I’ve always thought that Shirley Yam of the South China Morning Post has a great nose for financial risk, and this shows in an article she published last week on mainland real estate. For anyone knowledgeable about the history of financial bubbles and crises, much of the following story will seem extremely familiar. The point to remember is that what is normally recorded as business operations in activities described in the article results in fixed payments that are inversely correlated with underlying conditions, and so is really no different than debt in the way it will begin to generate financial distress costs when the economy turns, goosing economic activity on the way up while exacerbating the contraction when it comes.
Yam discusses how building contractors must pay developers to build real estate projects and write about one such contractor, whom she calls “George”:
This is how the system works. Say an apartment building costs 1 billion yuan to build. George will provide the developer 300 million yuan as “facilitation money” at an interest rate of about 4 per cent to win the job. The latter will then give George 80 million yuan for the services rendered.
George, however, does not have any shareholding in the project, whatsoever to cover his back. Neither is he assured that the facilitation money would not end up in the stock market. All George can do is pray and hope that the apartments sell well and he gets his money back with interest plus the construction costs. Despite the risk, there has been no dearth of interested players. As George puts it, it has been getting worse. His state-owned rivals are now offering “facilitation money” of up to 50 or even 60 per cent of the construction cost. Some are even pitching in with zero interest, while others are promising to help in eventual sales.
She goes on to talk about the desperate competition among developers to get new projects, and what is driving the record beating real estate prices:
The obvious question that comes to the mind is why are developers willing to pay record amounts to own a piece of land, or as some suggest pay more for the flour (land) than the bread (flat). But then the land parcels are not really meant to be the flour for the bread. A good case is China Cinda Asset Mangement, which has invested more than 61 billion yuan in property during the past 12 months.
Among its acquisitions was a piece of land in suburban Beijing that was so expensive that will break-even only if the property prices are four times higher. But Cinda has piles of liquidity to splash about. Its debt to equity ratio rose by a third to 368 per cent in 2015 and it paid just a quarter of the loan rate of its private rivals. For Cinda property seemed the best bet. After all, the real economy was not going anywhere and the stock market was twisting and turning. On the other hand, property investment promised huge returns and was more self-fulfilling in nature. The record-breaking land prices support the property market and therefore the repayment of the multi-billion yuan of loans via shadow banking that Cinda and other state firms are loaded with. So overpayment seemed perfectly okay.
Keep all of this in mind when thinking about stepped-up efforts to clean up China’s banking system. There has been a flurry of reports recently about steps taken to clean up the banking system, but from an economy-wide point of view, it is not clear that any reduction in debt burdens for the banking system actually reflect a reduction in the debt burden for the economy as a whole, and anyway new kinds of debt are growing quickly enough that even if it did, the country’s debt burden is almost certainly rising.
Here is Bloomberg on a UBS report two weeks ago on the topic of bank clean-ups:
The good news is that the capital raises have begun. The bad news is that they need to continue. An analysis of 765 banks in China by UBS Group AG shows that efforts to clean up the country’s debt-ridden financial system are well underway, with as much as 1.8 trillion yuan ($271 billion) of impaired loans shed between 2013 and 2015, and 620 billion yuan of capital raised in the same period. But the work is far from over, as to reach a more sustainable debt ratio the Chinese banking sector will still require up to 2 trillion yuan of additional capital as well as the disposal of 4.5 trillion yuan worth of bad loans, according to the Swiss bank’s estimates.
I think a lot of this misses the point, and not just because there is a lot more debt out there than we think. I think the optimism with which this news has been received reflects a failure to think systemically about the Chinese economy. The fact that bad loans overwhelm the capital of the banking system should not blind us to the fact that China’s problem is excessive debt in the economy, and not a banking system that risks collapse because of insolvency. The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.
The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.
Debt matters, not merely its location
Cleaning up the banks is much less important, however, when lending incentives are driven mainly by policy and there is widespread moral hazard. What matters is the impact of overall debt on Beijing’s ability to implement policies that work as expected, and its impact in generating economy-wide financial distress costs.
The key in China, in other words, is not whether the banks have been cleaned up. It is how the losses are going to be allocated, and that remains no clearer today than it ever has been. Until the losses are allocated, they will simply show up in one form or the other of government debt, either on bank balance sheets as a contingent liability for the government or as a direct liability of the government. Because debt itself is constraining growth – I expect it to force economic activity to drop to less than half current levels well before the end of this decade – the debt must be written down or paid down and its costs must be allocated, the sooner the better for China.
But that is of course easier said than done. I have already discussed many times why the losses should not be allocated to the household sector or the SME sector. Allocating it to the former worsens the imbalances and makes economic activity more dependent than ever on increases in investment, to which China will soon reach limits. Allocating it to the latter would undermine the only really efficient part of the economy and so disrupt any chance China has of long-term growth. The losses also cannot be allocated to the external sector because it isn’t large enough and it will not be allocated to the central government as long as the leadership believes it necessary to continue centralizing power. In the end the losses can only be allocated to local governments, but that has proven politically impossible.
I warn my clients that while all the excited chatter about reformist froth in the formal and informal banking sectors may seem like progress is being made or not made, and of course will have some impact on the stock selection process, in the end they should not take their eye off the ball. China’s problem is that to keep unemployment low the government must rely on a rising debt burden powered by surging non-productive investment, and the only way to constrain the growth in the debt burden and keep unemployment from soaring is to allocate the debt-servicing and adjustments costs to whichever sector of the economy is able to bear it with the least damage to China’s longer-term economic prospects.
This process is not being helped by a slowdown in the growth in household income. A July article in Bloomberg explains how, and presents a graph that shows growth in cumulative disposable income per capita dropping quarter by quarter over a two year period from 8.5% to 6.5% as GDP growth drops over that period from 7.5% to 6.7%:
Chinese consumers, whose spending helped underpin the first-half expansion this year, may not be able to deliver a repeat performance in the second as income growth slows. Household income growth slumped to 6.5 percent in the first six months from 7.6 percent a year earlier, data released Friday showed. Headwinds on consumer spending may increase as officials signal they will step in to curb pay gains to keep manufacturing competitive with rival nations that have cheaper production costs.
As shoppers become an increasingly crucial growth driver, any erosion of their strength would weaken the ability for the consumer-led expansion to offset weakness in exports and investment. That threatens the government goal of raising gross domestic product by 6.5 percent a year through 2020 and slow the rebalancing away from factory-led growth.
The conclusion is inexorable. Beijing must find a way of generating domestic demand without causing China’s debt burden to surge, which basically means it must rebalance the economy with much faster household income growth than it has managed in the recent past, and it must begin aggressively writing down overvalued assets and bad debt to the tune of as much as 25-50% of GDP without causing financial distress costs to soar. Everything else is just froth.
Can China “grow out” of its debt burden?
After many years of assuring the leadership that the debt burden was easy to manage and that reforms would resolve the problem of growth, economic policy advisors have still not been able to prevent the balance sheet from deterioration. They continue to promise that with the right combination of efficiency-enhancing reforms – and there seems to be a dispute among one group arguing for “demand-side” reforms and another for “supply-side” reforms – Chinese productivity will rise by enough to outpace the growth in debt.
But this will almost certainly not happen. Simple arithmetic indicates that the amount by which productivity must rise to resolve debt servicing is implausibly large and requires an unprecedented amount of efficiency enhancement. In the newsletter I sent out to clients on June 28, I calculated that if we believe debt is equal to 240% of GDP, and is growing at 15-16% annually, and that debt-servicing capacity is growing at the same speed as GDP (6.5-7.0%), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity Beijing’s reforms must deliver an improvement in productivity that either:
- Causes each unit of new debt to generate more than 5-7 times as much GDP growth as it does now, or
- Causes all of the assets backed by the total stock of debt (which we assume to be equal to 240% of GDP) to generate 25-35% more GDP growth than they do now.
If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity Beijing’s reforms must deliver an improvement in productivity that either:
- Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or
- Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.
These levels of productivity enhancement do not seem very plausible to me and I do not think it is possible for reforms to improve efficiency by nearly enough to solve the country’s debt problem. What is worse, the historical precedents indicate that while many debt-burdened countries have attempted the same or similar efficiency-enhancing reform strategies, there does not seem to be any case in which this strategy has actually worked. No highly-indebted country, in other words, has been able to grow its way out of its debt burden until after it has explicitly or implicitly paid down or written down the debt. There are different ways in which this history has been exemplified:
- In some cases, as in Mexico in 1989, after many years of struggling unsuccessfully to implement productivity-enhancing reforms and suffering from low growth and economic stagnation, governments finally obtained explicit write-downs of the debt when the debt was restructured with partial debt forgiveness (35% of the nominal amount, in the case of Mexico). In this case the cost of the write-down was allocated to foreign creditors, although during the many years of stagnation workers paid for financial distress costs through unemployment and suppressed wage growth.
- In some cases governments never restructured their debt, and so never explicitly obtained debt forgiveness, but they did monetize the debt and so obtained implicit debt forgiveness through high levels of inflation (as was the case of Germany after 1919) or through financial repression (as was the case of China’s banking crisis at the end of the 1990s), or both (as was the case of the UK after 1945), in which the cost of writing down the debt was mostly absorbed by household savers. This last point is important because iit creates a great deal of confusion among analysts who think that China can resolve its debt problem the same way it did fifteen years ago. China effectively forced the debt-servicing cost onto household savers mostly during the first decade of this century. With nominal GDP growth ranging between 16% and 20% and a GDP deflator between 8% and 10%, lending rates should have probably been at least 13-15%, but instead they were set much lower, between 6% and 7%, and deposit rates even lower, between 2.5% and 3.5%. Negative real lending rates effectively granted insolvent borrowers debt forgiveness every year equal to at least 6-9 percentage points for a decade or longer. Depositors effectively paid for the full amount of the debt write-down as well as to recapitalize the banks. Forcing the cost of the write-down onto household savers worsened China’s imbalances significantly, however. The household consumption share of GDP fell from a very low 46% in 2000 to an astonishing 35% in 2010. This was not a coincidence.
- In other cases in which governments never defaulted or restructured their debt, and so never explicitly obtained debt forgiveness, they implicitly wrote down the debt not by monetizing it but by means that involved allocating the costs to the wealthy in the form of expropriation or to workers in the former of wage suppression. Romania in the 1980s is an especially vivid case of the latter, and the way the Ceausescu reign ended suggests why this isn’t a model to be repeated.
- Finally in other cases, the most obvious example being Japan after 1990 and now parts of Europe after the 2009 financial crisis, governments never explicitly or implicitly wrote down the debt, and have instead spent many unsuccessful years attempting to implement reforms that will allow them to grow their ways out of their debt burdens. They have failed so far to do so, and after so many years it is hard to see how they will succeed.
Resolving the debt burden
Debt must be paid down or written down explicitly, or it will be implicitly amortized over time in an unplanned way and at great cost to the economy. A fundamental part of Beijing’s reform strategy, in other words, must be to reduce the debt burden as quickly as it is politically able in order to minimize the economic costs of economic adjustment and to allow for the most rapid economic recuperation. Reducing the debt burden means selecting the sectors of economy that are best able politically or economically to absorb the cost, and forcing them to absorb the cost of the debt write-down, however reluctant they are to do so.
We typically think of the economy as consisting of four sectors: the external sector, households, businesses, and the government. In China however it is more practical to subdivide these further into the following:
- Creditors. Creditors are forced to absorb the losses associated with writing down the debt when the borrower defaults on its debt and restructures it with a principle or interest reduction. Much of China’s debt burden has been extended through the banking sector, however, and because the debt that must be written down exceeds the banking industry’s capital base, ultimately the cost will be passed on to some other economic sector – for example Chinese households ultimately absorbed the cost of the banking sector losses generated in the late 1990s.
- The external sector. To pass on costs to foreigners requires that they have significantly larger exposure to China than they actually do, and would also probably require defaulting on external debt, a path Beijing is unlikely to choose to follow.
- Ordinary households. Most banking crises, like the recent US and European crises and the Chinese banking crisis at the end of the 1990s, are resolved by hidden transfer mechanisms that pass the cost of writing down debt to households. China today however must increase household wealth, not reduce it, if consumption is to rise fast enough to allow investment to decelerate, which means ordinary households cannot be allowed to absorb the cost.
- Wealthy households. Given high levels of income inequality, and the low propensity to consume of the wealthy, forcing them to absorb the costs of writing down debt – in the form of highly progressive income taxes, for example – is likely to be among the less costly ways economically for Beijing to pass on the costs of paying down debt. As their income or wealth is reduced, the wealthy are likely to convert most of that reduction into lower savings and very little of it into lower consumption, thus minimizing its adverse impact on domestic demand.
- Small and medium enterprises. Chinese SMEs are among the most efficient economic entities in China and are likely to be the main source of innovation and value creation in the future. Their long-term success is vital to China’s long-term growth. Like ordinary households they should be protected from absorbing the costs of Beijing’s debt-management policies.
- Local and provincial governments. These have amassed a considerable amount of assets whose liquidation would most efficiently absorb debt write-down costs and would entail the lowest medium and long-term economic costs, although not perhaps the lowest political costs. As their assets are liquidated, total Chinese savings will decline and Chinese consumption will remain largely unchanged, thus minimizing the adverse impact on domestic demand.
- The central government. Beijing too could pay for the cost of writing down debt by liquidating central government assets, although this may conflict with other economic policy objectives, including overcoming vested-interest opposition to the reforms.
These are the major sectors of the Chinese economy within which the cost of debt-management policies can be absorbed, and although there is likely to be a great deal of reluctance on their parts, the most efficient way economically is for the costs to be underwritten by the liquidation of local and provincial government assets and, perhaps to a lesser extent, by taxes on very wealthy households. It is important to recognize that if debt-servicing costs are not covered by the higher productivity generated by the relevant investment, the process by which the debt will be implicitly or explicitly written down and allocated will necessarily happen anyway, and according to only a limited number of ways. The only question is the extent to which it is directed by Beijing:
- Chinese borrowers can default or otherwise restructure debt such that the cost of the write-down is allocated to creditors in the form of a haircut on the debt. Because the creditors for the most part are the banks, which are insufficiently capitalized to bear the full brunt of the losses, these losses will still have to be allocated to some sector of the economy.
- If the regulators avoid defaults, there are three further potential outcomes. First, the authorities can implement efficiency-enhancing reforms that cause economic productivity to surge to the point at which excess debt-servicing costs can be covered by the additional productivity.
- Second, the authorities can implement reforms that specifically assign excess debt-servicing costs to targeted economic sectors in order to minimize the economic or political costs. For example it can force local governments to liquidate assets, or it can use taxes to appropriate the wealth of the economic elite, the proceeds of which are then used to absorb excess debt-servicing costs.
- Finally, if the authorities do not move quickly enough, excess debt-servicing costs, along with financial distress costs, will be allocated to those least able to protect their interests once debt-capacity limits are reached. There are many ways these costs can be allocated in an unplanned way. One way, and among the most likely, is if the debt is effectively monetized by continuous rolling-over of principle and accommodative monetary policy. While part of the cost may be paid out of an increase in productivity, this is likely to be a small part and can only happen to the extent that unemployment is already very high and the costs of increased production are low. Otherwise eventually either financial repression or unexpected inflation (with the former more likely than the latter because of the structure of debt in China) will force most of the costs onto household savers and others who are long nominal monetary assets, while unemployment and real wage suppression will force additional financial distress costs onto workers.[1]
Put simply, to the extent that Beijing refuses to follow the first path, and cannot follow the second, it must choose the third path or eventually the fourth will be imposed.
[1] Contrary to what many believe, the PBoC cannot simply monetize the debt. There seems however to be a huge amount of confusion about why it cannot. The standard objection is that “China’s ability to monetize this debt will only severely hurt households if it results in a hyperinflation.” This is simply not true, and reflects a misunderstanding of economies whose financial systems are structured in a very different way that of most Western countries, especially the US. See Michael Pettis, “Thin Air’s Money Isn’t Created Out of Thin Air”, Carnegie Endowment for International Peace, October 19, 2015
Why can’t China’s foreign reserves be used to pay down debt? What good does it do to build up a vast hoard of reserves if they can’t be used?
Reserves can only be used to make foreign payments, e.g. pay down external debt., and never domestic payments. Because the reserves were purchased with borrowed funds, they are backed by domestic debt, so that even if it were possible to use reserves to pay down debt, it would simply result in a dollar-for-dollar increase in the net liability of the PBoC. Effectively this would mean nothing more than transferring the debt to the PBoC balance sheet, which is exactly the same as monetizing the debt. In that case the reduction in debt would occur at the expense primarily of the household sector.
Why not tax land? Instead of taxing income, tax wealth. The most socially useless institution is privatized land rents. There is no reason why the wealthy should be able to hoard wealth in the form of land. Charging a 2% property tax should do it.
I would rather see taxes on urban housing so as to raise the carrying cost on apartments.With one-fifth to one quarter of all apartments vacant, there is a huge amount of investment in China that produces no value at all, and so perhaps a tax may force owners either to rent them out or to sell them. The problem I suspect is partly a political one (owners of urban property are probably politically well connected) and partly worries about causing a collapse in property prices, which might be risky for the banking system.
Micheal, please correct me if I am wrong, but my understanding is that China does not have either a comprehensive land registration system or the legal framework to take away property if the taxes are not paid. Without those two things people will simply not pay the tax. I have read that such a land registration system is planned. But I am sure those with vested interests are blocking this at every turn. Also, the manner by which property tax is being implemented is faulty, in the “experimental” cities I understand exceptions are made under certain conditions. Conditions which I am quite sure the privileged will meet, and pay little to no tax.
However, China is not the “authoritarian” government people accuse if of being. It is gridlocked in this case. And perhaps the exceptions and lax land registration is the best the government can do at this time. Leaving the implementation of a tighter and effective law to the next government.
@ Jefferey … a 2% mille rate would cause a revolution. Perhaps they should aim for .5% … but discussions about taxes should always begin with what is the desired tax burden, then how to collect it. I suspect the Chinese people are already highly taxed… but it’s all hidden from them. Your 2% suggestion could be reasonable if taxes where slashed in other areas.
If I could get a $ for everytime you answer this question!
Re: Minor Corrections
a. because debt itself is constraining growth – I expect it to force economic activity to drop to less than half current levels well before the end of this decade
b. A July article in Bloomberg explains, and presents a graph that shows cumulative disposable income per capita dropping quarter by quarter over a two year period from 8.5% to 6.5%
c. as GDP drops over that period from 7.5% to 6.7%:
I think (and hope) you mean in a. the rate of growth of economic activity; in b. the rate of growth of disposable income, and in c. the rate of growth of GDP.
Thanks, G
Thank you for another very interesting post.
It seems interesting to me to also look at the buildup of debt in terms of the parallel buildup of credits. Remembering that all debt is owed to someone, a rapid buildup of debt also means a rapid buildup of credits to the creditors. In the case of China, who owns all these credits? Please do not say the banks. Except for their tiny (or possibly negative) capital the banks are only intermediaries. If something is done to reduce debt or slow the buildup of debt then the buildup of credits (savings) must also be reduced. Who are the creditors that would be affected and how would that work?
Similarly, I reviewed the McKinsey report that shows from 4Q 2000 to 2Q 2014 worldwide government debt increased from $22T to $58T corresponding to an increase from 62% to 83% of world GDP. Total debt increased from $87T to $199T corresponding to an increase from 246% to 286% of world GDP. That huge increase in debt must be accompanied by a similar huge increase in credits. Who owns all those credits? What would happen if the world dramatically reduced the rate of buildup of debt and associated credits. I have not found anything out there that looks at the debt buildup from this perspective. Are there analyses out there that I have missed?
Every liability is someone’s asset, but the problem occurs when the value of liabilities rises faster than the value of assets, put differently, when debt servicing costs rise faster than debt-servicing capacity. Because you cannot simply net them out, you have all the distortions that debt can introduce that constrain growth.
Michael, I understand what you are saying. But both of you are talking about two different assets. One being the financial asset of someone owning the loan, the other being the physical asset related to the loan. The problem you describe in China being the present value of the benefits of the asset (rent for example) … does not equal the nominal value of the debt incurred to generate the asset. Especially if depreciation is accounted for. No?
Yes, if I understand you correctly, Cjared. If I borrow $100 which I use to create an asset worth $105, my debt rises but my debt burden declines. The problem in China is that I borrowed $100 which I used to create an asset worth only $50, and I keep both the asset value and the debt marked at $100. My $100 liability is someone else’s $100 asset, but if I am forced into liquidation of course the asset owner will take a big hit.
But whether or not it is the entity with the $100 asset, someone has to take the $50 loss, and will. Even if I keep on pretending forever that it is worth $100, my $50 asset won’t generate enough to service the $100 debt, so I have to transfer the balance explicitly or implicitly from someone else, who effectively takes the loss. My point, as I am pretty sure you know already, is that I can either explicitly assign the cost to whichever sector is best able to absorb the cost with the least damage to the economy (perhaps even the entity whose wealth benefitted from the pretence), or the cost will be absorbed in an unplanned and deeply suboptimal way. In the latter case basically it usually ends up being absorbed by whoever is the least able politically to force the cost onto someone else (which probably doesn’t come as a shock either).
Well, actually my point was your point, I just wanted it elaborated by you for G Stegen.
And…further to your point. China is also full of distortions created by government interference in the economy. This can cause things to appear in balance. I am thinking of Pudong, where vacancy rates are reasonable. So are the asset prices there reasonable? Or, were companies told to sign a lease in a Pudong building so that they could get a business licence? Filling up the buildings, but really just imposing a high cost of doing business. The present value of the rents would imply the buildings value is appropriate. But are the businesses going to operationally generate enough value to warrant the rent? It must be amazingly profitable to do business in China, so profitable I can afford offices on the 75th floor!
I tell this story to broadly question asset values in China, even when they seem to be appropriate based on cash flows…dig deeper. Question. If few tall buildings are being built in free market economies, why would they be economically justified elsewhere? Of course, this applies to places like Dubai as well…
We have discussed several times on this site that the way the banking system in its current set-up works is not mainly as an “intermediary of loanable funds” lending pre-existing deposited savings, as G Stegen question suggests. Instead, the fractional reserve banking system expands debt / money relative to income during good times out of mere accounting entries and balance sheet expansion (in a way that would be totally impossible with real savings), thus turning economic growth phases into euphoric speculative booms, only to contract debt / money relative to income during bad times via balance sheet contraction, thus turning economic recessions into depressive busts.
To answer GStegen question and satisfy Donald Benson curiosity, a good portion of these credits and corresponding deposits are nothing more than accounting entries that can disappear in a contraction of banks balance sheets as quickly as they have been brought to life by an expansion of banks balance sheets. In fact, the disappearance is typically a lot faster…
Should we be looking at the gross debt or consolidated net debt in China? Consider the Chinese party and state as a multicellular organism (as I do). One of the ‘cells’ is the PBOC, others are state owned banks and SOEs. The SOEs have large debts to the banks which treat them as assets. How do you consolidate the balance sheet of the entire organism – net or gross? I suggest it should be net in which case the net debt in Chins is much lower than the gross debt. Multinationals operate unconsolidated balance sheets in each juresdiction but it’s the consolidated balance sheet that matters.
Remember also that money is nothing more than a human institution which is nothing more than neural patterns in people’s brains. Money is no more real than love or pain, so it doesn’t need to obey the laws of arithmetic. The physical form of money is irrelevant (including gold) which brings me to helicopter money. Central banks can and do create money out of nothing. Giving people money to spend is the normal definition of helicopter money. The constraint on that would be a growing trade deficit or inflation. There is a much more useful type of helicopter money which is to extinguish debt. Debt levels can be reduced by central banks simply paying people to pay off debt. The excess cash reserves in the banks would simply be deposited with the central bank. People and companies wouldn’t have more money to spend except by having lower interest payments so inflation would not be a problem unless you really overdo it.
Debt isn’t simply extinguished by money creation. If that were the case, we could create an SPV to borrow enough to gift every American with $1,000,000, and then we could resolve its bankruptcy by having the Fed buy its liabilities and hold them forever, forgive them, or restructure them into zero-coupon perpetuals. If you extinguish someone’s debt by monetizing it, you increase his purchasing power, in which case either the act of monetization caused total productivity to rise by the amount by which purchasing power increased, or the act of monetizing the debt creates a transfer equal to the increase in purchasing power (i.e. reduces someone else’s purchasing power).
I agree that money isn’t a “thing”, at least not in my opinion, but it is a lot more than just a neural pattern. What matters is moneyness, and although this is impossible to quantify, it doesn’t mean that its quantity is undetermined. You can only increase the money supply without a commensurate increase in productivity or transfers if there is simultaneously a reduction in moneyness, for example the recipient is not allowed or unwilling to use the money. In the end the constraint on our ability to use money is the total value of goods and services produced by the economy. I tried to explain all of this in my October 19, 2015, entry.
I would very much If you weigth in in the polemics now in the EU about assigning the costs of bad debt pilled in banks. Particularly in Italy, where the EU Comission wants a bail-in procedure in wich creditors assume part, while the italian government thinks it is politically and economically dangerous because the creditors in those troubled banks are mainly households and not particularly rich households. Bail-outs would mean risk transfer to the Italian government but as a compensation, Italy does not surrender to the EU comission oversigth as ocurred before with, for instance, Spain.
In the case of Spain, such oversigth will result in the EU imposing a fine to Spain equivalent to 0,2% of its GDP that will not exactly help very much to reduce the debt burden of the country. For this reason I am sympathetic with the attitude of the Italian government although it means applying different rules to different EU countries and may give impulse the ever growing divide.
Last year was as good as it gets for Spain in terms of tailwinds, Ignacio. Prices of industrial metals, commodities, and energy, all of which Spain has to import, were sharply down. Money was loose, helping to drive foreign purchases of real estate. Terrorism in France and the eastern Mediterranean was hugely positive for Spanish tourism. But with all that, Spain grew by I think 3.2% while its deficit came in at 5.2%. In other words Spain still cannot grow its way out of its debt burden with even these massive tailwinds, which of course cannot be repeated forever (and God forbid there is a terrorist attack in Spain). And of course as the debt burden rises, it acts as a headwind against growth and so makes the gap between GDP growth and the deficit widen further.
That is why I still see no reason to believe that there is a resolution of the country’s economic problems until the debt is written down. But against whom is it to be written down? The rich? They’ll easily flee. Middle class households? Consumption will drop further and tank the economy. Workers? Yeah, right, as if they have any room for more pain. The government? It doesn’t have enough assets.
I can only do my arithmetic and conclude that Europe, i.e. Germany, must bear the brunt of the adjustment costs. I don’t see how else to get the numbers to work.
If Spain leaves the EU, would that force Germany to bear the adjustment costs?
If Spain, Italy, Portugal and other peripherals did, the euro would almost certainly rise sharply, forcing most of the adjustments costs onto the remaining euro countries.
Great post!
Why will the leadership not consider a devaluation and assign some of the costs to external producers? By some measures the yuan is overvalued and constraining their monetary policy. If they chose to do it, my guess it would have to be in one go to surprise CNY investors, correct?
I think the RMB is undervalued, Juan, and more importantly, it seems that Governor Zhou thinks so too, according to his Caixin interview from earlier this year. Look at the current account, which is more likely to be driven by valuation issues than the capital account, which may be driven by speculative or flight motives. While devaluing the RMB would almost certainly boost the tradable goods sector, it doesn’t seem that unemployment is very high and so whatever benefits received by the tradable sector would probably come at the expense of the service and labor intensive sectors and so wouldn’t add to growth, whereas it would anger China’s trade partners even more and reverse the little rebalancing that China has managed since 2012.
Devaluation has worked to boost growth in other developing countries, but almost always in countries with large current account deficits and rising unemployment. Devaluations convert a portion of income from consumption to savings, and because in deficit countries investment exceeds and is constrained by savings, devaluation can boost growth. But in surplus counties like China, where savings exceed investment, the problem is not that needed investment is constrained by insufficient savings but rather that there is insufficient domestic demand because savings are high. In that case reducing consumption and increasing savings, which is what devaluing would do, is unlikely to help. Notice that Japan, which has similar conditions, spent several years allowing the yen to collapse in the hopes of boosting the economy, but whatever help Japan got from expanding its surplus (to very unhappy trade partners) it gave back in the form of weaker consumption.
If RMB is actually undervalued rather than over valued, then why does it need to spend reserves to defend the usdrmb peg?
I’m also interested in what Michael has to say about this question. I’ve wondered a lot about it too, and it seems to me that if it’s so that the RMB is undervalued, it can only mean that there would be a lot more buyers of RMB if those buyers were actually free to buy RMB (in substantial quantity). Those buyers being outside of China, since those are the buyers who can’t presently buy unlimited quantities of RMB, or who have a way to buy a lot but don’t have a way to sell (expatriate) a lot. If one imagines the currency being utterly released from trading restrictions, then presumably there would be both a bunch of sellers from inside China (who haven’t been able to sell) and a bunch of buyers outside China (who haven’t been free / willing to buy), and so the RMB being undervalued means that one thinks that the latter is a bigger group. (Doesn’t look obvious on the face of things, but what do I know?)
The existence of a very high savings rate in a country like China would appear to necessitate a national balance sheet which is a large multiple of GDP. If the theoretical average citizen saves at 30 % during his 30 productive years and depletes it during his 30 declining years than in a period of rapid income growth such as the 30 years before 2015 the balance sheet is very likely to reach extreme multiples of GDP. Such a saver is likely to appreciate many conundrums as a result of participating in this collective behaviour. In China for example it is very likely that a portion of his savings would end up as the income of the well connected. It is possible his intermediaries such as banks are unlikely to find assets to invest in that provide a return which is actually positive therefore he may have to endure negative rates of return. It is possible that the rates of inflation far exceed the nominal return he is provided by his intermediary and therefore the value of his accumulated savings actually decline year by year. It is possible intermediaries may actually become insolvent and the saver has to endure outright losses or bail ins with respect to such institutions. The hazards and stresses associated with the accumulation of such a large personal balance sheet after many years of diligent accumulation appear formidable. Such an individual though is unlikely to be unaware of who is actually in the long run going to carry the cost of all these unfortunate circumstances.
Thank you again for a very interesting blog as always a very good read.
I think G Stegen’s query regarding the credit side of debt was a fascinating one, and deserves much more consideration.
Thanks Professor , as always great post! I have a question that has nothing to do with this post , instead I would love no know when you are releasing your new book ?? Hope is coming soon!
Thanks, Marc. I am hoping it will be done by the first quarter of 2017 (I am way behind) but this depends on how active the next six months turn out to be and how much time I will have to write.
Wonderful post as always. Great point on capital raising as it cannot substitute investment cash flows. The raisers remain borrowers and appear to remain “speculative” and “Ponzi” in Minsky’s terms. This brings me to my question on corporate debt allocation: Do you consider last year’s equity rally a form of debt allocation to the household sector, i.e. transferring household wealth to the corporations?
Source on Ponzi stage of corporate debt: http://www.businessinsider.com/goldman-sachs-china-debt-ponzi-stage-2016-7?r=UK&IR=T
I think one of the reasons Beijing hoped to see a strong equity market, AP, was to make it easier for highly-indebted companies to pay down debt with equity. Unfortunately by the time the crash occurred most of the equity offerings had been made by smaller companies, including tech companies, with little debt. Had it happened, it would have implied an allocation of the costs either to households who bought the equity or to local governments who were diluted depending on the prices at which the equity was issued. By June 2015 prices were in bubble territory and had they continued rising, it would have more likely meant that households paid for a part of the cleanup.
Long time reader of the blog and first time making a comment. I’d like to thank Professor Pettis for writing this blog. it is fascinating to compare and contrast the Western style of logical and analytical approach with the cultural framework of “saving face” coming from China’s mandarin regime.
I’m afraid there is no point in analyzing China from a “normal” point of view. Its investment-led debt binge is simply unparalleled in history (except maybe assumptions about the building of pyramids or of the Great Wall). China produced between 2011-2013 more steel and cement than US during the entire 20th century. It has led to building of artificial islands in South China Sea not for military reasons (a few missiles will destroy the islands and the runways in a matter of seconds) but as an outlet for their gargantuan output of steel and cement. In other words, in a sense, there has never been anything like China’s economic activity (not growth in the classic sense) in history and the West is trying to rationalize the irrational.
Same with China’s “banks”: they display the apparent functions of Western banks however they are just financial outlets for China’s political regime. Historically, such an unbalanced country between their realities and their aspirations, who tried to become a global power, ended up creating conflicts on a massive scale. I admire Professor Pettis in applying analytical tools in order to describe and predict China’s options. I’m afraid his best intentions are for naught given the nature of China’s political regime, who doesn’t want “truth” but to “save face”.
this seems a bit confused – there’s no obvious connection between saving face and producing more cement in a couple of years than the US did in 100, and there’s nothing inherently irrational about saving face (western politicians don’t like admitting they were wrong either – see, the euro). in the end Chinese people pursue their own perceived best interests just like everyone else, so the ruling elite wants to keep unemployment low to prevent social unrest, and the business classes move their savings offshore to reduce the chance of them being expropriated by the ruling elite, and the workers keep their heads down and try to get their kids into good schools, etc. of course you can analyse Chinese behaviour rationally – that just doesn’t mean that they will make the best decisions tho, any more than in any other country. what’s in the short term interest of one group might not be in the long term best interest of the country
Most interesting article and follow-up comment. In assessing what may come do you confirm or reject the opinion that Paul Krugman is simply too Keynesian on the debt side of the ledger in his strategic outlook. we live in a money climate so different than that of the historic past.
We have no idea where we are going with negative interest rates but my guess is that it will be a destabilizing rather than a positive strategy to induce spending. it would simply send the message that we are in a deep hole and would trigger a response opposite to what is intended. But analysts do not talk about psychological induced responses and I can understand why they don’t want to speculate on perception rather than on reality. yet it is the impact of perception and psychology that motivates spending or saving or indeed what any currency is actually worth!
I always wondered why the German people of the 1920s decided to trust the value of the new Deutschmark as against the old with which they papered the walls. After all nothing had changed with regard to either national debt or national assets or indeed in their international obligations. You must consider the effect of mass psychology here and it may well be that the Germans were simply fed up with worthless currency and simply hoped that the new one would travel
We live in an age where unlike the 1930s lies when repeated often enough become factual, or present-day Donald Trump’s emulation of that process. The net effect is difficult to assess. People play musical chairs with their investments and with their debt obligations not knowing exactly when to get off. All the fact inputs should tell us that the music is bound to stop sooner than later and that perhaps we would be better off if it did turn off sooner.
Not sure entirely, but I think the switch in Weimar from the hyper inflated currency to the new one was mostly about creating confidence that the old habits of literal money printing would be ended, no matter the other costs. It also followed the vitally important Ruhr industrial region being returned to Germany following its occupation (which itself resulted from Germany’s attempt to default on the crippling reparations payments to the allies), so there was in fact a real change in national assets. There was also a preceding change in stability, which was destroying confidence before and during the period of hyper-inflation – especially the effects of resistance in the Ruhr. With stability returned, the “new” currency looked a lot more stable, and this also allowed the Ruhr to come back online, which further helped the situation. By 24, there was the Dawes plan to further add to the stability.
So i think there were quite enough real reasons for the Germany people (and not just the German people, but the international system too let’s not forget) to have confidence in the newly denominated currency. I don’t think there was any mass psychology or “power of belief” explanations at the core, although I am sure they must have played a minor role.
Yea, we’ve had guys like Trump run for power repeatedly throughout American history. He’s now running as a Jacksonian populist (of course, he’s not one and Trump’s really more of a closet leftist than anything else). Trump’s to the economic left of Obama. The key factor about Trump is that he’s very representative of the GOP base. For all the talk about a “unconventional election”, we’re currently in a very conventional Presidential election.
There’s a few key differences between Nazi Germany and the current US. First off, there was 40% unemployment in Nazi Germany. Secondly, the American electorate is >30% non-white AND ~60% of white people (especially white women) have college degrees. Trump’s biggest problem is demographics and that won’t be easy to overcome. Honestly, I think there’s a good chance the GOP is headed the way of the Whigs. Trump’s base is old, angry, pissed off white people (mainly men) who don’t seem to care about the future of anyone else in the electorate. It’s not like this was hard to miss either. It was pretty easy to tell IMO.
In February, I wrote about how the structure of our political system (see link below) has a tendency to put the most divisive and polarizing figures as the two major candidates due to the democratic nature of the primary process. Well, that’s exactly what we’ve got. I think this election’s beginning to look like the Election of 1896 with Trump being a lot like William Jennings Bryan. The “we’re gonna win again” line is very similar to the “free silver” or “cross of gold” lines that’s just coding for the politicization of monetary policy. To me, Trump’s just a mix of Andrew Jackson, William Jennings Bryan, Teddy Roosevelt, and Richard Nixon (I tweeted this at Adam Tooze and he liked my tweet, which tells me he probably sees things the same way).
http://suvysthoughts.blogspot.com/2016/02/jacksonian-democracy-upcoming-political.html
Our next President will either be a corrupt puppet of a liberal capitalist oligarchy or a national populist using blatant demagoguery. Of course, the American people’ve become very anxious and distraught. I’ll probably be voting for Hillary Clinton (because I live in a swing state) although I do not like her. As I like to say:
“I’m ready for oligarchy. The choice is clear: there is none.”
For this process, I think Bernie has to take a large part of the blame (>50% IMO). When Republicans say bad things about Hillary, no one takes them seriously cuz most are hypocritical nuts (like Chris Christie calling Hillary corrupt when Christie’s own aide pled guilty to a corruption charge). When someone from the left points out those same flaws because “equality”, “democracy”, and “socialism”, then you’ve seriously damaged the candidate for the general election.
… plenty of lies were repeated often enough to become accepted as fact in the 1930s?
Sorry for the typo. It should have read -“like the 1930s lies when repeated often enough become factual or like present day Donald Trump’s emulation of that process”
Sid F
Great to have you back on the blog Professor. Great explanation as always too! Hope that the book mentioned in another comment can get done by 1Q 2017!
http://www.nybooks.com/articles/2016/08/18/when-we-loved-mussolini/
The tea-leafs look ugly. Assuming that:
1. Dr. Pettis is correct and the debt burden is inescapable
2. The Chinese internal political situation makes it impossible to shift the burden onto the elites
3. Placing the burden (yet again) on the powerless Chinese worker / household is a politically untenable breaking of the operative contract
From the Chinese political leadership perspective, there seems to be only one ‘good’ solution: Create political cover in order to enable #3. Stoke nationalism to shift focus of the masses from their woes by creating an external enemy to blame.
It seems likely that China intends to engage in a naval conflict that it knows it cannot win. The US has made clear it will not allow military base building on Scarborough Shoal. All China has to do is begin dredging operations to trigger a US naval response. Whether this results in a wide-spread or narrow naval conflict or even just a stand-off, it serves Chinese purposes: deflect attention from themselves while creating an enemy to blame for their economic woes. If this results in sanctions / embargoes / blockades, so much the better as far as the elites are concerned.
Its not an unlikely coincidence that Russia & China are holding joint war-games in the South China Sea immediately following the G20 summit. Nor is it a coincidence that both China & the US are shifting military assets forward in clear patterns that indicate anticipation of conflict.
These clear efforts by the Chinese to snub the US at the G20 meeting certainly aren’t helping things; I expect that just the above issues are the primary topic of conversation of the G20 members behind the scenes.
Frankly I am deeply concerned. There is nothing we can do but watch and pray this is wrong in some way. However I just did place some stop-loss orders on my holdings and suggest others do the same for the next few months.
Hopefully Dr. Pettis will see this comment as fit for publishing under the aegis of “political economics”
I am neither an economist nor am I a professor. Some of your reply correspondents on the record are of people owning erudite and educated brainpower. They are focused on understanding the dubious discipline of economics
I’m a simple Canadian who has done reasonably well. I try to educate myself on what Money represents, what debt supports or devastates ,what can be done to accomplish a boost to productivity and what hinders it. I try to understand where we are going. I feel I did not adequately explain what to me lies at the heart of the matter-that ultimately perception trumps factual analysis.
It’s simply that eventually even the common man will see that the turtle of productivity will never catch up to the hare of debt. At that time there will be a scramble to see who’s going to pay as between the middle class and the poor who are living a whole lot longer and who have learned to have a voice. The fight will be as to who pays and who gets.
My reference to Germany of the 20s is one of understanding perception as a motivating factor in political life matters. There was absolutely no reason why the average German should trust a new currency as having value against the old. Similarly eventually the average citizen will understand that accumulating debt will never be repaid no matter what the central bankers do or don’t do and no matter what comes out of their meetings like the recent one in Jackson hole Wyoming.
As is, they have devastated the hopes of the retiree and the life companies who cannot catch up unless the major economies improve to an unlikely sustainable 3% increase in GDP. No one can predict what social upheaval will follow when perception becomes reality.
Sid Freedman
Sid – the hyperinflation issue was compounded by a number of factors – Communisum – add this to the mix that confidence was lost with the Government – as they themselves struggled with the reparations – If the matter of the reparations had not been addressed and the Ruhr region not been reintegrated – I doubt the new currency would have had half a chance. So many items in the mix – and yes confidence – perception necessary.
As usual, an important fundamental analysis of china and what it should do. However, global market perceptions on their willingness to pursue rebalancing reforms for the long term stability of the economy are different. Observing them meandering through their reforms and protecting vested interests at each turn while piling up debts, it is great risk to trade/invest in that not more of the same is coming i.e the short term choice of stuffing the households.
Global markets are not benign and have no reasons to let them get their act together. So while I agree that the Yuan is undervalued from the fundamentals as a stand alone economy, global markets have so far given its verdict that it is not a currency to long.
A planned economy wrestling with free market forces engendered by rapid globalization, China does not stand a chance with its structure to raise productivity and grow out of debts. Worse, when debt reduction however seriously contemplated is not the consistent message that global markets are fed with.
Volatility enforced by global markets looks like the norm for many days ahead and traders can only express their risk perception in the global market sphere and with the Yuan that is outside their control.
will the pressure for debt be alleviated if China sovereign bond and corporate bond to be more popular sold for investor outside china?
Great article as always. My question is about the US trade deficit. At what percentage of GDP is it sustainable and at what levels is it not.
A follow up question. Should the US run a trade deficit or surplus. And which one is appropriate for America
Dear Professor Pettis,
You link relative debt accumulation and inefficient investment in and operations of assets.
In your list of possible allocations of debt servicing costs, you mention progressive taxation to direct the costs to wealthy households more susceptible to absorb them on “idle funds”, hence with the least fall-out on overall economic performance.
If taxation can be a tool for allocating the costs of excess debt after it has been incurred, can you think of a taxation system that would be better than the current one in preventing upfront such inefficient asset accumulation? Perhaps a different mix of taxes on asset values (higher) and on incomes (lower) so as to induce that assets eventually find their way to the owners best able to operate them efficiently?
This is not only a question for China, by the way, but one many countries in the world could ask themselves. In other words, could a correctly set-up tax system address not only distribution issues but also efficiency issues?
Thank you
Jeffrey Snider has an interesting outlook on China. His argument is that the Eurodollar that China and every other country in the world has been using to fund international trade is largely a construct of banks, and that none of these Eurodollars are actually backed up by anything with a real dollar value. I have heard $9 Trillion as the value of this valueless money, and I’m sure China accounts for a vast amount of that. His argument is that China’s most pressing problem is financial, in that China can never claim all of the dollars it is “owed,” and that a shortage of dollar funding is causing periodic financial crises that are only getting worse as time goes on. His idea adds an interesting twist to your analyses, but you both agree that debt is the issue that China must deal with first and foremost.
The idea that a shortage of dollar funding is the actual cause of periodic financial crises that are getting worse in intensity is an hilarious one.
How about skyrocketing global debt / global GDP since the late 1970’s as a result of (i) the US unilaterally walking away from the Bretton Woods discipline of keeping external accounts close to balance and (ii) the drive towards international trade liberalization since the 1979 Tokyo Round within the context of this new international monetary system? The combination of these two events has indeed resulted in huge and persistent trade deficits and surplus, such imbalances being settled by rising debt of deficit countries and rising reserves of surplus countries, reserves that have in turn underpinned dramatic credit expansion in most surplus countries domestic banking systems, with the very problematic result that both deficit and surplus countries are now both in excess debt situations (US, Japan, China, …).
While global debt / global GDP has been consistently decreasing from WWII until the mid-1970’s, the curve turned during the 1970’s when the international trade and monetary system changed and it has been exponentially rising since. It is still rising post 2008-2009, basically driving the world economy to the maximum debt / income limit compatible with 0% interest (~ 400% of GDP), after which point there is no equity left in the system.
By the way, this is not only the driver of rising relative debt, it is also the driver of the weakening real economic growth trend and the reasons why each crisis is getting more severe than the previous one. It’s not just China that must deal with excess debt, it’s the world. And the only way to deal with it is to change the dysfunctional international trade and monetary system. But here, we are in a paradox: while it would be the surplus countries (China, Japan, Germany, …) that would suffer the most if the global trade and monetary system would break down under the mountain of debt it is generating, the intellectual inertia very much comes from the US established wisdom. Without this intellectual paralysis and the diversion of fancy “dollar shortage” explanations, the whole issue would have been resolved decades ago. There is still time but not so much…
You don’t understand that the eurodollar is the global trade system, at least it used to be. All the things that you say about debt are true, but the system that China (and Japan) used to create global trade conditions were enabled by banks and the currency swaps that created money out of thin air. This is the issue that keeps China’s bankers up at night, because that money is now reverting back to the thin air from which it came. The critical collapse of the eurodollar system will be the fuse that lights up the debt volcano in both China and Japan.
I do understand.
The Bretton Woods system (1944-1971) eventually collapsed because of the built-in imbalance which is the use of the domestic currency of a participating country (the USD) as the anchor of the international system. This congenital imbalance – wanted by the US at Bretton Woods against the better alternative presented by Keynes – indeed allowed other countries to “game the system” and speed up their economic development by accumulating dollar balances. It also allowed the US to accommodate the perceived “dollar shortage” by issuing new dollars at will to fund dubious policies at home and abroad (Great Society, Vietnam war and many others since …). In other words, this built-in imbalance gave the wrong incentives to all participating countries. The incentives were not aligned with the stated goal of maintaining cross current accounts close to balance (see article I of the IMF articles of association) so that free trade can be mutually beneficial to all participating countries (see preamble of the General Agreement on Tariffs and Trade).
In the new international monetary system born de facto in 1971 with Nixon unilateral decision and de jure in 1976 with the Jamaica Agreement, the emergence and growth of offshore dollars has been the natural by-product of the emergence and persistence of large current account imbalances between the US as the main deficit country and the surplus countries (oil-producing countries, Germany, Japan, South Korea, more recently China) within the context of the USD as main international currency. Once you remove the discipline of keeping cross current accounts close to balance, the system will automatically generate these offshore $.
It is wrong to say that these offshore $ are a creation of the banks, they are a buy-product of the system as it operates since the 1970’s, the banks are just making a business out of recycling them and trading them. Indeed, the end of the 1970’s is when banks start opening large trading rooms as the recycling of all these offshore $ balances in this new world of floating exchange rates and liberalized capital movements becomes a business in itself. “Euro”dollars because London is emerging as a major hub in this global trading business, especially after Margaret Tatcher becomes Prime Minister in 1979 and pursues a financial liberalization agenda culminating in the so-called “big-bang”.
At core, what the collapse of the Bretton Woods international monetary system in 1971 and the uninterrupted series of financial boom-busts thereafter has shown is the fundamental contradiction of using the domestic currency of a participating country as reserve instrument for the international monetary system. This was clearly articulated by Robert Triffin in the US and Jacques Rueff in France in the 1960’s. It may also have been the thinking behind Keynes Bancor proposal in 1944. But Keynes, Triffin, Rueff and many others have been ignored. Instead, for the past 45 years, the official US position has considered that it was in its best interests and that “the $ is our currency but your problem” (the clearest expression that the international monetary system is fundamentally uncooperative). The uninterrupted series of destabilizing financial boom-busts since these unconstructive words were uttered has confirmed to all the economies concerned that it was indeed their problem. But, as far as the US is concerned, the official US position has failed to appreciate that this system is sinking the US economy under an unmanageable debt load that is endangering its prosperity. The consistently declining trend of real economic growth in the US, the consistently inflating balloon of debt and asset values diverging from real-life production and income flows ultimately backing them up (the same as during the 1920’s following the failure of the 1922 Genoa conference to design an adequate international monetary system), the rising intensity of cyclical crises when the dilated financial ballon threatens to explode (the 2008-2009 crisis was the most severe crisis since the Great Depression), all that is a clear empirical confirmation that this system is actually not in the best interests of the US. As Michael Pettis explained, this system is an “exorbitant burden” rather than an “exorbitant privilege” for the US. The fundamentally uncooperative nature of the international monetary system is now plainly visible in the currently raging currency wars.
To reiterate my previous conclusion: the solution is largely in the hands of the US: are they finally ready to give up the international role of the USD and the exorbitant privilege to rid itself of the exorbitant burden?
You still don’t grasp that the eurodollar is the pseudo currency that has been the actual currency that has funded world trade for decades. It has been very good to the trade surplus countries in that time. Unfortunately, it basically consists of iou’s from banks that can never be paid. It doesn’t require any grand theories about economics or history, it’s simply the way the financial system has worked, within the broader outlines that Mr. Pettis covers so well. Since 2008, that system has been imploding on itself. If you want to know how far that collapse has gone, just keep an eye on China’s increasingly desperate attempts to keep the dollar peg. I think this blog will be very helpful in analyzing China’s economic future, because Mr. Pettis knows more about China’s economy than almost anybody.
An IOU from a bank, as you say, is called a deposit. The fact that a bank can never honor all deposits – Eurodollar or otherwise – at any given point in time has absolutely nothing to do with Eurodollar per se but is inherent to fractional reserve banking. And yes, fractional reserve banking is fundamentally unstable and needs urgent fixing, as I often argue on this site.
But let’s go back to our Eurodollar bank deposit. Where do you think it comes from in the first place? For, you see, you need an initial reserve to set off the fractional reserve credit system into action and you need more reserves to feed it as it grows.
The Eurodollar bank deposit initially comes from the recycling of USD balances surplus countries receive as settlement from selling more goods to deficit countries than they buy from them, the main deficit country in the world being of course the US. The central banks of surplus countries typically invest these USD balances partly in the US financial markets directly (for instance, buying Treasury bonds) and partly in other markets where banks lend them out as $-denominated loans to non-US borrowers (for instance, the USD surplus from the 1970’s oil shocks – itself a consequence of Nixon 1971 decision, at least the first one – were largely on-lent to Latin America, leading to the debt crisis there in the early 1980’s).
So, you see, without large current account imbalances and without USD as the anchor currency of the system, no substantial USD balances to recycle, hence no large Eurodollar amounts outstandings, hence no dollar shortage. You’re mistaking the consequence for the cause. The Eurodollar is merely a consequence of the unbalanced trade system whereby large and persistent deficits and surpluses are accepted and settled in USD. The international trade and monetary system is the cause. To fix a problem, you have to fix the cause, of course. And the US hold the key to that, being the main influence behind the international trade and monetary system.
You are right on one thing, though, which is that the fractional reserve banking system serves as an amplifier to the large trade imbalances, and it is indeed the combination of a dysfunctional international trade and monetary system together with an inadequately set-up credit system which forms the powerful engine behind the staggering rise in global Debt-to-GDP for the past 40 years. It’s impossible to fix the global debt problem without fixing at least one of those, and preferably all of those.
Indeed, this unsound system came close to collapse in 2008. Which is why it’s bizarre that we are now 8 years later and the problem has grown worse since global debt has kept on rising relative to global production. This is because, like you, we have been focusing on the symptoms and not on the cause. By doing that, we have lost precious time and dimished the chance of a cooperative and peaceful resolution.
One more thing. You are too quick dismissing “grand theories about economic history”. You should know that it was precisely to your point – avoiding a repeat of the collapse of the unstable edifice of unbacked monetary claims in the late 1920’s that led to the Great Depression – that the negotiators at Bretton Woods on both the White and Keynes sides were in crystal clear agreement about keeping international trade balanced. This is not theory at all by the way but fully documented historical facts. As soon as this external account discipline was revoked – by the US in 1971 as it turns out and largely because of the poor design of the White plan that had prevailed – the same causes of widening trade imbalances have again led to the same consequences of mushrooming debt claims out of proportion with income flows backing them up. Which is no surprise at all: the same causes have a tendency to produce the same consequences. It is vain to try to fix problems by addressing the symptoms. There is no going around addressing the causes.
@DVD
Let’s say that the world swith to a bancor-like currency tomorow, wouldn’t there be a threath of hyper-inflation to the US? Because all of the dollar and dollar-denominated financial asset held abroad would lose some value and be sold back in the US, witch could trigger a destabilising spiral. I don’t know, maybe this could be another reason for the US immobilism on the question.
And I still have trouble grapsing the logic of why does the current system “automatically” generate a build-up of debt in both surplus and deficit country…could you please point me to a Pettis’ post or a comment where this logic is plainly explained.
Guillaume,
The reason why an unbalanced international trade system ends up increasing relative debt in both deficit and surplus countries is because of the duplication of credit it involves.
It works as follows, using China and the US as convenient proxies for surplus and deficit countries:
1. Chinese companies in aggregate sell more goods to the US than they buy from it, hence they have a net trade surplus for which they receive the corresponding amount of USD as settlement. These USD balances are converted to national currency balances (RMB) at commercial banks. Commercial banks convert these USD reserves to RMB reserves at the central bank. Said differently, China central bank issues domestic currency as counterpart to the USD thus acquired. The equivalent of the USD balances enters China money supply.
2. China central bank typically invests these USD balances in US financial markets, for instance buying Treasury bonds. Notice the round trip of USD from the US to China back to the US, with the effect that the US trade deficit doesn’t result in any monetary contraction, hence doesn’t restrict purchasing power, hence doesn’t trigger any downward adjustment in internal demand that would rebalance the external trade account. This is the secret of “the deficit without tears” or “exorbitant privilege” in the sense that the US can buy without paying now but by promising to pay later, ie. by incurring debt. Thus, the USD balances have entered China money supply without leaving US money supply. This feedback of USD is repeated endlessly on a daily basis. It is the mechanism by which trade imbalances have been allowed to develop and grow unrestricted for so long, accompanied of course by the corresponding rise in claims, ie. debt of deficit countries.
3. In the meantime in China, the new RMB reserves of the Chinese banks can support new loans for a multiple amount of those reserves, for instance a 10x larger amount of loans if reserve requirements are 10%. This is precisely how China spectacular credit expansion was made possible from 2009-2010: by multiplication in its domestic credit system of the monetary reserves accumulated after years of trade surpluses. There is duplication of credit between China and the US as the USD balances enter China credit system while at the same time being on-lent back to the US. This exact same mechanism was also behind Japan’s credit boom of the late 1980’s after years of Japanese trade surpluses. Note this last step is not “automatic”: a surplus country like Germany has so far refrained from resorting to credit expansion policies, at least not to the same extent as Japan or China.
This combination of large trade imbalances with fractional reserve banking is the powerful engine that explains the staggering rise in global Debt-to-GDP for the past 40 years via duplication of credit, ultimately pushing both debtor (US) and creditor (Japan, China) countries into excess debt situation. The fast increase in global debt relative to global production results from this double mortgaging of future production at each iteration of this duplicate credit structure.
” The ability to
have the preeminent reserve currency, without it being locked to a finite good such as gold, gives
the US enormous advantages.”
Here’s another view: https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-allocation/the-reserve-the-dollar-the-renminbi-and-status-of-reserve.pdf
Prof., http://www.sixthtone.com/news/ground-under-music-shaped-city
As with the last post, I’m frustrated there is no elaboration on what types of assets local governments actually have to sell. If its SOEs aren’t they overleveraged and inefficient and therefore of little value? If it’s land, the only reason to buy it would be leveraged development and if there is already way to much built space then doesn’t this just make the debt problem worse? So I think we need a discussion of what the provincial assets are
Mexico 1989 remember me the actual situation of Italy. Now workers are paying the costs through unemployment and suppressed wage growth. Until the costs of the write-down will be allocated to foreign creditors (Germany) through devaluation.
Thank you for your articles prof. Pettis.
Oxford Review of Economic Policy, Volume 32, Number 3, 2016, pp. 360–390
We conclude that, contrary to the conventional wisdom, infrastructure investments
do not typically lead to economic growth. Overinvesting in underperforming projects
instead leads to economic and financial fragility. For China, we find that poorly managed
infrastructure investments are a main explanation of surfacing economic and
financial problems. We predict that, unless China shifts to a lower level of higher-quality
infrastructure investments, the country is headed for an infrastructure-led national
financial and economic crisis, which—due to China’s prominent role in the world economy—is
likely to also become a crisis internationally. China is not a model to follow
for other economies—emerging or developed—as regards infrastructure investing, but
a model to avoid.
http://www.city-journal.org/html/if-you-build-it-14606.html
https://andrewbatson.com/2016/09/12/about-that-china-infrastructure-paper-that-is-making-the-rounds/
“The motivation for the Chinese policy is apparently not so much to facilitate the rationalization of capacity in sectors with too much of it, but to increase revenue of firms in these sectors in order to permit them to pay back debt to banks and the holders of wealth management products (which often turn out to be banks too). Further, the policy is also driven by a need to sustain employment in these industries. Thus, the policies are intended to prop up the financially weakest and least efficient companies, rather than cull them.” http://streetwiseprofessor.com/
Hey, what’s up prof?
You’ve got to check this !
https://www.bloomberg.com/features/2016-most-influential/
33, it’s you! You smoke Larry Summers(ok that’s an easy target)
MOST INFLUENCIAL PEOPLE 2016, well done!
Thanks, Cedric, lots of very nice people have been telling me. It just goes to show you get more out of scribbling than working.
[email protected]
Great article, thank you.
You mention selling of gov assets and tax on the wealthy as most immediate path to reducing debt. What about tax on the profits of the banking sector, the creditors, as another option?
The banks are essentially insolvent and will have to be bailed out, Theresa, and so whatever the government takes from them in the form of taxes simply increases one for one the amount of the bailout.
Thanks for a very informative article professor. It seems like all the new debt is being issued to more productive industries like electronics . There have been a number of smartphone manufactures (Oppo,Xiaomi,Huawei etc) trying to increase their market share in other countries. So my questions is how fast would they need increase market share in other countries to keep the economy going. Another words how fast would the economy need to keep growing to out grow debt? What is the magic number ( if there is one) where if the growth rate drops below that number we could see a collapse?
It’s not such an easy calculation because of the many moving parts, Akash, but debt seems to be growing at around 18-20% a year. GDP is growing at 6-7% a year, but this probably overstates real wealth creation. However you look at it there is a pretty big gap.
Michael, I find it amazing that the Chinese are grabbing up residential property outside China left, right, centre, top and bottom! So much, that in Australia, if the Chinese stop buying, there will be a significant downturn in the property market. And buying up luxury goods all over the world! And sending their kids overseas for education in huge numbers! Are they really so rich? Or is a lot of it borrowed money? Has China genuinely generated so much wealth in the last N number of years? How long will this last? (I am afraid that like mining, this could end in tears for Oz developers and Oz universities one day.)
China is a very large economy, Sameer, and several of its larger cities have populations roughly equivalent to all of Australia. Given that Australia is one of the favored destinations of Chinese, some perhaps just fleeing China but many who genuinely seem to like Australia, its not surprising that Chinese money weighs so heavily in the Australian economy. China is also among the world’s most unequal societies in terms of income distribution, so that although China has a smaller economy than the US and is much poorer per capita, it recently surpassed the US in number of dollar billionaires, and that doesn’t even take into account the possibility that many wealthy Chinese understate their wealth nor the fact that some Chinese billionaires have become American. Over time, the distortions caused by the Chinese will stabilize and disappear, but in the short run it isn’t surprising that their behavior does cause distortions in smaller economies.
Michael,
You’ve been running the same story, with minor variations, for 12 years. Best avoid prognostications, especially about China (which you do not understand) and particularly about the future.
Are you from the school of thought that thinks China’s economy is run by brilliant planners who can create rates of growth down to the last decimal point at the snap of their fingers? If so, please explain to us how that works.
Hi Michael,
I wonder if you could write about how Europe is handling the bad debt business in some detail. It is not often that we see most of the industrial world struggle with the same set of problems.
On China, do you think some of the easy debt policy has been spilling over internationally in the Chinese splurge on overseas property, commercial investments including overpaying for established businesses, overpaying and mismanaging mining investments, buying at peak etc?
me too, I would like to see some analysis on on Germany, (DB threat with derivative exposure) and the Italian banking system. How can they recap the banks with such a dysfunctional EU ? China maybe more leveraged,but the EU seems more likely to create the avalanche of debt. Minsky moment.
That’s the topic of my newsletter which goes out next week, Cypriot, but unfortunately only to clients. I will try to summarize the arguments at some later date and post them on my blog, but as you suggest, it”s going to take an awful lot to resolve European debt.
I’ve been increasingly wondering about an easier question–does DB going belly up (if it happens at all–I still don’t understand how they made it this far, but then, I’m not a markets kind of person), lead to Greece et al. getting debt write-offs? After all, all this sovereign debt couldn’t be written off up until now for fear of having to declare the large national banks insolvent.
Berlin can hardly acknowledge that it will support DB in case of insolvency, Claire, when it demands that Rome absolutely refrain from bailing out Italian banks, but I find it hard to believe they would not intervene to prevent a bankruptcy at DB.
For decades, the modus operandi of policymakers in Europe and elsewhere has been very consistent:
1. Get the diagnostic of the crisis wrong, usually explaining it by deviant behavior (for instance, banks behaving recklessly in the expectation that they would be bailed-out in case of problems) while the system in itself is seen as intrinsically correct.
2. Based on that erroneous (or at least very incomplete) diagnostic, put in place rules to prevent deviant behavior to recur, for instance the new banking resolution legislation in Europe since January 2016. During that second step, policymakers are stubbornly blind and deaf to protestations that they are making a mistake based on an incorrect understanding of the root causes of the crisis.
3. When the crisis recur to nobody’s surprise but theirs, they quickly violate the rules they have themselves put in place.
In the present case of Deutsche Bank, we are quickly approaching step 3.
It goes without saying that misguided policy responses to a misunderstood crisis can only destroy policymakers credibility…
I wish I could say you’re too gloomy.
I’ve said it for years, but the entire European banking system (outside of maybe Switzerland, the UK, and a few other handful of places) is built on a pile of sand. Deutsche Bank will go down and Berlin’ll have no other choice than to prop it up and save it. Will they say that’s what they’ll do when the inevitable happens? Of course not. What do you expect? For them to tell the truth?! That’s just not gonna happen.
Can one be a rational optimist, given the situation? If the government can resolve the debt burden by selling assets of local, provincial and central governments and by a combination of borrowing money from the public and printing money (leading to higher inflation) – it could result in a much higher public debt to GDP ratio eventually, but the situation would still be a lot better. And if ongoing financial reforms makes it possible for future growth to not be based on increasing debt/GDP ratio but on rising consumer demand and investment by private businesses, then some economic growth can also happen along with the rebalancing?
Is DB’s crashing the first step in the Eurozone’s inevitable re-balancing?
Thank you for the post! I’m wondering though, aren’t the debt-to-equity swaps a way of partially allocating the cost of bad debt – to the extent that the equity is not worth the book value of the debt, which it by definition is not since in that case the companies could just issue new equity to the market rather than going through this contorted process, the cost is allocated to the banks. And we have a pretty good idea of who covers the losses of the banks.