
- Suvy August 9, 2015 at 6:41 am
  
  On notes about the video:
  1. All of the guy’s “estimates” aren’t really estimates, they’re bounds
  2. I’ve gotten similar numbers from using a similar analysis, except my numbers are worse
  3. He has an excellent understanding of balance sheets
  4. He’s got a good understanding of the historical aspects too
  
  I’m impressed.
  
  Reply
- Dan Berg August 9, 2015 at 5:11 pm
  
  Csteven; thank you for that; I thought the other guy’s argument was revealing; they had done field work and everyone they talked to said “no problem; they have plenty of real assets;” this was his argument as well; “the other side of the balance sheet.” He mentioned foreign reserves (nope); booming equity markets (oops); sell bits and pieces of bankrupt SOEs (good luck); finally, he concluded that they have a liquidity problem, not a solvency problem. Sound familiar?
  
  Reply
  - Vinezi Karim August 11, 2015 at 12:05 am
    
    ^Dan Berg WROTE: “Csteven; thank you for that; I thought the other guy’s argument was revealing; they had done field work and everyone they talked to said “no problem; they have plenty of real assets;” this was his argument as well; “the other side of the balance sheet.” He mentioned foreign reserves (nope); booming equity markets (oops); sell bits and pieces of bankrupt SOEs (good luck); finally, he concluded that they have a liquidity problem, not a solvency problem. Sound familiar?
    ———————–
    
    Speaking of blind-spots….
    
    A) Statement: US debt-load has been rising in a secular fashion since 1980. This is unsustainable. The growth-model used over the past generation has reached a dead-end and must now be CHANGED.
    http://blogs.reuters.com/rolfe-winkler/files/2009/12/US_DEBT1209.jpg
    
    B) Here are some of the responses to the statement in (A):
    (1) This is not a problem because household net-worth (house prices, asset-prices) has risen spectacularly over that period.
    (2) You are looking at only one side of the balance sheet. The biggest asset on the other side is the sovereign printing press.
    (3) Instead of looking just at the external debt of the US, you should also consider the foreign equity holdings of the US.
    (4) Debt may have risen faster than GDP, but look at the booming equity markets; they have risen faster than the debt.
    (5) Even if the fed’s rate is at zero, they can always keep selling chunks of printed money (QE).
    (6) The US does not have an unemployment issue, it has a non-participation issue.
    (7) What the US has today is not a solvency problem, but a liquidity problem. All we need is negative interest rate, implying zero nominal rate, massive QE and higher inflation.
    
    Now compare what the “America-defenders” are saying (in my comment) about the sustainability of the US debt-load model to what the “China-defenders” are saying (in Dan Berg’s comment) about the sustainability of the debt-load in China. Sound familiar?
    
    We need CHANGE in America. NOW. Before it is too late.
    
    Reply
MacroHFGuy August 9, 2015 at 9:14 am

Agree with a lot of your points. But translating them into actionable ideas in the markets is difficult.

I am personally surprised you spend very little time discussing RMB devaluation — that seems like the most obvious release valve in this situation and perhaps inevitable. The RMB peg today is basically serving as a conduit for elites to transfer their domestic wealth abroad before the inevitable peg break.

A country with -4.8% PPI growth should not have 3%+ interest rates. Real interest rates in China have never been higher. CNY REER is at all-time highs.

China is literally the strongest currency in the world running right into a USD rate rise.

Reply
- csteven August 9, 2015 at 9:45 pm
  
  We discussed the likelihood of RMB weakening years ago.
  
  Michaels commentary probably estimated that such would lead to trade tensions.
  With their hope to be included in the SDR; it is estimated that allowing devaluation wouldn’t occur before November decision.
  
  Rise would hit similar level producers but be controversial in the developing world; with the advantage likely causing both complaints from advanced and developing world peers.
  
  This would strengthen trends toward protectionism; especially insofar as the US before elections.
  
  But, a real story, without need to over-emphasize the US, has been the rise of walls across many in the developng world. Where China has stymied the development trajectory of non-resource dependent emerging economies, from its vast over-investment in productive capacity, and raising the cost of development by pushing up commodity prices, making everyones development more expensive, every developing countries industrialization drive, the devaluation would likely see import cost rises while causing dissension globally. So exports which have become less competitive vis a vis other destinations, import price rise, and more difficult for the government to structure current account deficits or provide dollar liquidity for retreating domestic money as economy slows.
  
  Doesn’t seem that they can go in any direction. But they will likely move after IMF decision and US elections, with the same results as described, I suspect.
  
  Reply
  - csteven August 9, 2015 at 10:01 pm
    
    current account surpluses**
    
    Reply
    - csteven August 12, 2015 at 12:01 am
      
      I should note that I don’t view today as a devluation, despite everyone hyperventilating, seems more to me a slight exercise to see what happens:
      
      With a movement this small what happens, does it lead to an increase in capital flight? crys from abroad? impact on markets? etc….
      
      (China trialing on a small scale everything, before larger implementation)
      (response of region, world) (impact domestically, region, globe)
      
      Reply
- DvD August 10, 2015 at 2:11 pm
  
  Yes, re-exporting deflation right back to the West. How will the West respond? More QE to try to devalue back? It is plainly visible that everyone trying to simultaneously devaluate against everybody else is not a solution. Any other idea?
  
  Reply
  - Dan Berg August 11, 2015 at 4:10 pm
    
    DvD: homework assignment: http://www.federalreserve.gov/econresdata/feds/2015/files/2015047pap.pdf
    
    Reply
    - DvD August 11, 2015 at 6:01 pm
      
      Dan, China devalues, the Eurozone devalues, everybody devalues and shifts the entire worldwide burden of debt and employment adjustment onto the US and the most urgent homework assignment you can find is the Fed approach to raising interest rates? You must be kidding?
      
      Reply
  - Vinezi Karim August 12, 2015 at 12:29 am
    
    ^^DVD WROTE: “Yes, re-exporting deflation right back to the West.”
    ———————————
    
    AUD down. CAD down. JPY down. KRW down. HKD down.
    CNY down. BRL down. RUB down. INR down.
    MYR down. IDR down. THB down.
    Here a down. There a down.
    Everywhere a down, down.
    
    USD up. GBP up. EUR up.
    
    Since Europe is currently running a surplus, the strengthening should cause their surplus to shrink.
    US & UK, as always, are running a deficit. Therefore, the strengthening should cause their deficits to widen. In light of this, disinflation and a further leaking out of aggregate demand are to be expected in America. Unemployment, under-employment and ‘statistical non-participation’ may rise again.
    
    “What is the point of having this expensive military if we can’t go bomb someone?”
    
    Reply
John August 11, 2015 at 3:36 am

Well, China just started to devalue the currency. No doubt the first out of many more to come.

I guess at this point we can finally stop with the “re-balancing” delusion, there is not going to be any, history will simply repeat itself and China will go the same path as most other developing countries.

I fear for the world my kids will grow in.

Long USD short everything else.

Carry on.

Reply
- Laurent Harvey August 12, 2015 at 12:49 am
  
  I don’t know if Michael is starting to rub off on me but I think they are rebalancing, albeit slowly and in a zig zag fashion. In the 2nd half of last year everyone was calling for the PBOC to drop rates and ease monetary policy as property prices started falling month after month after month- they didn’t. They watched as parts of the economy really started to do it tuff and as exports and imports and PPI maintained their downward trend. What is it, about 40 months PPI has been in decline? That’s a lot.
  
  Premier Li said at the conference at the start of the year that, ” This years problems may be more formidable than last year”. They knew problems would grow this year. The data this year has grown steadily worse with gdp slowing and among other things, exports unexpectedly dropping about 8% rather than the forecast 1-2% drop so they devalued the Yuan.
  
  They are rebalancing in a very zig zag fashion where they tighten (relatively) until the data starts looking very bad and then they loosen. Then when the data stabilises somewhat they tighten (relatively) and then then when things get really bad again they loosen. They are not loosening to increase gdp from 7.5% to 8.5%, they are just loosening enough to make gdp decline from 7.5% to their target of 7% and not 6%.
  
  But the PBOC is not the all knowing being that can do this all the way down to their preferred rebalanced position. In spite of the way my argument has sounded I do still believe that at some point, people (including the Chinese) will gain an unequivocal grasp of what’s going on which is a long slow downward adjustment. Maybe in a year or 2 when the PBOC has zig zagged their way down to 4.5% gdp growth (or something like that) people will finally get the picture that the double digit growth ain’t coming back and that this decline is in a solid downtrend. People will have their “ah ha” moment and begin to quickly unwind their over leveraged assets and the rebalancing will take an unwanted quick turn.
  
  Reply
  - John August 13, 2015 at 5:46 am
    
    Well, I have a huge Pettis portrait tattooed on my back with the words “Volatility Machine”, in flames, just below it but it does not mean I have to agree with everything he says. Of course I do not believe that at any point he stated that China is indeed re-balancing as it should, on the contrary. They are indeed trying to. Sorta. Kinda. You know. Right now it looks like too little too late.
    
    Reply
    - Laurent Harvey August 14, 2015 at 12:32 am
      
      Haha, if you post a pic with “Volatility Machine” in flames on your back I will transfer you $100.
      
      Yeah maybe Michael hasn’t exactly said that they are adjusting as they should, but he has said many times in print that he thinks “they will pull it off” and the political wrangling behind the scenes determines how well they will rebalance.
      
      I just think they tried to tighten in the last half of last year (or atleast not loosen as things got worse) and then this year they couldn’t take the pain anymore and so they are trying to stem the bleeding. I don’t think they care what credit growth is when things are this bad, they are just trying to react to the fires in declining exports, falling property and PPI and trying to stabilise it ASAP before “tightening” again. I think if we put ourselves in the PBOC/governments shoes, could you not change monetary policy/fiscal policy and just let “Rome burn” while everyone from the government to businesses to the public is screaming “DO SOMETHING!!!”. Even though I know credit should tighten I would prob cut a rate or 2 just so that I’ve done something to stop the nose dive and show that I’m trying to stabilise the rough landing.
      
      Reply
Complex Velocity August 11, 2015 at 5:19 pm

The devaluing of the renminbi / yuan has just started.

Those expecting another Q.E. by the fed may be waiting awhile as the inflows of funds into the usa, the strengthening of the consumer economy and pension funds needs point toward interest rates going north. Thus, expect the deflation tsunami crashing down upon dollar denominated debt users bringing wrath upon themselves as the false gods of more debt fixing a credit / debt crisis was can kicking at best as the velocity of money crashes leaving many searching for chairs as the music stops ……

Asset prices crashing will be the norm, the smart money will wait for further cram downs. Velocity of money, commodity implosion, global trade ring fencing, point toward very ruff waters looming and not sure it can be stopped at this point as risk transfers public / private have been exhausted as many countries sit upon massive amounts of worthless paper already and zero bound rates with internal pressure building towards unwinding not more QE, ect, ect …..

If / when the federal reserve starts moving interest rates upward / dollar upward ascent, the inner reflection of dollar denominated debt holders sitting upon assets in a deflation whirlwind will ask ” how could I have been so stupid ” economics 101′ – debt / credit is not money / wealth , it’s a choke hold

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- Vinezi Karim August 12, 2015 at 11:59 pm
  
  ^C.V. WROTE: “Thus, expect the deflation tsunami crashing down upon dollar denominated debt users bringing wrath upon themselves as the false gods of more debt fixing a credit / debt crisis was can kicking at best as the velocity of money crashes leaving many searching for chairs as the music stops. ”
  ——————————————————
  
  1) Deflation Tsunami crashing down upon
  2) Bringing wrath upon themselves
  3) The false gods of more debt
  4) Kicking the can down the road
  5) Searching for chairs as the music stops.
  
  http://www.economist.com/blogs/prospero/2013/07/financial-writing
  
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  - Complex Velocity August 13, 2015 at 6:30 pm
    
    Sorry for the play on words just having some fun … 😉
    
    The securitization alchemy that driven leveraged credit for the past twenty three years has skewed perception, expectations and fundamental analysis. This alchemy has fooled the leaders of the PCoB, the Princelings into a false assumption regarding implied manufacturing expectations, commodity needs ect, ect ….
    
    This miscalculation of growth across all asset classes clouded by structured investment vehicles, derivatives ( global ) in a world of ZIRP leaves macro fundamental analysis twisting in the wind.
    
    With money velocity crashing, dollar denominated debt’s overhang the continued credit issuance into the abyss of interest obligations toward NPL’s leaves a deflation tsunami without precedence in the history of finance. Solving a debt / credit crisis with more debt is lunacy at best and those perpetuating this farce without questioning the construct of said alchemy must look in the mirror and ask W.T.F is going on …. ? Materialism is a bitch in a deflationary vortex. The fact velocity has been crashing for years in a fiat banking world has the smartest guys in the room trembling, as they should be.
    
    Lets hope the mistakes made throughout history are not repeated as we slouch toward gomorrah ( war ) once again. Will the stupidity be exposed for what it is or will the top 1%ers thrust the unwashed into another war as amortization schedules, letters of credit supersede falling on one’s sword regarding past sin’s, no matter ones position in this game called life. We can only hope our ” leaders ” can learn from history and not swallow one’s tail ….
    
    C.V.
    
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  - Complex Velocity August 14, 2015 at 12:39 am
    
    Also …… The headwinds are very stiff projecting consumer consumption moving forward …
    
    China’s gini coefficient has trended well above developing nations over the last thirty years. Ugly …… Combine this with the financial albatross with debt issuance within a system who’s accounting standards are laughable at best. The technology cram down upon job growth / prospects if robotics, 3D printing, nano tech ect. are projected forward in this space, the rain clouds soon become F5 tornados. This is not the 1930’s so projecting consumer driven GDP #’s moving forward should be mindful of the internet of things.
    
    The embedded abhorrence within society regarding materialism should also be weighted against assumptions of consumer growth as those currently working offline may not view the western consumption playbook set up as desirable. The ” mafia like ” heavy hand used across many provinces has left a very bad taste as the lower class look upward with little respect and distrust as land acquisition, land – water destruction by the industrial revolutionist create generational hatred towards the system of corruption.
    
    The ” panic ” by the politburo backsliding regarding markets, currency, interbank rates betrays stated goals exposing it’s weakness as the underbelly of NPL, off-balance sheet leveraged debt, projects funded by trillions in recent issuance producing absolutely no revenue streams, account fraud, province driven statistics are predetermined …….. The statistical fraud can only mask the issues for so long, the princelings buying assets abroad preceding the hot money exodus is really just getting started. Seems the people at the top are worried about something big looming …,
    
    Buckle up V.K. it’s gonna get a Lil’ bumpy …..
    
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Peter Lintner August 12, 2015 at 9:47 am

First, the chinese bubble pops, then the western bubble pops, then decades long global stagnation sets in. All hail Hyman Minsky.
OR
Maybe Im wrong and we can actually print wealth. Then all hail Ben Bernanke.

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[email protected] August 12, 2015 at 11:08 am

Dear Prof.

The devaluation caught none of your readers by surprise!

Thanks.

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Giancarlo Bergamini August 17, 2015 at 2:25 pm

Nick Lardy has just posted a thoughtful piece on the Peterson Institute’s website
http://blogs.piie.com/china/?p=4469 “Skeptics of China’s GDP Growth Have Not Made Their Case”.
His point is that such data as a sharp decline in overall industrial growth, very weak expansion of electric power, and declining amounts of freight movement that once would have pointed to a weak overall economy are no longer useful proxies for China’s GDP growth. The reason ?
Quote
China’s progress in transitioning to its new model of economic growth, one less dependent on expanding industrial output, investment, and exports and more dependent on expanding private consumption expenditure [… ] The expanded role for the services sector reflects a continuous four-year rise in the private consumption share of GDP […] The rising share of private consumption expenditure is feeding off increases in disposable income—which have exceeded the pace of GDP growth for several years—and a slightly reduced household savings rate. The relatively rapid growth of disposable income is in turn the result of the continued rapid growth of wages and an improved rate of job creation in sectors with higher incomes than agriculture. All of this growth—in consumption, disposable income, wages—is hard to square with the skeptics’ view that China is in an extreme slump
Unquote
In other words, according to Nick Lardy (usually one of my favourite sources with regard to China) China is currently on a sustained path towards the very rebalancing that was recommended by none other than… prof. Pettis. A “Virtuous circle” to use his own words.
In summary, I take it as a confutation not only of the skeptics’, but also of the pessimists’ view of China’s conditions.

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- Michael Pettis August 18, 2015 at 6:38 am
  
  The so-called “pessimist” view has proven far more accurate than pessimistic, Giancarlo. I don’t understand why current growth levels confirm the optimist view, when they are far below what the optimists said was possible and well in line, for example, with the forecasts I made as long ago as 2009-10, when I said that once rebalancing began (most of us agree that China began rebalancing in 2011-12), GDP growth would drop by 100-150 bps a year. We have in our market a strange ritual. Every year, China does what the optimists said wouldn’t happen and the pessimists said would, and the former respond by publishing articles proclaiming that they were right and demanding to know when the “pessimists” will finally give up and admit they were wrong.
  
  Fundamental to the argument in these articles is that China hasn’t collapsed, and so the pessimists were wrong, and if the pessimists were wrong, than logically this means the optimists were right. Actually it doesn’t. If the pessimists had predicted collapse, and the optimists a decade of 9% growth, then both sides would have been wrong, but in fact while a few pessimists did indeed predict an imminent collapse, most didn’t, and it doesn’t help the debate — at least I don’t think it does — to insist that only two views are possible, either that China maintain current growth levels sustainably over many years, or that it collapse very soon, nor is it helpful to say the former must have occurred if the latter didn’t.
  
  I would suggest two very different sets of views among most “pessimists”, which these articles never want to address. First, all pessimists have called for a rapid slowdown, not necessarily a collapse, and some of them, like me, have always insisted that a collapse is unlikely, at least for now, and only becomes so if Beijing does not get credit growth under control. Second, among those who think a collapse is likely, the argument has always been that it is likely because China’s debt level is already past the danger point and it will not be able to resolve its addiction to unsustainable credit growth. These views overlap a great deal, and only differ in their assessment of how much longer debt can grow, but for the pessimists, unsustainable growth in debt has always been the key vulnerability.
  
  Look at the numbers. China’s nominal GDP growth is reported to be 7.0%. Growth in total social financing is reported to be 12.0%, but this excludes the provincial bond swaps in which loans included in TSF were converted into bonds that were not included in TSF. Adding them back brings credit growth to 13.0%. Most people believe that a lot of credit growth occurs outside TSF, but even if you accept the reported numbers, China is doing exactly what the “pessimists” said it would and the optimists said it wouldn’t. GDP growth is slowing rapidly and credit growth isn’t. It is growing at nearly twice the pace of GDP, so that even if you believe GDP growth is a proxy fro growth in debt capacity (and it almost certainly isn’t), how can you believe that this is sustainable.
  
  One way is to say that only external debt matters and China’s debt is internal, but this only shows how little most economists know about finance history, about other developing countries, or about why debt matters, and a few obvious examples of countries that suffered from internal debt have made that answer obsolete (it’s incredible to me that in spite of all the comparisons made by “pessimists” between China today and Japan in the late 1980s, no one has noticed the fact that internal debt, and almost no external debt, has driven it from miracle economy to 25 years of nearly 0 growth). Another way is to say that debt isn’t a problem because in China most debt is owed between state controlled companies, who will never force each other to pay, but the implicit assumption, that debt is only a problem when default has been legally called, is absurd and it should be enough simply to point out the implicit assumption to defuse that argument. Finally we are told that debt isn’t a problem because there won’t be a crisis, but this assumes, against far too much historical evidence as well as against the whole concept of financial distress (which is widely understood and accepted in finance), that debt only matters if it causes a crisis, and even if it were true, if debt is growing unsustainably then shouldn’t you explain why it will stop without causing growth to slow? And isn’t this argument a tad circular? If debt isn’t ever a problem until there is a crisis, then why are there ever crises?
  
  As for the fact that China is rebalancing, of course it is. It has to rebalance. This was the whole point of “pessimist” view. They have always insisted, and the optimists denied, that China’s only two options are a long contraction period with grow dropping steadily year after year, or explosive growth in debt until debt capacity is reached, and growth collapses, in which case we will see a disruptive rebalancing.
  
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  - DDFund August 18, 2015 at 6:53 am
    
    I work for a large investment fund that subscribes to your newsletter, Professor Pettis. It is obvious why every year, after another drop in GDP growth once again confirms your forecast and proves the bulls wrong, a well-known China bull writes an article proclaiming that bulls have been proven right and the bears are wrong again.
    
    It is because their credibility has taken such a beating that either they leave the market, as many of them have, or they have to explain why they deserve to be listened to. We joke about these articles all the time.
    
    Notice that in the big banks, 3-4 years ago all the China strategists disagreed with you. Today, they have all been replaced by guys who agree with you. Why do you think that happened?
    
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    - DvD August 18, 2015 at 10:01 pm
      
      Now that, 5-6 years later, the fruits of China gigantic credit expansion stimulus of 2009-2010 are maturing in the form of bitter NPLs, we also don’t hear anymore the huge crowd of orgasmic self-proclaimed “experts” who clamored loud praise for this rather serious policy mistake, the consequences of which are now becoming plainly visible.
      
      The urge to always repeat the same mistakes again and again despite clear and abundant evidence of their detrimental long term effects is absolutely fascinating.
      
      Criticizing the Chinese stimulus back in 2009 made you feel like an heretic who had offended the prevailing inquisition. It is indeed impossible to make the blind see nor the deaf hear. As for fund managers, the most lucid know they are not managing pools of genuine savings but simply an exponentially growing pool of freely-created paper claims backed by insufficient streams of real life income.
      
      The current economic and financial crisis is first and foremost a wide and deep intellectual crisis, as Vinezi Karim has pointed out.
      
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  - Giancarlo Bergamini August 18, 2015 at 8:05 am
    
    Many, many thanks, prof. Pettis. On the one hand I’m glad that I have elicited this masterful clarification of yours, while on the other I regret having expressed myself badly. I did not want to infer that Nick Lardy had convincingly proven the pessimists wrong, only that this was the aim of his piece. Sorry for the misunderstanding, I swear I will shut up at least until Christmas!
    
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  - Claire August 18, 2015 at 8:27 am
    
    As for the fact that China is rebalancing, of course it is. It has to rebalance.
    
    I believe that you have also said that basically every country will also need to rebalance (you phrased it much more eloquently, but wrote in one of your blog posts something along the lines of the global system can only be understood in terms of imbalances, and that a major imbalance in one part of the system must identically cause other imbalances elsewhere). You also wrote hypthesised elsewhere about what such rebalancing would look like.
    
    However, I am not sure if I understand what the eventual “steady-state” scenario would be. Is it that the US, for example, increases its manufacturing base and reduces its services base while countries like China and Germany reduce their manufacturing capacity and increase services while consuming more domestically? Or can the imbalance be resolved purely in terms of exports and capital flows without worrying about internal balances? (ie, could Germany reduce its Current Account Surplus while sustainably maintaining its existing Manufacturing/Services ratio)?
    
    I hope this quesiton makes some sense.
    
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  - Complex Velocity August 18, 2015 at 1:10 pm
    
    Great post Michael,
    
    We can also ask the ” optimist ” a few simple questions.
    
    Even with the debt obligations being an internal issue as the two parties will not expose continued funding issues if they develop. But is obscurification really something we should continue count as a positive as in reality it will cause those parties to question further investment in the long run in the businesses they are running. This is precisely what has taken place with the continued credit issuance within China, as investment continues dropping across all businesses tracked and the liquidity instead goes into bubble investments like real estate or the markets chasing yield instead. So in the longterm, the overhang of debt upon the system does have a negative impact as it changes ” social mood ” within a deflationary downturn that took place in 2007-2008 as the world is experiencing different issues as the deflation causes pause regarding further credit / debt as society weighs this against personal / business balance sheets that have previous debt obligations that need servicing every month.
    
    Can the ” optimist ” understand the truths in a fiat credit driven banking system deflation is devastating ? The ZIRP world we live in may have pushed up asset prices in bubble sectors or created new ones but the simple truth is this ” new normal ” is not normal, in fact it weakened the system beyond repair as the next crisis or part two of the last will be far more destructive as interest rates, sovereign debt are limit down. Everyone is painted into a corner.
    
    When will the madness stop ? When will someone stand up and speak the truth against further alchemy within finance that comes forth from the ” new schools ” in finance, MIT, Chicago school proponents never addressing core issues or developing foundational change as the corruption within many countries prevents the truth or change because the wealthy built empires or played the ” game ” for personal gain in ones life without exposing the fraud around us.
    
    Deflation is not only a monetary issue, it changes social mood and destroys the Q.E. playbook and dreams of more debt / credit solving a debt crisis.
    
    Every single asset price around the world must be called into question as global assumptions regarding forward growth and earning and debt servicing expectations in the face of the truth of crashing velocity, impaired balance sheets, wage stagnation, true unemployment / under employment figures, technology headwinds regarding employment, ect, ect …….
    
    China is now using it’s reserves as the systems contracts, markets, real estate, now yuan stabilization is chewing up and spitting out the reserve safety zone. The chickens have come home and the roost will be overwhelmed. The hot money outflows, the dollar denominated debts, the projected unemployment, the many, many issues happening at once will cause massive problems as history has proven time and time again regarding credit driven growth stories always end the same. The credit / debt issuance in China since 2008 has produced what ?
    
    Can the ” optimist ” tell me or this forum what has the credit issuance produced regarding future revenue streams as the consumer transformation happens not overnight or short term but it plays out over many, many years. The social dynamic within the top down authoritative government expecting solutions as the reactionary panic driven solutions by the PBoC, Politburo speak volumes as it’s impossible task of juggling chainsaws in this environment is viewed by the smartest guys in finance / banking with pen and paper always creating another white paper .pdf after said crisis never forward looking or being proactive as the truth is avoided at all cost.
    
    So sit back and grab the proverbial popcorn as the ” optimist ” have a foundation made of sand as the deflation is galloping across the earth unabated now, the slowing growth across Europe, Asia, North America using tried and true analysis lays waste the fraud and alchemy of the ” optimist ” cheerleaders farmed out of most financial schools.
    
    You can not solve a debt / credit crisis with more debt, this bed time story is just that, more can kicking is not a solution. Can the global roost handle the deflation chickens running wild with no heads or bearing ? Or will the credit crisis 2.0 explode with a black swan event ….. ?
    
    Tick, tick, tick, tick, tick, tick, tick…….
    
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    - DvD August 18, 2015 at 8:53 pm
      
      Laurent Harvey wondered in an earlier comment above whether the current situation was not like 1926.
      
      Now, Complex Velocity just above is alluding to the deflationary debt liquidation forces that seem to be resurfacing in different parts of the world.
      
      In fact, i would argue it feels like early 1928 when the Fed started raising interest rates to try to cool down the stock market exuberance triggered by its own easing during the 1920’s up to 1927. Only to trigger a rush to the Dollar as capital fled Europe back then, just like there is a rush to the Dollar today from many places. The inflows into Dollar-denominated assets led to a massive further run-up in the stock market from the spring 1928 to the autumn of 1929. The rest is history.
      
      Not completely coincidently, total capital today in the US at about 560% of GDP is at similar valuation than late 1928-early 1929. Margin debt was 2% of stock market capitalization then, it is 1.5% currently.
      
      There are even reasons to argue the current situation is worse than in 1928: total debt was 200% of US GDP back then vs. 330% now, so the potential for self-reinforcing debt liquidation and financial distress is greater today. Global debt issues are just as massive today as they were in the 1920’s from WWI. US unemployment was 3% back then vs. 5% now (which understates the real level of under-employment, unclear whether or not that was also the case in 1928 to the same extent). Southern Europe has replaced the UK as laboring under huge unemployment having joined the Euro as England rejoined the gold standard at pre-WWI parity in 1925.
      
      Of course, economic policymakers are supposedly better equipped today to prevent the kind of deflationary death spiral that occurred during the great depression. Still, it is intriguing to see the Fed ending up in a situation quite similar to 1928 as a result of having followed the script to, precisely, prevent the 2008 crisis from degenerating into a great depression. It does indeed raise the staggering possibility that the 2008-2009 crisis was in fact analogous to the 1920-1921 crisis, not to 1929. Humm…
      
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      - Laurent Harvey August 19, 2015 at 6:01 am
        
        Nice follow up. Yes it seems to have the same “feel” (even though I wasn’t alive in the late 1920s) to today. After the nasty depression in 1921 the fed “saved” the country and markets went up giving people the false security that they could save them from any crisis the market might throw at them. I speak to people today and they have the same feelings- central banks and governments “saved” them from 2008 so they are the all knowing beings and can save them from any future downturns. Let the complacency set in nice and deep. No need to worry.. ;).
        
        It was 8 years between 21 and the crash of 29. I can imagine how after 5,6 years people would have hailed the gov/fed as restoring balance and order in the markets. Little did they know that in just 2 more years the longest downturn in history would occur. 6 years in, I’m sure no one has become complacent this time..?
  - Complex Velocity August 18, 2015 at 1:46 pm
    
    Very ugly data via Yardeni independent research – ” Keqiang index ” , real GDP 3.1 %
    
    http://blog.yardeni.com/
    
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- Dan Berg August 18, 2015 at 4:45 pm
  
  Confutation of confutation: http://www.baldingsworld.com/
  
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DvD August 27, 2015 at 4:06 am

Let’s recap:

– “Brute force” was used “to create a credible floor” under the Chinese stock market: trading was suspended, short selling was banned, the official sector was ordered to buy in size, interest rates were cut, regulatory reserve requirements were cut, the currency was devalued, threats and intimidations were made, brokers and journalists were arrested, etc.

– “Brute force” was overwhelmed by much more brutal selling force.

The simple conclusion is that it is no more possible to stem the cascade of margin calls than it is to prevent a flamboyant tulip from fading. The put protection is thus fictitious, hence worthless. Policymakers desirous to maintain credibility and avoid unwanted consequences could start by not actively seeking their causes. This conclusion is valid not only in China but everywhere.

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mike November 17, 2015 at 7:07 pm

I must say, this article http://carnegieendowment.org/2012/09/16/by-2015-hard-commodity-prices-will-have-collapsed was genius. I saved the article back in 2012 in my email and just recently came across it again. Incredibly insightful and couldn’t have been more accurate.

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