For the past ten years much of what I have written about debt in China was aimed mainly at trying to convince analysts and policymakers that the Chinese economy was structurally dependent on an unsustainable increase in debt in order to generate GDP growth rates above some level. This level might have been around 5-6% ten years ago but it has steadily declined with the rising debt burden and is currently probably not much above 2-3%.
Today it no longer seems necessary to explain that Chinese debt levels are far too high. On May 9 the People’s Daily published a major front-page interview with an “authoritative figure”, thought to be very close to Xi Jinping, warning that the Chinese economy was in much worse shape than many believed largely because debt had risen far too quickly. Here is the South China Morning Post:
A People’s Daily article published yesterday showed that China’s leadership is trying to make a grand shift in the nation’s economic policies in a bid to say goodbye to debt fuelled growth. In a sign of distaste for the credit-pumped growth in the past couple of months, the Communist Party mouthpiece cited an unidentified “authoritative” figure as saying that boosting growth by increasing leverage was like “growing a tree in the air” and that a high leverage ratio could lead to a financial crisis.
“The whole world”, according to the China Daily the next day, “seems to be talking about the People’s Daily interview on May 9.” It went on to say:
The People’s Daily article is good for all local officials to study and to follow. The message cannot be clearer. If it is from the top leadership, as some readers speculated, then what it represents is a requirement on the policy level – cut the debt level, by whatever means. Deleveraging, or cutting down indebtedness, is in fact listed as one of the five tasks of China’s supply-side reform for 2016. Now that half a year already has passed, at least some action should be taken during the remainder of the year, as the interview suggests.
Probably the real indication that the argument over whether or not China has a debt problem has been resolved is a May 7 article in the Economist. For years I had been extremely frustrated by the magazine’s coverage of the Chinese economy as being far too credulous and altogether too willing to assume away problems that other countries in similar circumstances had been unable to resolve.
Not all periodicals were so frustratingly cheerful. The Financial Times had long been writing about China’s balance sheet risks, with the FT Alphaville blog in particular zooming in on the key monetary and balance sheet vulnerabilities that by now have become so familiar to everyone else. Every time new evidence came out that suggested debt levels in China were becoming worrisome and needed to be addressed, however, the Economist responded by dismissing concerns over the debt as overblown. It consistently seemed to argue that China could easily manage it rising debt burden.
Last month, however, in a much-commented departure, the Economist suddenly reversed positions, warning that debt levels had become so extreme that “it is a question of when, not if, real trouble will hit in China.” In an alarming, but not alarmist, piece, the magazine acknowledged how serious China’s balance sheet distortions had become:
China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.
China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.
The article ended with what all of us should have been saying for nearly a decade: China’s debt burden would have been relatively easy to manage had Beijing started doing so much earlier, under Hu Jintao’s presidency. It is no longer easy to manage, but the longer Beijing waits to begin the deleveraging, the more difficult it will be:
One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.
Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.
Finally there is consensus
This, I think, is really the key point. There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.
Not that most analysts understand how important it is to constrain credit growth, the task is to explain exactly why debt is a problem, how it will undermine growth, and why many of the “solutions” that economists propose are simply not solutions at all. These “solutions” include a number of especially treacherous ideas: China’s rising debt can be managed for quite a long time before it becomes a serious constraint, countries have near-infinite capacity for domestic debt when it is “backed” by even greater amounts of savings (this is an especially foolish conceit), China can easily monetize the debt at no significant cost, or the right solution is to improve productivity to the point at which economic growth can outpace credit growth (it is nearly impossible to find a trained economists who doesn’t think this last is self-evidently the only way to approach the problem of debt management).
A little over a year ago in the newsletter I send out to my clients I tried to explain how debt constrains growth. In that issue of the newsletter I discussed debt generally, as it affects any kind of macroeconomic balance sheet, but of course the focus was on China. In the newsletter I posited a number of rebalancing scenarios in order to try to work out the implications fro debt. I have made some small adaptations to these scenarios but most of the rest of this blog entry is taken from that newsletter. One obvious consequence or revisiting this one-year-old exercise is to make clear just how optimistic were the assumptions I made in designing the various scenarios.
Economists are trained with models in which the structure of the balance is barely relevant to growth except to the extent that fear of a debt crisis undermines confidence. Of course this completely circular reasoning cannot be true except if we assume that the fear of a debt crisis is totally irrational – as it must be if growth is not otherwise affected by the structure of the balance sheet. Still, the implications of these totally unrealistic models seem to dominate the kinds of reforms that policy-making advisors have proposed even since Xi Jinping has come to office, and if my suspicions are right, and Xi and those closest to him have become intensely frustrated by the advice both Chinese and foreign advisors have proffered, we may be in for a much needed change.
The first implication of the balance sheet approach to reforms is that given extremely high debt levels there really is no easy way to rebalance the Chinese economy. It is foolish to think that China’s adjustment will be anything other than extremely difficult, and it is in the best interest of China that the challenges facing the Xi administration are not minimized.
Examining China’s debt scenarios
To show why, I thought it might be helpful to summarize the various scenarios for rebalancing and non-rebalancing that I presented to my clients over a year ago. In the table below I look at three possible scenarios in which China is able to maintain current GDP growth rates of 6-7%, with three different amounts of government transfers to the household sector expressed as a share of GDP. This is followed by three possible scenarios in which GDP growth rates drop to 3-4%, with the same three different amounts of government transfers to the household sector expressed as a share of GDP.
I divide each of these scenarios into two time frames. The first is the next three years under President Xi Jinping, and the second is the last three years of his administration (assuming, of course, that Xi, like his predecessors, serves two five year terms).
These scenarios are very rough, and I have tried to select the most optimistic and least disruptive conditions and assumptions. I assume that debt is easily refinanced, that rising debt imposes no financial distress costs, that the amount of unrecognized NPLs is too small for their refinancing to have a significant impact on the growth in credit, and that the growth in household income is not highly correlated with investment growth. I think these assumptions are very optimistic, to the point of seriously underestimating the difficulty of the rebalancing, but they nonetheless help us frame the set of possible outcomes by pretending that all those costs that are hard to quantify are negligible, even zero.
In the first of these three scenarios I will assume that it is politically very difficult for the Xi administration to transfer significant amounts of wealth from the state sector to the household sector – either directly, in the form of transfers of assets to household or to the social safety net, or indirectly in the form of houkou reform, the sale of assets to pay down debt, and so on. In this scenario in other words I assume total transfers are negligible.
| Growth remains at 6-7% | 2016 -2019 | 2020-2023 |
| · No government transfers
|
· Debt growth is steady at 12-14%
· Investment growth is steady at current levels · Consumption growth is steady at current levels · Growth in household income is steady and household share of GDP is unchanged · No rebalancing
|
· Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP
· Debt growth rises to 15-18% · Investment growth is steady at current levels · Consumption growth is steady at current levels · Growth in household income is steady and household share of GDP is unchanged · No rebalancing |
This scenario posits no consequent changes in any of the main variables. Investment and consumption continue growing at current rates, with no change in overall GDP growth (I am ignoring possible changes in the current account). For this to happen, debt must continue growing at current levels of roughly 12-14% annually. I have argued many times before that China is now in a stage – similar to that of the late stages of every other country that has experienced a growth “miracle” – in which so much bad debt remains unrecognized within the banking system that credit growth must accelerate simply to maintain current levels of debt financing for economic activity.
This means that even maintaining current levels of investment, consumption and GDP growth implies accelerating credit growth. Since I sent out the newsletter last year I have already been proven vastly optimistic on this assumption because the latest data just one year later suggest that debt has been growing by 15-17% to maintain 6-7% GDP growth. I suspect that within another year debt will be growing by much closer to 20%.
But I want to be extremely conservative so as to give the optimists every chance for the arithmetic they implicitly use (but don’t seem explicitly to recognize) to work. I will assume, then, that there is no need to accelerate credit growth from levels at the beginning of last year and I will assume that the acceleration we have already seen this year was somehow an aberration that can be reversed (I assume this for the sake of conservatism. Of course, and not because I think it is remotely likely). I also ignore the financial distress effects I discuss above, even though there is an overwhelming amount of evidence that suggests that as debt levels grow and create increasing uncertainty about their resolution, economic growth slows fairly automatically and rapidly.
The key point about this scenario is that if we maintain current levels of consumption, investment and GDP growth, at the end of three years even conservative assumptions imply that China’s already high debt levels rise, as the table shows, by at least a quarter (i.e. if debt is currently equal to 200-240% of GDP, it rises to 250-300% in 3 years). I don’t show in the table that at the end of six year, debt would rise again by at least one-third, so that it would amount to perhaps 330-400% of GDP.
Debt probably already amounts to more than the 200% of GDP recorded in the June 2015 release of the World Bank’s China Economic Update (pp. 23), with many claiming that it is closer to 250%. Whatever the actual debt ratio, it is hard to imagine that the growth in Chinese debt, already among the fastest ever recorded in the developed or the developing worlds, can be maintained at anywhere near current levels for more than two or three years. The same World Bank report suggests (pp. 6) that there may already be strains in Beijing’s ability to maintain credit growth:
Policy interventions are increasingly focused on unlocking new funding sources. Besides promoting public–private partnerships (PPPs) as a new funding model for infrastructure funding, there have been efforts to intensify use of policy banks. Further, in April the State Council expanded the use of the Social Security Fund to buy local government bonds and other financial instruments. The new rules allow it to invest up to 20 percent of its portfolio in local government debt and corporate bonds.
It may very well be that Beijing’s credibility is so strong that even substantially higher debt levels won’t matter, but I would argue that it will not be easy to manage another three years of debt rising much faster than debt servicing capacity, let alone six, and if this happens it must undermine confidence, even without more credibility setbacks, like the stock market panic earlier this month.
The new normal with government transfers
The “muddle through” scenario, in other words, in which current investment and consumption growth rates are maintained, and with them current GDP growth rates, is an extremely risky one and, in my opinion, makes the possibility of a hard landing as China runs into debt capacity limits very high. Debt capacity limits are reached, as I have long maintained, when debt cannot grow fast enough to cover its two main functions: First, it must grow at a geometric rate to roll over old bad debt as well as new bad investments whose principle and interest cannot be met by increases in productivity, and second, it must grow at a linear rate to invest into new projects that generate the targeted growth in economic activity. This will be made worse if rising debt uncertainty causes wealthy Chinese residents to disinvest locally and send money abroad at even faster paces than they have in the past, but as I point out above, I am ignoring this possibility so as to present the most optimistic scenario.
But Beijing can tray another strategy. Instead of simply muddling through, Beijing might try to maintain current growth rates while transferring wealth to the household sector to force up consumption growth. I posit two scenarios, one in which Beijing is able to transfer 1-2% of GDP every year, and a second in which Beijing is able to transfer 3-4% of GDP every year. The first scenario will be hard enough to pull off politically, and the second extremely implausible, but I include both to give a sense of the range of outcomes.
In the two transfer scenarios I assume that the decline in investment has no adverse impact on household income because its impact on employment is more than counterbalanced by the rise in consumption. With household income at a little more than half of GDP, the transfers would cause household income growth to rise by 2-3 and 6-7 percentage points respectively, and I assume that this translates directly into equivalent increases in the consumption growth rate (i.e. I assume, perhaps very optimistically, that rising debt does not create enough economic uncertainty in the minds of Chinese households to cause them to raise their savings rate).
| Growth remains at 6-7% | 2016 -2019 | 2020-2023 |
| · Annual government transfers of 1-2% of GDP
|
· Debt growth drops to 9-10%
· Investment growth declines by 2-3 percentage points · Consumption growth rises by 2-3 percentage points · Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly · Minimal rebalancing
|
· Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth
· Debt growth rises to 11-13% · Investment growth declines by another percentage point · Consumption growth is steady · Growth in household income is steady and household share of GDP rises · Gradual rebalancing |
The key point to which I would want to draw attention is the impact on the country’s balance sheet. In both cases the surge in household income would allow Beijing to bring down investment growth much more aggressively and so to rein in debt growth.
| Growth remains at 6-7% | 2016 -2019 | 2020-2023 |
| · Annual government transfers of 3-4% of GDP
|
· Debt growth drops to 8-10%
· Investment growth declines by 6-7 percentage points · Consumption growth rises by 6-7 percentage points · Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher · Material rebalancing
|
· Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth
· Debt growth rises to 6-8% · Consumption growth declines by 1-2 percentage points · Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher · Material rebalancing
|
In both scenarios debt continues to grow, but in the second scenario it is now almost in line with the growth in GDP, which we are assuming is no higher than the growth in debt servicing capacity. While the first scenario implies that the debt-to-GDP ratio has increased by 10-15% (or, if debt is currently equal to 200-250% of GDP, it will rise to 220-290% of GDP in three years and 260-340% in six years), the second scenario implies a gradual rise in the debt-to-GDP ratio. The lower end of the estimate, I think, might be sustainable, although no developing country has managed to sustain such high levels of debt as the higher end, and it requires an implausibly high annual transfer of wealth from governments to households of 3-4% of GDP.
Adjustment with slower growth
What happens if Beijing reins in credit growth and forces down the investment rate much more aggressively, so that GDP growth rates drop to 3-4%? The decline in investment growth will cause growth in consumption to decline too, but not by as much, given that the decline in investment would affect the more capital-intensive public sector. I will assume that there is no significant rise in unemployment because Beijing will allow debt to rise to keep unemployment down while it manages the transition to a more consumption-driven economy, in which demand tends to be more labor-intensive.
Again I will consider three scenarios, the first of which involves no transfers of wealth from the government sector to the household sector. The second two will include a manageable transfer of 1-2% of GDP annually and a highly implausible transfer of 3-4% of GDP annually.
| Growth drops to 3-4% | 2016 -2019 | 2020-2023 |
|
· Debt growth drops to 6-8%
· Investment growth declines by 4-6 percentage points · Consumption growth declines by 2-4 percentage points · Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher · Material rebalancing
|
· Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth
· Debt growth is steady at 6-8% · Investment growth is steady at current levels · Consumption growth is steady at current levels · Growth in household income is steady at current levels and household share of GDP is materially higher · Material rebalancing |
As in the first three scenarios I would argue that the key point is what happens to debt, as this, more than anything else, determines the sustainability of the growth model and how much time Beijing has to manage the rebalancing. In this scenario the debt burden continues to rise, but after three years the debt-to-GDP ratio is likely to be only 10-15% higher than it is today.
| Growth drops to 3-4% | 2016 -2019 | 2020-2023 |
|
· Debt growth drops to 5-6%
· Investment growth declines by 7-9 percentage points · Consumption growth is flat · Growth in household income is flat and household share of GDP is higher · Material rebalancing
|
· Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth
· Debt growth is steady at 5-6% · Investment growth is steady at current levels · Consumption growth is steady at current levels · Growth in household income is steady at current levels and household share of GDP is materially higher · Material rebalancing
|
If Beijing is able to combine lower growth with government transfers equal to 1-2% of GDP annually, the growth in debt will barely exceed GDP growth (under admittedly optimistic assumptions), and finally, if Beijing transfers 3-4% of GDP annually, the debt-to-GDP ratio begins to fall almost immediately.
| Growth drops to 3-4% | 2016 -2019 | 2020-2023 |
|
· Debt growth drops to close to zero
· Investment growth is zero · Consumption growth rises from current levels · Growth in household income rises from current levels and household share of GDP is materially higher · Substantial rebalancing
|
· Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth
· Debt growth drops to well below GDP growth · Investment growth is steady at current levels · Consumption growth is steady at current levels · Growth in household income is steady at current levels and household share of GDP is substantially higher · Substantial rebalancing |
Clearly the more wealth is transferred to the household sector, or the more Beijing is willing to allow the economy to slow, the more stable is China’s economic adjustment and the less painful economically over the long term. Greater transfers and slower growth, however, both come at the expense of the vested interests who oppose the reforms, and so it is politics, more than economic logic, that will determine the success of China’s rebalancing strategy.
I should note that there are so many moving parts to this analysis and so many simplifying assumptions, that the scenarios listed above should not be taken as predictions. There are important points, however, that I think emerge from this scenario analysis.
First, even after overwhelming the analysis with implausibly optimistic assumptions – discounting the disruptions caused by shifting strategies, for example, assuming financial distress costs are close to zero, and ignoring the impact on debt sustainability that results from rolling over a significant share of total loans that cannot be repaid – it is pretty clear that without a major change in policy or a tolerance for slower GDP growth it will be hard to prevent debt from becoming unsustainable. At some point, and my guess is that this would occur within the next two to three years at current growth rates, China runs the risk of a very disruptive adjustment as it reaches debt capacity limits, perhaps even the risk of negative GDP growth rates.
Second, any analysis of future growth that doesn’t tie changes in the growth rates of investment, consumption and government transfers to changes in debt levels misses out on perhaps the most important constraining factor. I think failure to understand this point explains, by the way, why over the past few years very few economists had expected GDP growth to slow as sharply as it has, and debt to rise as quickly, or allowed for either in their projections.
My guess is that the same economists will continue to make the same mistakes. To avoid doing so, as we continue to make projections about growth in GDP or in any of the drivers of GDP, we must estimate their impact on debt and how this further constrains our assumptions about growth in GDP or in its drivers. This requires a deeper understanding of how balance sheets affect growth.
What is inevitable and what is possible
Unfortunately, much of the analysis we have seen on China in the past two decades almost completely ignores the balance sheet. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still easily manageabble, there was a chance, no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers. Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.
The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of that consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.
I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable and that debt was already constraining policymaking.
To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth and was underestimating how difficult it would be for the new administration to break out of this process. There is in other words a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system.
I think this was exemplified last year when the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s very detailed and carefully argued book, Markets over Mao. I was one of the five analysts who were asked to participate in the reviews. Lardy is one of the best informed and most knowledgeable of the economists covering China and so I was honored to be invited to review the book. In my review I praised his book for the quality of its analysis, and it well deserves that praise.
But there was a fundamental disagreement in how he and I interpreted the data. Lardy believes China is in good shape economically and concludes with very optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth at the time, I think, was around 6-7%. Lardy thinks this is a low number, and has said that with the right reforms “China could grow at roughly 8% a year for another 5 or 10 years.”
I believe, however, that he is wrong. The reforms he means consists largely of productivity- or efficiency-enhancing reforms aimed at boosting growth by implementing what I refer to as “asset-side management”. But to me these asset-side reforms are barely relevant at this stage, although had they been implemented a decade ago China might not be in the difficult balance-sheet position it is in today. I have argued instead that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%, no matter how aggressively Beijing implements the standard grab-bag of orthodox reforms offered by orthodox economists.
These are the same reforms offered not just in the case of China today but during nearly every debt crisis in modern history, including to policymakers in peripheral Europe following the 2009 crisis. As far as I can tell there is not a single case in modern history in which the reforming country was able to grow its way out of its debt burden. Instead the debt burden has always increased until the country either engineers or is forced into explicit or implicit debt forgiveness.
That is why we disagree so strongly in our forecasts even though I largely accept his analysis of the Chinese economy. We disagree for the same reason I disagreed with the Standard Chartered China strategist who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement rather than an inevitable consequence of a structural dependence on debt. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.
As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst seem to recognize how the balance sheet might affect growth in the future and how it affected growth in the past. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review:
Rebalancing is often harder than expected, in other words, not just because of opposition by vested interests, but more importantly because highly inverted balance sheets cause policymakers to overestimate potential growth during the miracle years. But when growth during the rebalancing phase contracts more than expected, the same balance sheet inversion that exacerbated the expansion phase will also exacerbate the slowdown, especially as declining credit quality reinforces, and is reinforced by, slower growth.
I made a similar argument a few weeks later in a Wall Street Journal OpEd about why it is so important that Beijing maintain its credibility, which is the only way of ensuring that China’s substantial balance sheet mismatches can be managed and rolled over:
History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.
…Over time, this means the entire financial system is built around the same set of optimistic expectations. But when growth slows, balance sheets that did well during expansionary phases will now systematically fall short of expectations, and their disappointing performance will further reinforce the economic deceleration. This is when it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise.
Financial distress can be worse than a crisis
The second misunderstanding is about why “too much” debt matters. For most economists, the main and even only problem with too much debt is that it might lead to a financial crisis, and that the fear of crisis undermines confidence and so can cause spending to drop. But while these are important problems, these analysts are mistaken in limiting their concerns to these two issues. While a financial crisis is certainly a risk, the damage debt does to an economy occurs long before any crisis, and for debt to be terribly damaging to an economy’s long-term growth doesn’t even require a crisis.
In fact one can easily make a case that while a financial crisis may be spectacular, it nonetheless limits the damage caused by excessive debt by forcing a recognition of the losses, only after which does the system begin to allocate capital efficiently. Until this happens, the adverse impact of debt on growth can persist for decades. A case in point is Japan. Japan never had a financial crisis or a banking sector collapse, but from 1990 to 2010 the amount by which its share of global GDP has declined far exceeds the damage caused to any other country by a financial crisis. Or consider the heavily indebted countries of Europe, like Spain, Italy and Portugal, who have avoided crises without showing convincingly that they are better off economically today and over the rest of this decade than they might have been had they suffered a financial crisis in 2009 or 2010.
In my review of Lardy’s book I try to explain why debt constrains growth, whether or not it leads to a crisis:
The second way liability structures can constrain growth, while often poorly understood by economists, is actually well understood in finance theory. An economic entity will suffer from “financial distress” if debt has risen so much faster than expected, or growth is so much lower than expected, that economic agents become uncertain about how higher debt-servicing costs will be assigned to different sectors of the economy. This uncertainty forces these agents to react in ways that unintentionally but automatically intensify balance sheet fragility and reduce growth. This uncertainty is intensified if the debt burden rises and falls inversely with debt-servicing capacity, which almost always happens when economic growth is highly credit-intensive, and which seems to be happening in China.
Because this seems so counter-intuitive for many people, it bears repeating. The problem with too much debt is not just that it might cause a crisis. The problem is, first, that debt may be structured in a way that systematically enhances volatility, which means good times appear better and bad times worse. This automatic leveraging-up of volatility has seriously adverse impacts on long-term growth. Second, when debt levels are higher than expected and growth lower (one of the nearly inevitable consequences of highly volatility-enhancing balance sheets), if this divergence causes uncertainty about how the debt servicing will be resolved, the uncertainty itself forces agents to behave in ways that automatically reduce growth and increase balance sheet fragility further.
Lardy’s response to my discussion of debt indicates, I think, just how much confusion there is here and how easy it is for most economists to misunderstand the relevant issues – although in fairness it should be noted that he is responding to five separate reviews, and so this is unlikely to be his full response:
Contrary to Michael Pettis’s assertion, the book does give some attention to the liability side of the Chinese economy. I note the huge buildup of debt starting in the fourth quarter of 2008 and analyze the challenges this debt poses for financial stability. But in Markets over Mao I point out that China differs in several critical respects from other countries where rapid debt buildups have precipitated financial crises.
To begin with, China’s national saving rate, reflecting the combined savings of households, corporations, and the government, approaches 50% of GDP, significantly higher than any other economy in recorded history. Like households, countries that save more can sustain higher debt burdens. Second, the vast majority of this debt is in domestic rather than in foreign currency…Thus, its debt does not involve any significant currency mismatch, a major contributor to many financial crises. Third, the majority of this debt has been extended by banks, and China’s systemically important banks are financed entirely by deposits rather than through the wholesale market…Finally, the government has enormous scope to further increase bank liquidity should that become necessary. Other factors, too numerous to list here, also suggest that a banking crisis is far from certain in China.
But Lardy is not actually disagreeing with anything I said. In fact I fully agree with him that a banking crisis is unlikely, and have written many times that while it is possible, and the risk of its happening should not be dismissed out of hand, I do not think China is likely to have a banking collapse, any more than Japan in the late 1980s and early 1990s was ever likely to have a banking collapse. This doesn’t mean however that China’s debt burden is irrelevant.
A system of interlocking balance sheets
Japanese GDP growth, after all, did indeed collapse as it was forced to rebalance its debt-laden economy, and this collapse in growth has lasted an astonishing 25 years, with, as I see it, still no end in sight. During the first wave of excitement over “Abenomics”, for example, I wrote in this newsletter and elsewhere that just trying arithmetically to work through the consequences on the country’s debt burden of the success of Abenomics made it hard for me to see how Abenomics could possibly succeed in generating inflation and real growth without an explosion in its current account surplus that the world would not be able to absorb.
It was precisely because of China’s debt dynamics that I began arguing in 2006-07 that China’s growth model was unsustainable, that its debt was rising too quickly and could not be reined in without a significant drop in growth, and that China had urgently to rebalance. The same logic made me argue in 2008-09 that China’s adjustment was going to be brutally difficult and would entail at least a decade of GDP growth that could not exceed 3-4% on average. And yet I have always also argued that China’s banking system is very unlikely to collapse, and if one excludes things like the credit crunch in June 2013 or this month’s stock market panic, we are unlikely to see a financial crisis unless GDP growth – and with it credit growth – remains at current levels for another 3-4 years at most.
It is neither enough to note the amount of debt a country has or to speculate on the probability of a debt crisis. What matters is the systemic role of debt in generating economic activity, the feedback processes that are embedded in debt structures, and the uncertainty that may arise about the resolution of debt-servicing costs. To summarize, there are at least four important issues to consider:
- It is possible to structure an economy in such a way that excessive debt creation is not a “choice”, not even a bad choice, but is instead the automatic consequence of institutional constraints within the economy, and in fact it is very rare that a country experiencing many years of “miracle” growth hasn’t created such constraints. This is why it should have been possible to see well over a decade ago that China’s excessive indebtedness was inevitable. Economists who warned of the possibility of a deterioration in the balance sheet, but who thought nonetheless that China could avoid this outcome without a major restructuring of its growth model and a significant reduction of its growth rate, were always fundamentally mistaken. Excessive debt levels were never a “possibility”. They were a necessity as long as the growth model was not fundamentally transformed.
- The structure of the balance sheet, by which I mean the types of mismatches between assets and liabilities when debt levels are high enough, can systematically enhance volatility, so that periods of expansion, real productivity growth, or benign global conditions can result in many years of growth that exceed expectations. This comes however at a cost. First, the same balance sheet structures that enhance growth during the expansion phases will cause growth to slow much faster than expected during the contraction phases, and second, enhanced volatility always reduces value, although not always perceptibly at first, because it increases gapping risk. This process is perhaps counterintuitive to those who think all economic activity is driven by fundamentals, but is well understood by traders and investors, who know how it works in margin buying, leveraged positions, and derivatives that directly quantify leverage and gapping risk.
- Apart from enhancing volatility, high debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be resolved, i.e. to which sectors or groups they will be explicitly or implicitly allocated. This uncertainty will affect the behavior of any sector of the economy to whom the costs might be allocated, in the form of either direct taxes, indirect taxes (e.g. inflation or depreciation), appropriation or expropriation, or wage and consumption suppression. These sectors, all of whom will alter their behavior in order to protect themselves from bearing the costs of debt, comprise most of the economy, including foreign creditors, small business owners, savers within the banking system or in other forms of monetary assets, workers, wealthy owners of financial and non-financial assets, the agricultural sector, importers and exporters, the mining sector, and many others. The wealthy might take their money out of the country, for example, and creditors might shorten maturities and raise interest rates, business owners might disinvest, the middle class might dis-intermediate savings, workers might organize, local policymakers may engage in protectionist activity, borrowers might invest in riskier projects, banks might reduce the scope of their lending to the most protected sectors, etc. The point is that it is a mistake to assume that the only or main cost of excess indebtedness is a financial crisis.
- The balance sheet can embed strong feedback mechanisms within the economy that make it almost impossible to predict the growth of debt. The balance sheet mismatches that during the expansion phase could be refinanced in ways that created unexpected profit, can easily lead to rising debt instead as the mismatches become harder to refinance or require government guarantees.
This is why I would argue that once a country’s balance sheet reaches a certain critical point, any analysis is fundamentally mistaken if it simply acknowledges the existence of a great deal of debt, or sees a debt buildup as unlikely, or as the consequence of bad policy, when already institutional constraints make it a necessary corollary of growth.
Debt was already a problem in the Chinese growth model more than ten years ago (and is a problem in several advanced economies too, who are going to find it nearly impossible to grow out of their debt burdens without debt forgiveness). Those analysts who do not understand why this is the case probably do not understand why the balance sheet will continue to be a heavy constraint on Chinese growth and will underestimate the difficulty of the challenge facing Xi Jinping and his administration, which means among other things that they will be too quick to criticize Beijing for failed policies when growth drops below their projections.
Transforming the financial system
Related to the failure to understand the balance sheet constraints, there is another argument that has made the rounds in the past year or two as economists covering China slowly have come to recognize just how misdirected investment allocation has been. This argument remains optimistic about growth prospects while nonetheless warning of ways in which things can go wrong, but I think it is based on a similar kind of misunderstanding.
It is well understood that Chinese growth relies excessively on investment, and that consumption is too low a share of GDP to drive demand mainly because household income is too low a share of GDP. But with so much misallocated investment driving the surge in bad debt, China must bring investment growth down as rapidly as it can. I have long argued that the only sustainable way to do this without a surge in unemployment is to transfer wealth from the state sector to the household sector. If this is done forcefully enough, continued consumption growth can drive enough demand to prevent a rise in unemployment as Beijing gets its arms around credit growth.
The main constraint is likely to be the political difficulty of transferring wealth to the household sector from the state sector, where it is managed and controlled by the so-called “vested interests”. Historically for the many developing countries that have faced a similar rebalancing problem, this constraint is a powerful one.
But according to this new, and optimistic, argument, China doesn’t need to rebalance nearly as quickly as we might think. China’s soaring debt burden is not caused because investment levels are high, according to this argument, but rather because Chinese banks systematically channel credit to SOEs, municipal and provincial governments, and infrastructure projects, and that these are no longer able to generate debt servicing capacity in line with debt servicing costs.
All Beijing has to do, consequently, is to implement the right financial sector reforms that will result in a significant re-channeling of credit away from the old recipients and towards new recipients who are able to use this credit to fund productive investment. These new borrowers include China’s very efficient small and medium enterprises (SMEs), and as credit is redirected towards them they will invest it in projects that generate more than enough debt servicing capacity to stabilize or even reduce the country’s debt burden and so give it far more time to rebalance its economy.
Would redirecting credit to more efficient users solve China’s credit problems and give Beijing more time to manage a very difficult rebalancing? Of course it would, but it is completely absurd to expect that this will happen. There is no question that if the Chinese financial system were reformed so substantially and quickly that is was able to channel savings into productive investments, and not into nonproductive ones, there would no longer be any urgency to rebalance. But for Beijing to pull this off would require too profound a transformation of the way the financial system allocates credit to make this a very likely outcome. Many countries have tried to do so and none have come close to succeeding.
Such a dramatic reform of the financial sector is politically almost impossible to pull off without first implementing very rapidly extremely implausible politically reforms. In that context I have regularly cited a line from a book Fragile by Design, co-authored by Charles Calomiris and Stephen Haber. According to the authors, “a country does not choose its banking system: rather it gets a banking system consistent with the institutions that govern its distribution of political power.”
The point is that banking systems do not allocate credit on the basis of a set of well-understood rules that can easily be manipulated or redirected. The credit allocation process is the outcome of a complex set of institutions that are at least as much political as economic in nature. To transform this process requires a long and difficult transformation of these political institutions.
It would also require, in China’s case, the creation almost from nothing of a credit culture, replacing a banking culture in which loan officers paid very little attention to credit risk because money was mostly lent directly or indirectly to government or government-related entities (most or all of which enjoyed implicit or explicit guarantees). Beijing would have to transform this banking culture into one that is driven by the credit evaluation of businesses that are often not very transparent and that operate in complex systems of ownership. But it is not easy to build a credit culture, and it is a virtual certainty that any attempt to do so quickly will, very soon after it began, generate large amounts of NPLs.
The political challenge
Even assuming that in a world of declining demand, falling profits, and excess capacity, Chinese SMEs and other potentially productive investors were willing to borrow and invest at nearly the scale necessary for China to postpone rebalancing, the process of reforming the banking system would be incredibly complicated and would require far too long for anyone to propose this realistically. Offhand I cannot think of any country in history that was able to implement a similar transformation of its banking system, with the possible exception of Chile perhaps in the early 1980s, and even that took a decade and included a political crisis followed by a severe financial and economic crisis in which nearly the entire banking system collapsed as GDP declined by 14%.
To suggest that this is a viable path for the Xi administration would, once again in my opinion, severely understate the challenges that Beijing faces. To imply that only poor policymaking on the part of Xi Jinping’s administration could explain Beijing’s failure to pull it off would be extremely unfair, and would blame Beijing for failing to implement a wholly unprecedented level of financial sector reform.
China, in that case, would essentially be expected to do something that I think no other country has ever been able to do, and certainly no large one, and while this does not mean that China cannot do it, it does mean that at the very least we should be well aware of how difficult it is to accomplish and rather than simply recommend that Beijing do it we must specify what the conditions are that make us so confident that Beijing can do what no other country has been able to do. A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.
Aside from this blog, once a month or more I write a newsletter that covers some of the same topics covered on this blog, although there is very little overlap between the two and the newsletter tends to be far more extensive and technical. Academics, journalists, and government officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation. Investors who want to buy a subscription to the newsletter should write to me, also at that address.
To the “authoritative figure” quoted in the People’s Daily who belongs to the policy circle that decided the gigantic credit expansion program of 2010 despite China being already in a state of excessive investment at the time and who now laments excess debt, we can only quote Bossuet:
“God laughs at those who deplore the effects of which they cherish the causes”.
True, although in fairness it was the previous administration, and u’ll remember that there were very few of us back then that didn’t think it was a brilliant idea.
I remember very well but it doesn’t say much, for the consensus is often nothing more than the incessant repetition of “official wisdom” at a given point in time.
In any case, as you point out, it is now much more difficult to correct what now appears more clearly as a policy mistake of not insignificant proportion (the exact same mistake that Japan had made 25 years earlier with the unambiguous outcome very well known at the time of China decision) than it would have been not to make it in the first place. Correct policymaking can only come from correct diagnostic of a given situation. It is much more demanding than simply influencing public opinion to fabricate “consensus”. Consensus around short term expedients that makes matters worse is just as laughable.
Thanks for the thoughtful blog, Dr. Pettis.
Reading between the lines, you seem to be saying that China is facing a doomsday hard-landing scenario. Trapped between unemployment, inability to re-balance due to political realities, and exploding debt, it seems that an inflection point is rapidly approaching.
However, I fail to see how a credit crisis plays out when the government implicitly (soon to be explicitly) the vast majority of outstanding debt. How can a hard-stop, forcing realization and reallocation of bad debt happen unless the CCP allows it to?
I think your readers would be well served by an analysis not of implausible what-if scenarios, but rather what your best guess of what a most likely scenario would look like, what signs of it’s eminent arrival would look like, and how such a scenario would look like.
I am of the opinion that a China hard landing scenario is not only virtually inevitable at this point, but it would be a good thing in the mid to long term for both China and the world. Forcing a readjustment full of SOE bankruptcies would end the dangerous distortions effecting the world economy in so many ways. It would end overproduction and dumping, unabated pollution that is harming our planet, and rapid militarization that endangers the region and the world with military conflict.
It is my hope that a hard-landing scenario leads to deep political realignments along every axis, including geographic, demographic, and ideological. Smaller, more regionally focused countries would be more manageable, and able to focus on the needs of their local populations. It would be a difficult transition, but the CCP could focus on doing what it is supposedly supposed to do well – feeding & caring for its people.
A hard-landing would be very good for the rest of the world, which would be relieved of the burden of having deflation and unemployment forced on them and would rapidly adjust to a less distorted economic system.
However, I don’t think that Chinese leadership will allow a hard landing. It is my expectation that when their backs are up against the wall (soon) they will play the nationalism card, probably provoking a conflict with the west in some form or other. This will give them political & economic breathing room, enabling them to utilize their propaganda & censorship institutions to stoke nationalism while pivoting their heavy economy towards rapid military buildup.
Of course this turn would be a disaster for China and the world. That path leads to a highly unpredictable China/Russia vs. the world. I don’t want my kids nor Chinese or Russian kids to grow up in such a world. Earth has enough problems at the moment, the last thing we need is global conflict.
(I challenge you to allow this post to be published, Michael. It would be great to participate an honest, uncensored discussion of the real issues)
Actually Dave I go out of my way to repeat as often as possible that while a hard-landing scenario is always possible, and the probability of a brutally hard-landing necessarily rises as the debt burden rises, for now I think a hard landing is far less likely than a long, slow non-disruptive grinding away of GDP growth as it drops steadily to much lower growth rates well before the end of the decade. Since 2009 I have argued that the next administration had to centralize power dramatically if it were to implement the necessary reforms, and the Xi administration seems to be doing just that. The key is Beijing’s credibility, because only credibility prevents a collapse in the banking system as a consequence of terribly mismatched assets and liabilities. So far credibility remains high, and we would know when it begins to drop because we would almost certainly see bank runs affecting the smaller, provincial banks, as we saw during the 1998-2005 period. The purpose of the exercise in this blog entry is to show as plainly as possible the tradeoff Beijing must make between debt (or unemployment) and wealth transfers. As for publishing your comment, there is no question that there is a lot of censorship, and especially self-censorship, in China, but we shouldn’t overestimate it, and there is nothing in your comment that can’t be said. I know economists living in China, both foreign and Chinese, that have been far more pessimistic.
I do agree with you that while a financial crisis (which I assume is part of your “hard landing”) can be very painful, in the long run it usually leaves countries economically better off than the long, slow grinding “lost decades” that characterized Japan after 1990 and perhaps Europe and, to a lesser extent, the US, after 2009. A crisis forces the breaking up of the institutions that are responsible for the misallocation process and, if bankruptcy is transparent and efficient, reassigns resources from those who used them unproductively to those who will in the aggregate use them much more productively. But while a crisis is usually better for the economy in the long run (and I leave aside whether or not the short-run social cost to the most vulnerable sectors is justified because in principle there are policies that can mitigate this cost), it isn’t always better. This depends on the robustness of social and political institutions. A crisis can cause a political collapse that can be far more damaging in the long run than the alternative lost decades of growth.
While a slow grinding away of GDP growth is most likely if you look at Chinese economy in isolation, wouldn’t a recession in EU and US be enough to push China into a hard landing?
Dear Professor Pettis
An extremely interesting read. Can you elaborate further on why a high savings rate does not help? I have seen that argument a number of times.
Thanks
It is hard to explain why it doesn’t help, CY, because there is no reason it should. If you tell me some of the reasons why other people believe it helps, then I can address those reasons, but in my experience most people who say that China doesn’t have a debt problem because the debt is financed by internal savings just assert the fact as if it were a sufficient explanation. Basically the idea seems to arise from the mistaken notion that only external debt matters, a claim only taken seriously because being ignorant of economic or financial history isn’t seen as a barrier to understanding finance of economics. But given a very ample history of debt crises and economic crises in heavily indebted countries in which the debt was financed by domestic savings, it is hard for me to know how to respond to people who simply assert that it cannot happen.
To be honest I also struggle to find a reason and was hoping that you are already aware of a good one.
The only reason I can think of is probably not a good enough one ie. a system that is funded by retail deposits is less likely to have the same level of liquidity risk as one funded by wholesale deposits. However this only applies to retail funding and banking liquidity problems. It also does not address the more debilitating issue of a long term debt overhang that you have described.
Basically if you borrow $100 and invest it in a project that is worth less than $100, your debt burden rises and you must write the debt down, but in China it isn’t written down. If you do it enough, you end up with a significant debt burden and significant overstatement of wealth, and the cloer you get to the limit of your debt burden, the more urgent it is to reverse the process (when you reach the limit, growth collapses). This causes several problems including:
1. If your GDP growth is dependent on a continued increase in debt, reversing that growth in debt will reduce your GDP growth
2. During the growth and leverage phase, there is a significant risk that the country’s balance sheet has become inverted, i.e. the structure of liabilities reinforces shocks on the asset side, and while this causes growth to be higher than otherwise on the way up, it also causes growth to be lower than otherwise on the way down, setting off booms followed inexorably by busts.
3. The overstatement of wealth and the failure to write down the debt creates uncertainty about how these costs will be allocated socially, which cause nearly all economic agents to change their behavior in adverse ways.
There’s more (this is the topic of my next book), but as you can see from this list, whether debt is external or is supported by domestic savings has no impact on 1 and 3, and as for 2, it is simply one of the many ways a balance sheet can be inverted.
Can I offer my opinion? Well I’ll do. The assertion that high savings match excess debt is common amongst economists whose models do not account for debt dynamics. They just believe that because someones’ liability is just anothers’ one asset, debt doesn’t matter. So, the argument is based in a belief that completely ignores debt dynamics. So, the answer is, re-read this illuminating piece to understand why debt matters!
“. . .uncertainty about how these costs will be allocated socially, ” There is no doubt in my mind about who will bear the costs – the long suffering ordinary Chinese people; certainly not the coastal nor big-city elites.
I wonder if any of you regular commenters here can respond to Christopher Balding’s post outlining his research that suggests China is already running a trade deficit?
http://www.baldingsworld.com/2016/02/23/why-china-does-not-have-a-trade-surplus/
Love reading your stuff as always.
Great article, as always.
When I read the editorial by the “authoritative figure”, the first thought that came to my mind was exactly the opposite of what seems to have emerged as the consensus. I thought that the editorial sounded like a frustrated Premier or central bank head whose policy prescriptions have gotten no traction because they have been overruled by political leaders. Instead, it seems to be the general consensus that it was Xi himself (perhaps through his deputies) who was expressing his frustration with leaders who are in more specifically financial roles. I find this to be implausible for the simple reason that the most visible and decisive actions that have been taken by the government since Xi came to power, above all the anti-corruption campaign, pretty plainly had Xi’s signature on them. Which is to say, it is hard to believe that Xi would have been able to lock up so many powerful people but would be unable to push through, say, SOE reform if that had really been his intention from the outset. I’d be curious to know what you think about the possibility that the general take on the identity of the authoritative figure has the story backwards.
I always warn my clients that we “China experts” can happily speak about the ins and outs of Chinese politics for hours, Luddy, and its fine just as long as they understand that we have absolutely no idea about what is actually going on. Maybe 50-80 people do, and they aren’t telling us.
Such a dramatic reform of the financial sector is politically almost impossible to pull off without first implementing very rapidly extremely implausible politically reforms. In that context I have regularly cited a line from a book Fragile by Design, co-authored by Charles Calomiris and Stephen Haber. According to the authors, “a country does not choose its banking system: rather it gets a banking system consistent with the institutions that govern its distribution of political power.”
“The point is that banking systems do not allocate credit on the basis of a set of well-understood rules that can easily be manipulated or redirected. The credit allocation process is the outcome of a complex set of institutions that are at least as much political as economic in nature. To transform this process requires a long and difficult transformation of these political institutions.”
What about the Australian banking system Prof. Pettis? Any thoughts on the 4 pillars policy, the overall regulatory regime here (e.g. APRA), how it came about throught the Hawke Keating government reforms and how this interplays with our political institutions.? Something similar needed in China?
What would transfers to the household sector look like and is there any historical precedence?
I was wondering about this as well. What, more concretely, would 1-2% transfers or 3-4% transfers look like?
Good stuff. Post request: how do Brexit and the low-into-infinity global interest rate environment impact China’s debt crisis? What types of triggers could force debt reconciliation? Thank you.
I’ve been too busy to read and reread Michael’s work for a while, so I likely forgot some of his main analyses and got re-“brainwashed” by “common sense” views, but let’s see if I’ve even half-figured this out:
1. Britain is one of the world’s few relatively large importing countries.
2. For the rest of the Eruozone (mainly Germany) to export to Britain required a cheap EUR with respect to the pound.
3. Although it’s not really clear what “Brexit” really means gong forward, let’s suppose that it means no more free trade between the island and the mainland. In that case, Euroland must find substitute buyer for its goods or, more likely, in a world lacking demand, the markets will make it harder for Euroland to export, likely by bidding up the Euro.
Similarly, all the public announcements notwithstanding, if somebody ends the free trade agreement between the two zones, it should be Britain, which, like the US, has basically been struggling from the effects of an artificially high currency brought about by “beggar thy neighbour” policies. How artificially overvalued is the pound? I guess we’ll find out over the next couple of weeks…
4. Europe is rightly selling off because it lost one of its key export markets (either if the European Ministers are serious about making it difficult to trade with Britain, which they can not afford to seriously do, or simply because Britain refuses to allow such large and persistent trade deficits with Europe, which is more likely). This will increase unemployment in the Eurozone. More importantly, Europe has managed to stay afloat largely by the whole game of “extend and pretend” whereby everybody pretends that the Sapin-like countries can pay off their debts and therefore the major European banks (Deutschebank is just one of them) are not completely insolvent. Anything that increases the likelihood of other countries leaving the Eurozone puts increasing pressure on those banks (and, I think, should drive the Euro higher, so long as Germany is part of the zone. If Germany leaves, then the Euro will drop and the Deutschemark will rise). In either case, the countries with the rising currency will experience higher unemployment unless and until more domestic demand is stimulated.
5. With British exports rising and imports falling, an increasing burden falls on the US to absorb this demand (Britain is not nearly as significant as the US, of course, but it’s just one more straw on the camel’s back, and the camel is already caryying a very heavy load). That burden will even further increase if the disasters that are the European banks actually start going bankrupt in a cascading manner, or if other countries break off from the EU.
So, effects on China (as I see it–and I am *not* an economist):
1. Harder for China to export (more competition from othre exporters and fewer importing markets)
2. More expensive to maintain a peg with respect to the USD (which is rising)
3. More difficulties exporting + more difficulties maintaining currency value = problem.
–>and perhaps forces the Chinese leadership to speed up market reforms and try to increase domestic demand (?)
There’s my best crack at this, anyway–others may chime in with much better responses.
As an aside, I don’t see the large risk to Britain at the moment based on the above analysis. Maybe I’m wrong?
Re: China, would be interesting to hear responses to this, from Brookings:
“Brexit is a modest negative as Europe’s gross domestic product (GDP) and trade are likely to grow less rapidly, and the EU is China’s largest trading partner. But the Chinese economy is simply not that export-oriented anymore. In the aftermath of the global financial crisis, the contribution of net exports to China’s GDP growth has averaged around zero. China initially made up for lost external demand with a massive stimulus program aimed at investment. This has now led to excessive capacity in real estate, manufacturing, and infrastructure. As a result, investment growth is slowing (see figure below). But China’s GDP growth has held up well because consumption is now the main source of demand. It consistently delivers more than 4 percentage points of GDP growth and its contribution has been on an upward trend.
China has developed a virtuous circle in which wages are rising at a healthy rate (more than 10 percent over the past year), consumption is growing, consumption is mostly services so the service sectors expand, and they are more labor-intensive than industry so sufficient jobs are created to keep the labor market tight. There are plenty of things that could go wrong, but maintaining consumption is the big challenge for China, not the external sector.”
The author mentions things could wrong, but seems rather optimistic (virtuous cycle, consumption now main source of demand…)
PETTIS BREXIT REFERENDUM:
With all due respect to China, Europe is far more interesting now. If you would like to read Prof. Pettis’ detailed thoughts on Brexit kindly reply to this comment. Once we have 100,000 comments he might not be obliged to comply but surely it could be considered.
Ha,ha,ha!!!
I am also interested. Yes, Brexit is quite interesting and important. The problem for Pettis, and for all us, is that we don’t have a clue on how will it be resolved. It is all about politics, and institutions, like the reform of financial institutions in China. For better or for worse? I hope for better but…
Exactly right, Ignacio. There is so much uncertainty, and whatever happens is so path dependent, that the only thing we know for sure is that those who insist on the horrors that England will suffer or the ecstasies it will enjoy don’t have very strong support for their arguments. We’re mostly guessing. As Claire points out, it isn’t even hard to build scenarios showing this as positive for England, but we also have to remember that if England does well out of this, it would make a dissolution of the EU more likely than ever. Spain, for example, may very well be forced into yet another round of votes, and with both centrists parties doing better than expected this weekend, to the delight of the EU bureaucracy and probably thanks at least in part to Brexit, it is clear that disaster in England would help them ensure their survival, whereas solid growth in England might seriously undermine them and would probably kill the Socialists. For that and similar reasons I would imagine Paris, Berlin and Brussels would be eager as eager to see economic turmoil in England as would Madrid, and might even be able to help it along. There is too much uncertainty to make forecasts. That doesn’t we can’t do anything. I would argue that we should be constructing systemically consistent scenarios in which all parts of the global system are kept in balance, including both the capital and the current accounts, to get a better understanding of how this pans out.
All I can say is the UK is not a fly in the wall like Greece that the EU can kick to oblivion like they are doing. BREXIT is not only a UK issue, it demonstrates the need to reform the EU so others can live in the current hell, largely a product of the dysfunctional Eurozone and the heavy handed and whacky economics of the Germans, Of course, a Norway type solution will be coveted by others, but it would make for a large customs union and a smaller core where the Eurozone might survive. Is Schauble a statesman or simply a bitter, crippled old man and another disastrous element for mankind???
I am not an expert by any means and I don’t follow politics other than for the intellectual game, but I don’t think it’s fair to call Schauble “a bitter, crippled old man”–and even if accurate, it doesn’t really help in analysing the situation or anticipating the outcomes.
Somebody can correct me if I’m wrong, but Germany is also stuck in the current situation–I don’t think it can allow any debt write-downs without blowing up its entire banking sector, and I can’t think of a single instance in history when a country knowingly allowed its banking sector to blow up to help foreign debtors. However, even if Germany could do so for a small country like Greece, it certainly cannot afford all of the debtor nations to default or take siginficant haircuts. Nor can Germany/Europe at large simply export their way out of this (although they certainly seem ot be trying against all readon to do so) given their enormous size with respect to the world economy (and because Asia as a whole is also playing the same game).
So what makes this situation so seemingly intractable, I think, is the mathematics, not the politics, of debt.
Having said that, if “Europe” can’t punish England (and in my very amateur opinion I don’t think they can–at least not seriously–without really screwing themselves over and likely getting themselves kicked out of office in the process, likely to be replaced by anti-Eurozone politicians) and if the powers that be want to try to keep a Eurozone and a Euro intact, my guess is that their only option is to somehow forgive much of the outstanding debt and likely do something to ensure that there is wealth distribution on a very large scale. Basically, since punishing their citizens won’t work and might really backfire in a huge way, the European leadership are going to have no choice left but to bribe.
Michael once said (I hope that I am not misquoting) that his students once concluded that China’s leadership had to somehow redistribute wealth, and that in turn implied that Xi Jinping would have to either decentralize or strongly centralize power. In China’s case, it seems obvious that the leader would strongly centralize power. I think Europe is more or less facing the same issue, but in its case there is simply not enough legitimacy (or institutional power structures) to centralize power (especially since “centralization” basically means putting Germany in charge), which leaves decentralization as the only option.
Of course, I could be wrong, but I so far haven’t seen anything to suggest otherwise. I really haven’t seen anything to suggest that the current fear-mongering about London losing its status as a financial centre to some random European capital is even remotely credible.
The EU is gone IMO. It isn’t gonna last.
To be replaced with what? EU-lite? The pre-EU structure? Or something else entirely?
I’ve got no idea. I suspect it’ll be replaced with chaos.
In the case of chaos, do the rich and talented try to move to America (or South America?)
If so, do you think the US will accept them?
I’m wondering if the US benefits or gets hurt by Europe’s problems.
Chaos is by no means inevitable.
The European Union is fundamentally a very good idea. It is the idea that, through a system of permanent collaboration between European governments, peace can be maintained between countries that have been frequently at war throughout history, most notably France and Germany in recent centuries, but also England, Italy, Spain. In its peaceful objective, it is probably a vital idea.
The nature and objectives of the European Union changed with the entry of the U.K. in 1973 just when the global trade and monetary arrangement was radically changing post Nixon’s decision in 1971. The main goal of the European Union shifted towards becoming a free trade union, itself immersed into the expanding international free trade system as it emerged post Nixon. In 1992, the Maastricht Treaty confirmed that economic and monetary union took precedence over political union.
Since then, the three fundamental principles of the European Union have been:
– Freedom of movements of people. This has now degenerated into a significant migration crisis.
– Freedom of movement of goods. This has now degenerated into significant intra-zone economic imbalances (the famous if totally irrelevant “convergence criteria” of the Maastricht are today violated by virtually all member States) and the worst long range real economic growth and employment performance of any region in the world.
– Freedom of movements of capital. This has now degenerated into a state of virtual bankruptcy for large parts of the European banking system.
In light of these disastrous outcomes, it seems to me that the correct interpretation of the Brexit vote (and of similar inclination of public opinions in many other member countries) is not to say that the primary goal of preserving peace via permanent political collaboration between European countries is no longer valid. It is not even, I believe, a rejection of the three principles of freedom of movements for people, goods and capital. It is simply a sanction towards the poor results produced by an ill-devised, badly organized and democratically-deficient system.
The good news is that – like the dysfunctional global trade and monetary system – the dysfunctional European Union system can be reformed. For that, it is just necessary to have a well grounded diagnostic of the root causes of the problems and a clear vision of the changes to be brought about in a democratically legitimate way to address the root causes. In other words, it is necessary to have leaders at the helm. Which is of course – in Europe and elsewhere – where the real crisis lies… As Gavekal recently suggested, populism is nothing more than a symptom of the wholly inadequate quality of established politicians at a given moment in time.
I think we should accept all skilled labor from basically everywhere provided we know they’re not crazy nuts. I’d let in the rich and talented too. I’d hand people who study at our college to finish with graduate school degrees in subjects like math, engineering, etc a green card when they graduate while fast-tracking them for citizenship–again, provided they’re not crazy people.
Let me add in that the reason I think we should limit immigration from very specific countries is so that we can be more liberal in our immigration policies from elsewhere.
I’ve heard this idea used in the past, but I think that all it does is depress wages/increase unemployment of skilled groups at the expense of “unskilled” groups. I have no particular preference of one group over the other, but I think that your proposed policy would discourage the groups that you are trying to encourage.
As an aside, even if trade barriers get (re-)erected and so on, I don’t know if it really has the intended effect on those who make a living in mathematics or other abstract ideas–it is very difficult to stop the free flow of information. I think it would have a bigger impact on the blue collar jobs, while the white collar jobs would still continue to be pressured.
Maybe I’m wrong–and I am aware that the “this time is different” argument is normally a good indication that I am–but I don’t think that the “de-globalization” process this time will be as effective as the previous six or seven.
If the importation of skilled labor depresses wages, then I just don’t care. Once skilled labor flows flip, you’ve hit the decline stage.
Actually, what I find really dangerous is the rise of this “progressive” bullshit on the far-left where they wanna prevent the importation of skilled labor, the intelligent, the brilliant, etc and bring in the retards from warzones to essentially give themselves political power to redistribute. Bringing in people from warzones with ideologies circulating in these regions explicitly violent and hostile towards our views of society here in the West is just dumb. What do you possibly have to gain? And you’ve got so much to lose too.
We can have more immigration from the lower classes, but if you don’t want problems, you need to reduce the size of the welfare state. You can’t create incentives for people to come here so they can just say “equality”. The very fact that these “progressives” want single-payer while bringing in the idiots and leaving skilled labor out to dry is a major red flag. If you don’t change these views, you’re gonna end up with permanent fascists on the right–and that’s deeply concerning to me.
As for the “de-globalization”, I think you’re correct provided that Trump doesn’t get elected. With that being said, the current political campaign movement is looking more and more like it could end in a landslide for the Democrats, but it’s still early. It’s funny because much of the far-left that despises Hillary and that admires mainland Europe is actually hopping on board the Trump Train, but Trump’s biggest problem is the same as Bernie’s problem was in the primaries: demographics. If the only people you can win are white males who’re largely lacking in skilled labor, you’re just not gonna win in today’s America. So unless he starts making inroads into minority communities (and fast) or somehow increases the base level of his rhetoric so that he can win more people with college degrees, Trump will likely be defeated. I thought he’d do one or the other by now or at some point. I was probably wrong in my judgement.
Let me add in a few additions to my comment above. Bernie could win young people and white skilled laborers. I’m not convinced Trump can and I think most young people find Trump as out of touch, delusional, and retarded. He’s alienated a lot of people and women with a college degree despise Trump (this should be obvious). This is the first election in a long time that white college educated people are trending Democratic and Trump is actually doing better in many polls among Latinos than Romney, although he’s losing groups like Cubans by much larger margins. This is a very weird election to say the least. I can’t really say I’m surprised, but this is gonna be insane.
Well, depressing wages/job opportunities of white collar while simultaneously increasing wages on blue collar would cause more people to pursue blue collar jobs, I think. In that case, allowing more white collar foreigners to settle wouldn’t change the net “intelligence” in the system.
As a general rule, btw, I find that very smart people seem to overemphasize the importance of intelligence (just as very rich people tend to overemphasize wealth, and strong people tend to overemphasize force). I don’t think that civilization as a whole would be better off if everybody’s IQ doubled overnight–rather, we would simply have (mostly) different problems to deal with.
I don’t spend too much time on politics and have no interest in picking sides on a debate, but I assume that those who are explictly violent would choose to remain in the warzones, and those who are hostile to Western society would probably choose a non-Western (and especially non-North American) country to move to. But then again, I could be wrong.
I don’t know if more skilled labor jobs would push people into blue-collar work. The thing about skilled labor is that it contains capital inputs. So the importation of skilled labor would have a much more complex feedback on wages.
The thing about blue collar jobs is that they’re starting to be automated out. So I don’t think you can really push white collar people into blue-collar jobs. And it’s not like white-collar people are the ones having difficulty finding jobs. Most firms today that’re looking for skilled labor are having difficulty filling their positions. So it’s not like the labor markets are telling you we have too much skilled labor.
Another thing about skilled labor or such kind of immigration is that these people are often entrepreneurs or the ones who start businesses. That needs to be encouraged.
I agree with you on the overemphasis of IQ or strength or whatever else by people. I think the problem with my previous comment was the way I said it. I’ve got no problem with letting people in here and I’d prefer to maintain liberal immigration policies in a socially liberal society. If you don’t restrict immigration, it becomes very difficult for a society to remain socially liberal. If you allow large amounts of Arab men from the Middle East, it’s gonna put social pressures on a society. Allowing migrants makes sense if you limited the immigration to women (especially young women), families, and children. Beyond that, you’re heading down a dangerous path. And if you do get internal issues, you’ve gotta end up tightening immigration policies to a much larger degree. One of my biggest concerns in this regard is about the security of women.
I want a liberal (classical) society that’s open. It’s difficult to do that if you don’t put some restrictions on immigration. I also wouldn’t put money on saying those who’re explicitly hostile to Western ideas wouldn’t come here if they were in a warzone. Hell, anything is better than a warzone.
Just to repeat, I’m not against low-skill or lower-class immigration. I’m just saying you need to be careful where they’re coming from, how they’re coming, and about the current state of the lower-classes in your society.
As for politics, I love the Presidential years. This entire thing has turned into a shit show. I’m working on a post about how we’re in a New Chapter of an Old Game: The Imperial Globalists vs the National Populists. The thing now is that all of the primary financial risks have fundamentally become political.
Claire, Prof. Pettis, and others,
I have a new post on the political axis that we’ve got today in relation to both history, the domestic policy concerns, and the relation of those domestic policy concerns towards international policy. I think many of you may find it interesting.
http://suvysthoughts.blogspot.com/2016/07/a-new-chapter-in-old-game-imperial.html
The Brexit situation reminds me of the Creditanstalt situation in ’30-’31. At that time the French vetoed aid to the Austrians because of sentiments still remaining from WWI. This was the first major bank failure and the cascading defaults thereafter created the Great Depression.
If the EU decides to “punish” the Brits for whatever reason we could see some hard times.
That’s why I don’t think they are stupid enough to do it–expecially since the reverberations of doing so will likely mean that they lose their own elections.
Europe’s much bigger concern should be that the US decides to “punish” the European and Asian countries by erecting trade barriers. There is every short-term (and maybe even long-term) incentive to do so, and the ensuing cascading defaults would likely create another Great Depression around most of the world, I think. I can’t figure out if this would benefit, harm, or have no effect on the US in the longer term, but I think this outcome is likely inevitable.
“…this outcome is likely inevitable.”
I agree.
One thing to keep in mind is that the US and much of the world is so urbanized that we cannot endure an exact repeat of the Great Depression. In 1929 60% of the US population was involved in farming to some extent, farming was widely dispersed, and millions could eke by, so democracy survived. Now the grocery stores must be stocked and people must be able to go in and get something to avoid starvation. That augurs heavy government control and intervention in the US and worldwide – not a recipe for tranquility.
Very good point, Fred, and important to consider in the Chinese context.
Thanks for the point, but could you please walk me through this (I’m normally a little dense…)?
If the US is a net food exporter, then intervention is essentially limited to halting/limiting food exports. In that case, the price of food domestically drops and the price internationally rises, so the average American is still able to go buy something and avoid starvation.
Because the US is exporting less (i.e., no food exports) then either the dollar drops, thereby improving American output again to some equilibrium, or foreigners buy even more dollars so that they can continue selling products to the US to the same degree they were previously.
Where does starvation/lack of food stocks enter the picture for the US? The food importers, of course, will likely have a very big problem, but I’m guessing that initially many of those places could probably delay their problem by industrializing agriculture–which may have lots of other harmful side effects, but would at least increase yields for a while.
In effect, there would be “wealth distribution”, but in terms of food instead of dollars (and the masses–of which I am one–will finally get some bread to go along with their games).
As an aside, somebody on this site once wrote that the entire concept of unemployment didn’t even exist until the industrial revolution, since so many people lived on farms before then. I don’t know if it’s true or not, but I found the concept interesting…
This is a belated response to Claire, July 4, 7:37
My point has essentially nothing to do with the US being a food exporter, but with the fact that people are dependent on the wheels of commerce turning in order to get their daily bread whereas in the 1930s many people lived much closer to the land, closer to the locus of food production and could get by on growing their own or on barter. Out in the countryside people could also hunt and fish. People could “work for food” by doing jobs for farmers or others with direct access to food supplies.
Today the US, and indeed the world, is overwhelmingly urban. There are many more links in the chain from farm to consumer and those links are vulnerable to breakdown in an economic crisis. If (when) “cascading defaults” overwhelm the system there will surely be links in that chain broken.
The logical recourse will be for the government to step in. In the US we have the Defense Production Act that gives the Federal Government essentially dictatorial powers once Congress declares an emergency. The problem is that the interconnected web of debt that exists in the world depends on cooperation for its maintenance. Situations where governments have to take direct responsibility for the maintenance of its people tend to turn into “devil take the hindmost” free-for-alls between nations. That is what is “not a recipe for tranquility.”
I was born in 1946. The world has tripled in population in my lifetime. This link (below) will take you to a map that shows world population graphically with the little “play” button or slider at the bottom. I think watching population density grow in this way helps make the point.
http://worldpopulationhistory.org/map/1932/mercator/1/0/25/
In early 2009 I thought we would continue sliding into depression, was quite surprised when we did not. Since then I learned about the importance of US automatic stabilizers passed in the 30’s and later, which boost or at least maintain demand when the business cycle falters, plus that banks/bond holders were saved and, more importantly, depositors lost nothing even if their deposit exceeded the guarantee.
IMO, China has excessive savings because there is no social net. Gov should quickly pass SS and other plans to institute stabilizers lacking in China… US has done better than EU because our stabilizers, and the associated deficit spending, we’re not constrained, as they have been on the continent.
Granted, in earlier recessions there was recognition of the need to boost deficits (remember nixon’s ‘we’re all Keynesian now’), however no new spending could be brought to bear (other than military) since 1980, IMO on account the Vietnam war destroyed the American people’s faith in gov, previously created by getting us out of depression and winning WWII… The new distrust, intensified by carter’s failure re the hostages, brought Reagan and all the neolib policies that followed to power.
Thank you for your thoughts. I’ve been reading up on your work recently and was wondering if you wouldn’t mind sharing some of the other examples of the 30 or so countries that have experienced difficulty transitioning after experiencing “investment-led miracle growth”?
I am familiar with the examples of Germany in the 1930s, USSR in the 1950s-60s, Brazil in the 1960s-1970s, and Japan in the 1980s, but can’t seem to think of/find other instances.
Those certainly do seem to be the most notable. The US used the model (lightly) in its history before. There was also Czarist Russia which successfully transitioned from an investment driven growth model before the First World War. There was Italy before World War I as well. There were others, but those are the first few that’ve come to mind. Nazi Germany effectively used the variation of a model if you count armaments production as “investment”. The Ottoman Empire used the model and tried liberalizing reforms in the Tanzimat Era (if I remember correctly). I might be missing some of the details, but this stuff is not new.
http://www.paecon.net/PAEReview/issue75/Koo75.pdf
Thanks for the post. The majority of the lending is done from the state to the private sector. If we presume that there are bad debts and rollovers cannot continue indefinitely, then there must be write downs. This is a direct transfer from state to private sector (which is a good thing). Furthermore, it will reduce the size of state balance sheet and increase earning generation of private enterprises (which is positive of GDP growth). Would be nice if Prof P can post a detailed mechanism on how liability side of the balance sheet (borrowers ie private) vs asset side of balance sheet (lender ie state) will effect earning generation of the country (china GDP). Thanks
Isn’t this a transfer from the household sector (who is on the hook for state debts) to the state (via SOEs)?
I think the household skin in the game is via the low interest rate / weak currency. If the current situation continues, I don’t c it benefiting the household. I think anything that benefits the private sector will be good for the household thru increase of employment opportunities.
Hi Michael,
I find one of your assumptions a bit confusing:
Why is 3-4% transfer so entirely implausible? I would have thought that if the Chinese leadership were to decide to transfer of wealth to the household sector, then they would do it in size instead of in minor increments–after all, if you’re going to pursue a set of people that antagonize a certain group of elites, you might as well go all the way.
Incidentally, I understand your main point and conclusions–I’m just curious about the assumptions of why one is so much more likely than the other.
On a slightly different topic, you have frequently argued that debt levels at the national level should be structured so as to be sustainable, but you have also pointed out that reckless bank lending by American banks was likely a key reason why the U.S. grew so much faster than Canada, whose banks were much more cautious. I guess I’m wondering if a country is *in the long run* better off for assuming unsustainably high debt levels during a boom time followed by sharp panics rather than accepting slower growth combined with “sober, cautious debt growth” (even though it is hell for the people who experience a crisis at the time, are, for example, the grandchildren’s generation better off if their grandparents’ generation went through wild booms and busts, or would they be better off if their grandparents acted cautiously and prudently?)
Just curious…
“I guess I’m wondering if a country is *in the long run* better off for assuming unsustainably high debt levels during a boom time followed by sharp panics rather than accepting slower growth combined with “sober, cautious debt growth”
I’d personally tend to think so. Why? Because the latter is volatility suppression. Also, debt growth “cautiously” can slowly pile up and act as a drag on productivity. With that being said, explosive and unsustainable debt growth in bubbles can cause major permanent effects–including environmental degradation. So that’d be my concern about it. The thing about “explosive” debt growth that’s unsustainable is the question of how long it’s sustained. If it’s not sustained for very long, then you have much less issues because the correction is swift and relatively painless.
I’m not sure if volatility suppression is necessarily bad–even if you live in a hurricane zone, for example, you would presumably choose to avoid the actual hurricanes rather than go jogging in the middle of one because “voltaility is good”. I think the capacity to survive volatility is probably far more important than whether the volatility actually occurs. (As a “fun” thought experiment, what would FIRE/other corporate balance sheets look like if the central banks just used a random number generator that spit out a random number between 0-100 each meeting, and whatever number was drawn would be set as the interest rate until the next meeting? I’m not sure that the outcome would have been much worse in aggregate than central banking policies since the late 90s).
In any case, I’m wondering if The Volatility Machine’s perscription to make debt more anti-cyclical might be wrong-headed, since in the long run you may want to accentuate the bubbles and crashes. I have absolutely no way to model this, and there could very well be extremely obvious reasons why this is a bad approach. I’m just playing with ideas…
Claire,
Volatility suppression is a phenomenon that occurs in complex systems. Any complex system is composed of layers of actors of some kind or another arranged in a hierarchy. In complex systems, some volatility is not just normal, but healthy because it transfers information.
In your weather example, places that have volatility suppression would be a place like Florida that’s nice and dandy for almost all of the year, but then you get hammered with really bad hurricanes every now and then.
In the case of exercise, you get stronger when your muscles are recovering after being torn. You have to expose your muscle fibers to tears in order to get stronger. The regular volatility by some stressor (like weights) allows your body to recover so that you can increase the level of stress your body can handle. A case of volatility suppression here would be someone who’s weak and never lifts anything heavy. So when you ask them to lift something very heavy, they’re liable to throw out their back. If you’re able to deadlift 500 pounds, you’re not gonna have trouble lifting a 100 pound bag of luggage. If you’ve never lifted anything in your life and try to carry around a 100 lb bag of luggage, you’re running the risk of seriously getting injured.
In the case of financial markets, volatility suppression would be a place that’s had consistently “strong” GDP growth at a very stable level for a very long time. Look at the history of countries with explosive GDP growth for decades on end and then tell me if that’s good for them. On the other side, if you’ve got a country with GDP growth that’s very volatile on a regular basis, a higher average rate can be much more sustainable and healthy (the classic example here would be the United States in the ‘Gilded Age’).
Now, to return to your point about your capacity to survive volatility, I agree with you. If you’ve experienced regular bouts of volatility, you’re much more likely to be able to deal with a sudden surge of volatility than someone who’s never experienced it before. I know I gave you the lifting example, but I’ll give you one from boxing or Muay Thai. When you train to withstand body shots, you don’t go in and start going at 100% with your training partner. Instead, you practice at 10-70% shots for 2-3 minutes straight on a regular basis. The intensity of the shots depends on how far along you are and what your body is used to in your training.
In political science, autocracies are much less volatile because you don’t get regime changes very often. But when you do get regime changes, you get massive changes all at once that causes instability. Democracies, on the other hand, work because they’re able to rotate elites so they’ve got a decent amount of regular volatility in the political system.
Do you specialise in pure math, or in applied math?
Are you familiar with the Dirac delta “function”? I think you (and Taleb) are implicitly trying to model economies and political systems as impulse response functions. It’s an interesting idea, and exposing systems to impulses may be better than outright volatility suppression, but I am not sure how accurate such models are when applied to a very complex system such as an economy with a political system overlaid on top of it. In fact, in a very complex system, I don’t even think it is easy to sort out cause from effect. Even Michael’s models (which I absolutely love–at least the parts I understand) don’t really adress when debt begins to matter (i.e., what cause triggers the avalanche)–only that “debt levels are excessive when the uncertainty associated with the resolution of the debt is high enough to change the behavior of stakeholders. To put it in terms guaranteed to infuriate policymakers, a country has too much debt whenever the market believes it has too much debt. Anyone who does not understand why it is as simple as this does not understand the economic impact of debt.”
Having said that, even though I find the impulse-response model flawed, I can’t necessarily think of a better “mathematical” model, either. If I could build one, though, I would probably begin with R.I. Cook’s observations ( http://web.mit.edu/2.75/resources/random/How%20Complex%20Systems%20Fail.pdf ) and then work from there…Cook doesn’t mention economic systems, but I think they equally apply.
(I hope this post made sense–I’m a little sleep deprived at the moment)
I’ve done a lot of stuff in pure math, applied math, probability, statistics, chaos theory, complex systems, and you name it. I’m quite familiar with the Dirac delta (impulse function).
In a complex system, it’s basically impossible to sort out cause from effect. What you usually have in complex systems is that you see 3-5 “causes” (out of many tens or hundreds) accounting for 60-90% of the variation.
From a stochastic standpoint, it has to do with the fact that there’s nonlinear dose-response curves with stochastic dosages (this is actually my research). What creates the few causes to have most of the impact is because of winner-take-all effects in complex systems. They’re just two different ways of approaching the same issue. One is using random variables as functions of other random variables. Then using functional and measurable links while adding more stochasiticity (by say, turning up volatility) in order to find the impacts. The other method is to use a more systemic, integrated approach by looking at the system as a whole.
I’m actually doing research to connect those various approaches. You’re, quite literally, getting into my research topics.
Hello Dr Pettis:
Would a continued rise in salaries at the current pace (roughly 10% I believe) be enough to hit the modest goal of 1-2% of GDP transfer? This seems to be the easiest path to redistribution and it would over time make China less dependent on exports as they will gradually be put at a cost disadvantage to other low-cost countries.
P.S. As an engineer I don’t always understand your points but I love wrestling with the ideas!
Michael,
You once wrote somewhere (either on this site or in one of your books–I unfortunately can’t find the quote anymore) that globalization explains why a trader in Brazil makes less than a trader in London.
Could you (pretty) please re-explain this point? It’s driving me crazy because when I think of it now, the logic should seemingly be reversed–if globalization encourages free movement of people and goods, then the City would presumably arbitrage the salary cost differential by firing the expensive Londoners and hiring the cheaper Brazilians until the salaries even out (once costs of relocation, etc, are accounted for).
Having said that, I know that your argument made sense to me at the time–for some reason, though, I just can’t remember the threads in the argument that let me follow the thought process to its conclusion…
In “Great Rebalancing” I wrote about how the balance of payments mechanism links economies in profound ways, Claire, and one of the examples I used was: “Financiers in Sao Paolo earn substantially higher compensation than their peers in London in part because Chinese households receive an artificially low return on their deposits.” The point there was that the financial repression mechanism in China, by transferring wealth from household savers to borrowers on a massive scale, was one of the main explanations for the orgy of investment in China that drove up the prices of commodities to a ferocious extent (iron ore, for example, went from below $20 a little less than a decade earlier to above $190 by 2012, when the book was written), and Brazil was in the final stages of a commodity-driven economic boom that left the currency vastly overvalued and bankers raking in the money. I also pointed out in the book that once China began its economic adjustment, the collapse in industrial metal prices would probably bring Brazil to another round of sovereign debt restructuring before the end of the decade. The idea that you can understand any economy and forecast growth without fully understanding its global linkages is, as you know, guaranteed to make a fool out of you.
Thank you!
Reading your book was incredibly enlightening (despite my poor memory, it remains one of the best books I have read over the last decade)–I think it’s the first time I realized how smart (at least some) Wall Street traders truly are…
Can this be translated into biophysical terms,thinking of the yuan as claims on BTUs? The household savings become mostly virtual, no stores of actual goods in the closet, thus not true savings. The country has borrowed resources and energy from future generations taking the cheaper low-hanging fruit first, leading to diminishing returns. Serious problems occur when the costs of energy(not the market price) get too high for the continued growth of the economy. This may be happening with coal at the present time(closing small mines). The debt is an index of increasing biophysical restraints.
Money as a claim on future energy will become less valuable. It does make the distribution of the future diminished wealth interesting. China appears to be doing at least some planning in this regard, more wind, more nuclear, it will be interesting to see how this works out. The capital required is now, the energy returns are in later decades. If at least some of the debt provides long term energy flow it may be productive, in economic sense, perhaps not for the ecology.
The biophysical view would also seem to predict volatility.
Hello Dr Pettis:
Thank you for your great article. I was enlightened. I just wonder if you think bad debt ratio is also important, other than just the amount of debt itself. If so, then the slower speed growth model may not be a better alternative as slower speed growth will increase bad debt ratio. In Carmen Reinhart’s book “This Time Is Different”, there is historical evidence between slow speed growth and bad debt crisis.
Prof. Pettis,
For the sake of discussion, lets we are at some point in the future where you estimate there’s one year left for China to reach its debt ceiling, would you reconsider your stay in China?
Same question for anyone else who has been living in China for years. I know several people that after many years in China left last year or will this and next year; these are people who really understand the economy and the situation in China, one of the reason for leaving, according to them, was the fear that as foreigners they will be in a certain amount of danger when the proverbial shit hits the fan.
Looking at the storm raised in China this past few days, including in official newspaper against the whole of Australia just because some swimmer said something, this is totally believable.
South Korea wants to install defensive missiles on its own land and China retaliates in a certain manner.
The UK does not want to proceed with the nuke plant and…etc. etc.
I don’t think I’d want to be a foreigner in China when things turn ugly.
I wonder when the people in China are going to wake up and see the silver is the only way out for them. If they wish to hold real money then silver coins and bars is the one true way to hold real wealth.
And so Goldman Sachs are at it again, playing the part of cheerleaders for China’s sustainable growth story:
“Those looking for proof of China’s economic rebalancing act should stay clear of macro data and focus instead on micro evidence, according to Goldman Sachs” http://www.cnbc.com/2016/08/16/goldman-sachs-look-at-exports-and-commodities-to-judge-chinas-economic-transition.html
Worth a look, hype notwithstanding.
Dr. Pettis,
On the point of monetizing state asset and transfer those to the household sector – I wonder that from a total leverage point of view, isn’t this simply a transfer of state leverage to private sector leverage (excl. some unique cases like shifting SOE equity to social security fund etc)?