June 20, 2012; Michael Pettis on Tomorrow’s China

Weekly Commentary • Jun 22 2012
June 20, 2012; Michael Pettis on Tomorrow’s China
David McAlvany Posted on June 22, 2012

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: Today, David, we are going to be joining a conversation that you had with Michael Pettis on the phone, on a couple of cell phones. This is as promised last week. We are keeping with the theme, looking at China.

David: The importance of looking at China is really this: We are long-term concerned about the U.S. dollar and the U.S. debt markets, and as things change in terms of international trade relationships and the funding of our government debt, we need to look at the back story to that and figure out what are the relationship today, with our creditors? Are they improving? Are they in decline? And what does this mean for us on a 2, 3, 4, or 5-year time-frame? It may seem odd that we are talking about China, except that they are our largest creditor, and ergo, we are going to explore issues relating to China, not only last week, this week, next week, but as we actually travel and spend some time in Beijing and in Hong Kong, and in Singapore, as well.

Kevin: And even though there is disagreement as to the timing, David, I think there are very few people who would argue that of all the countries that we look at, China is the one that will affect people more than any over the next couple of decades. Let’s listen in to that conversation.

David: I’ve been reading Michael Pettis now for a number of years. He is a finance professor at Peking University, with a unique background in trading in emerging markets, but also an entrepreneur, so day job and night job distinct, day job being a finance professor teaching central banking and a number of other things there at Peking University, and by night, an entrepreneur running a nightclub, and very involved in the Beijing music scene.

Michael, welcome. Thanks for joining us.

Michael Pettis: Thank you.

David: We have seen growth in China for the last 20-30 years, which has been predicated on exports and government-directed investment projects. A rebalancing is in the process of being attempted, to bring the consumer household into a more significant economic role. As we look back over the last ten years, we have actually seen consumption, as a part of GDP, in decline from roughly 45% to about 35% today, moving in the wrong direction. That’s a trend that the politburo has determined they would like to change, they have purposed to do so in their recently released 5-year plan. Can they accomplish the necessary reforms to achieve this and some of their other long-term economic goals? What kind of a time frame do you think they are up against?

Michael: There is a huge amount of debate about that. I tend to be on the more pessimistic side and my guess is that we have 4-5 years, at most, of doing this. I say this because the growth model that China follows is not unprecedented, it is actually a growth model that has generated a lot of “economic miracles” in the past – the Soviet Union in the 1950s and 1960s, Brazil in the 1960s and 1970s, Japan in the 1980s, to name some of the most obvious examples.

But in every single case, it ran into a debt problem, and I think that that is not an accident, that is endemic to the model. Debt levels have certainly been rising very, very quickly in China. I think in the last 3-4 years there has been widespread recognition of that and my guess is that we probably cannot keep this up for much more than 4-5 years, so the balancing process has to start well before that.

David: With the unsustainable elements in the Chinese economic policy, massive over-investment and unsustainable in terms of the increase in debt, what might that debt limit be for the Chinese?

Michael: There is no real science to figuring out what that capacity limit is, but there are a number of things that you have to take into consideration. The first thing is that the banking system has become less and less liquid and part of the reason is because we have been seeing money leave the country, and part of the reason is because a lot of the loans simply aren’t capable of being repaid, they are rolled over forever, so there are constraints within the banking system, although that is usually easy to get around.

But there are other constraints, and that is that when you borrow money and invest it in principle, the additional debt servicing capacity that you are creating, the additional wealth that you are creating, should be greater than the debt servicing costs. If they are, then you have sustainable debt. But when you are misallocating investment and you are investing in projects that are wasted, or that are excessive, or that won’t pay off for many, many years, then the problem there is that your debt servicing costs, correctly calculated, removing all of the subsidies, grow faster than your debt capacity, and by definition, that is unsustainable.

So, I would argue that for at least a decade now, China has been misallocating investments, which means that it is generating economic activity, but it is not generating as much wealth as it is generating debt, and that is when you run into the limit. At some point, you simply cannot go on any further.

David: The whole world has been operating with a debt-driven growth model, where exponential growth has been exceeding the exponential accumulation of debt. Everyone has remained happy as long as that has been case. Now growth is slowing, but the accumulation of debt has not. It is as if the entire globe rises and falls on a sea of easy money. Where are we in the cycle of credit expansion or credit contraction, in your opinion?

Michael: I think of these more broadly as globalization cycles. We have seen, by my count, roughly six of them in the last 200 years, and they all look fairly similar, for some reason. It could be discoveries of gold, it could be changes in the structure of the banking sector. You get this increase in underlying liquidity, and with the increase in liquidity, risk appetites go up, the risk premium goes down. Money goes into lots of different sectors, and it becomes self-reinforcing, because asset prices move up, etc. We have seen this many times before.

One of the consequences is that you get increasingly risky debt structures, and, increasingly, debt it used to finance things that cannot be repaid. If you look at countries like the United States and Spain before the crisis, a lot of the debt was being used to finance consumption. In addition, and this is the problem in China, a lot of the debt is used to finance assets, the value of which isn’t sufficient to pay the debt, ultimately. We saw that again in Spain and in the United States in the real estate boom.

In China, we are seeing it in the real estate boom, in the infrastructure boom, and in the huge expansion in manufacturing, well beyond the needs of the global demand, so in every case, we can narrow it down to the same thing. Debt levels are going up, and that is generating tremendous growth, but it is not generating sufficient repayment capacity, and ultimately, it has to stop. So, it is not strange that we have seen the contraction occur first in the rich countries, and it is going to move over to the developing countries.

A lot of people have argued that because the U.S. and Europe are in economic crisis, and the developing world, including China, is not, that that signifies some major break from the past, but that is really not the case. We actually saw the same thing happen in the 1970s. In the early mid 1970s Europe slowed down, the U.S. slowed down dramatically, but we didn’t see the impact of that slowdown in the developing world, in large part because of the recycling of the huge petrodollar surpluses into the developing world, which funded a massive investment boom in countries like Brazil, but also significantly misallocated investment.

So what ended up happening is that the developing world had their version of the 1970s crisis in the 1980s after the credit tap was turned off. I worry very much that we are going to see a repeat of that. The huge investment-driven boom in China has generated great growth in China, and great growth in a number of developing countries like Brazil that have been exporting commodities to China, but it is not sustainable. So the global crisis that first started in the U.S. and moved to Europe is still due to move in a significant way, to China and the developing world.

David: It was in the recent World Bank study on China, looking at the past, from 1978 to 2030, that the authors suggest, and I quote them, “The forces of globalization will remain irresistible, and further cross-border movements of goods, services, finance, people, and knowledge, will endure and deepen.” But you intrigued me when you wrote several years ago that globalization is primarily a monetary phenomenon, in which expanding liquidity induces investors to take more risks. This greater risk appetite translates into financing in technologies, and investment in less developed markets.

In other words, it really is a function of credit and a function of liquidity flows – this globalization phenomenon. Innovation and technology – all of that is along for the ride, but it is not necessarily introduced on the basis of innovation and technology. It is liquidity flows that precede. That brings us back to the point of decoupling, or the reality which emerging markets are just on the cusp of facing, which is sort of Act II in this crisis. We were Act I in the developing world, and the emerging markets, really, are the next ones in line. Maybe you could speak to this idea of globalization. Is this likely the end of a period of globalization, and can you tie in some political anticipation with that?

Michael: The history of globalization makes pretty clear that one of the things that always comes out during these periods is globalization or whatever the contemporary word for it is, is that it is often proclaimed as being irreversible. It is part of the process that we claim that it is irreversible, and yet in every case, it has not been irreversible. There has been a significant contraction of what had previously been called globalization. So the fact that the World Bank claims that it is irreversible is par for the course. That is part of the process, and it has very little information content, I would argue.

But the way it seems to work, for example, we have been through, in the 1990s and the past decade, a major technological revolution, driven by personal computers and the Internet. But the truth is that neither of these were recent innovations. With the personal computer, the most important steps were pretty much taken in the 1970s, and the Internet, itself, arguably, was invented in the 1960s. It wasn’t really until there was a significant amount of capital available to fund rapid expansion in the Internet infrastructure that we really began to experience the effects of this Internet revolution.

So I would argue that what really drove this stage of the technological revolution was the availability of financing, and if you look at past stages of the industrial revolution, they always seem to coincide with burgeoning stock markets, massive capital flows to risky countries, etc., and I think that is not a coincidence. It is capital that drives all of that. And just as we have periods of rapid credit expansion, those are always followed by, when they become excessive, and they usually tend to become excessive, periods of credit contraction, and it is during those periods when we see a lot of the reversals of the supposedly irreversible process.

And never in history has there been a major globalization contraction, in which the poor countries, the peripheral countries, the developing countries, didn’t suffer disproportionately. There have been periods when it seemed it wasn’t going to happen, for example, in the 1970s. But it always does happen, and the reason I suspect it happens is because developing countries, peripheral countries, are even more sensitive to changes in liquidity than the rich countries are. So, as you get that contraction, the rich countries suffer, and the poor countries suffer more, although it may be a delayed suffering.

David: Setting aside, for the moment, the idea of globalization, and perhaps this being the end of a period of globalization, the Chinese are set on rebalancing. At least in word, they are intending to rebalance, and as they say, the old phrase, “There’s many a slip twixt the cup and the lip.” They may, or may not, be able to achieve that. But which policies would you focus on if you were advising the Chinese leadership, and which rebalancing scenarios are tenable, and most likely to be implemented?

Michael: The problem with rebalancing, and it has been many years, basically since 2005, when consumption was brought to what was then an unprecedented 40% of GDP. Policymakers in Beijing said, “This is a real problem because it means we are overly reliant on exports and on investment. To generate growth, we need to rebalance the economy.” In fact, the imbalances got worse, not better, and I think the reason is fairly well understood now.

The same process that generated lack of growth also generated the imbalances, and the way I think about it is that there are a number of processes, but the three most important were an undervalued currency, and it is important to understand how that works. When the currency is systematically undervalued, that is effectively a consumption tax on households, so it reduces the value of their income. And it is a tax, the proceeds of which are used to subsidize the tradable goods sector.

So think about how that works. Basically, you are forcing households out of their income to subsidize the export sector, the tradable goods sector, so the tradable goods sector grows more quickly than it otherwise would. But household income grows more slowly than it otherwise would.

The two other important mechanisms are relatively low wage growth. Wages have grown quickly in China, but they grew more slowly than productivity. Normally, if wages and productivity grow at the same pace, then workers maintain their share of what they produce, but if wages grow more slowly, you can think of it, again, as a kind of tax on workers, and the proceeds of that tax are used to subsidize employers. Again, notice the impact that it has. It causes GDP growth to be higher than it otherwise would be, because employers are subsidized, but it causes household income growth to be lower, because the households pay for that subsidy.

The final mechanism is by far the most important, and that is, incredibly low interest rates set by the central bank. Very low interest rates, basically, tax savers. They confiscate the wealth of savers, and they use that confiscated wealth to subsidize borrowers, and in China, the household sector are net savers, and the net borrowers are infrastructure investors and large companies and local governments, etc.

Again, notice what the impact is. You are taking money away from the household sector and you are subsidizing borrowers, so you are pushing up GDP growth faster than it would have been, and pushing down household income growth. The result is, you get very, very rapid growth, but rising imbalance, and in order to reverse those we know what we have to do. We have to raise interest rates, we have to raise wages, we have to raise the value of the currency. But if you do that, you eliminate the source of that rapid growth.

The problem is, if you don’t do that, you run into a debt crisis, so they are sort of stuck, there is no easy way out of this mess. They have to gradually reverse all of these transfers from the household sector, and it is not going to be easy, it never is. No country has been able to do so easily.

David: There seems to be a parallel here between China and the U.S. There is repression of rates, which, as you just said, always entails a transfer from households to the state. That transfer of wealth is happening in the U.S. through the zero interest rate policies currently in place, and a similar transfer has occurred, as you mentioned, for years in China. How does the Chinese government reverse the flows, and increase the role of household consumption as a contribution to economic growth? You say gradually is the key, but as we started the conversation out by saying, “We need to do this sooner than later, 4-5 years is really what we have.”

This harkens back to a conversation I had with Stephen Roach about a year ago in which he was very positive about the prospects of the Chinese accomplishing this transition. The one variable he suggested they don’t have enough of is time. So it’s a gradual process on the one hand, but you can’t take all the time in the world because you don’t have it. Tell us about this dilemma.

Michael: That’s the problem. The transition has to be made fairly early on in the process when it becomes clear that investment is being misallocated. The problem is that everything is going so well that those who advocate a radical transformation at the growth model are generally sidelined. “Everything is going so well, why would you say we have to change the rules? It’s been working great.”

As a result, the changes generally don’t take place until it is too late. I hope Stephen is right about how difficult or how easy the process will be, but if he is, it will be unique in history. Every country that has gone through this growth model has always had a very, very difficult adjustment, and in fact, the adjustment always turned out to be much worse than even the biggest skeptics thought it would be. So, maybe China is different, but when I look at the numbers, the only difference I can see is that the imbalances have been pushed to a greater extent than we have ever seen before, which, in and of itself, doesn’t give me a lot of comfort that China will be different.

But one thing that I think is very important to note, David, is that my projection for growth rates in China over the next decade is that they are going to average something like 3%. Not immediately, it will be front-loaded, more now and less later, but that is the growth rate at which a plausible rebalancing can take place. A lot of people say that would be a total disaster for China and the world, but that misunderstands the meaning of rebalancing.

If China rebalances, household income must grow more quickly than GDP, that’s almost the definition of a rebalancing, in the case of China. So even if growth rates drop to 3%, if household income grows at 4-5%, China will be genuinely rebalancing, and Chinese households won’t be suffering. They will continue to do almost as well in the future in the next decade as they did in the past decade. The rebalancing often sounds scary when we look at GDP numbers, but if we look at household income numbers, it tends not to be so bad.

So that means that they managed the transition well, which is a big if. Not every country has managed the transition well. But what I am hoping is that if they begin the process in the next year, seriously making the kind of reverse transfers to the household sector, it should not be nearly as damaging or as painful as we think, except in terms of GDP growth, which doesn’t matter so much, and in terms of investment growth, which does matter because if you are a commodity exporter, like Brazil, it will be very, very painful. If you are a commodity importer, like Switzerland, it will actually be quite beneficial.

David: We go back to the political realities and you suggested this in discussing some of Victor Shih’s work, as well as Minxin Pei’s, and there is this segment in society which has benefited immensely from the last 20 years of growth. Can the transitions which need to take place, essentially expanding the ranks of the enfranchised, can that happen voluntarily, or are we talking about something that is politically unlikely? If that is the case, it would certainly raise the prospects of a debt crisis in China within the next several years.

Michael: That’s the million-dollar question. One of my favorite political economists, Jeffrey Frieden, at Harvard, wrote a book in 1993, I think, called Debt Development and Democracy, in which he talked about the experience of Latin America under very similar conditions. I think Brazil, in the 1960s was the first country to be called an economic miracle. One of the points that Frieden makes is that when you introduce distortions into an economy, obviously certain sectors benefit. And the longer and more extreme those distortions, the more they benefit, and of course, the more powerful they become.

Historically, those sectors have traditionally been the greatest impediments to reform, for obvious reasons. In China, I think people are very well aware of that. There is a very contentious debate taking place with the coded phrase “vested interests.” If you read articles in China and you see that phrase, basically, that is what they are talking about. Economists know what needs to be done, though there is some debate, but broadly speaking, we are in agreement. It just becomes politically very tough to do that because of eliminating the source of a great deal of wealth generation in certain sectors of the economy, and clearly, they are going to oppose it.

David: Yes, the vested interests, and certainly this is a Western press-oriented thing. I don’t know how much veracity there is to it, but out of the 5,000 most influential people in the one-party system in China, we are looking at a cumulative net worth of close to 90 billion dollars. Again, the wealth-generating machine behind that is what we are talking about being re-geared, or removed, or certainly, retooled, and for those 5,000, or perhaps many more, within the party, that’s a bit of an issue. So there is some question as to whether or not that can be done or will be done, or if the market will force it.

I am also curious on a different issue. A past guest of ours, Barry Eichengreen, was involved in a scholarly gathering at the University of California, San Diego, last week, and the topic of discussion was internationalizing the renminbi. Again, this is a critical step toward global rebalancing, in his opinion, because when we are talking about Chinese rebalancing, we are, in fact, talking about not just Chinese rebalancing, but global rebalancing – underconsumption on the one hand, overconsumption on the other, if you are looking at the developed world. What is your view on internationalizing the renminbi, and how quickly could that process be moved ahead?

Michael: I was at that conference. I actually spoke the day before Eichengreen did. One of the points that I tried to make, and I don’t think Eichengreen would disagree, is that internationalization of the currency for a developing country is a very risky strategy, and it only makes sense to do so once you have a very robust and flexible financial system in place. Both of us agree, and in fact, I think most people agree, that the financial system in China is anything but robust and flexible.

So the argument there is that it is possible that one day the renminbi will become a major international currency, but it is not going to happen soon. In fact, I think Eichengreen made that argument very forcefully. I would add to that, that much of what seems to have been the process of internationalization is, I won’t say fictitious, but it doesn’t really represent what it looks like it is representing.

A lot of redenomination of trade in renminbi occurred not for transactional reasons, but for speculative reasons. I won’t bore you with the details, but much of that trade is really not trade, it is other stuff. The same thing with the use of the renminbi by foreign central banks – those are special one-off deals, and when you dig through the fine print, you will see that it is not really so clear that that is happening.

There is an argument that is widely made within China that a number of proponents of internationalization of the renminbi, for example, believe that much of the central bank strongly favors greater capital flexibility, fewer capital controls, and a more international role. The argument is that because internal reform is so difficult, if they internationalize the renminbi, that will exert much more pressure to reform the domestic financial system.

This was, to a certain extent, the strategy of the WTO. Before the WTO, China, itself, wasn’t a single market. It was lots of different markets. Each province had its own trade barriers, and Zhu Rongji, the then-premier, tried very hard, and largely unsuccessfully, to break though those barriers. So my interpretation is that one of the reasons China was so eager to join the WTO is because the WTO agreement, itself, would force many of those barriers internally to drop. It would become very difficult to have free trade if there wasn’t even free trade domestically.

Using an external force to force domestic change sometimes works, but sometimes it doesn’t work. My favorite example is Argentina, or perhaps even the peripheral countries of Europe. In 1991, Argentina put in place a currency board, which meant, basically, it gave up control of the currency, and handed over control of the currency to the U.S. Fed. The reasoning there was that we are completely unable to prevent provincial governments from spending money left, right, center, so by them giving up control of monetary policy, we will force them to adjust.

It didn’t work that way. It ended up becoming a disaster for Argentina. You can say that Portugal, Spain, Greece, and some of the other countries felt that by joining the euro, they were going to force monetary discipline upon themselves. It looks like that isn’t going to work either.

It is risky to try to use external pressure to force domestic change, but perhaps the reason they may be doing this, if this is, indeed, what they are doing, is because they recognize how difficult it is going to be to reform the domestic financial sector without external pressure, so that may be part of the thinking.

David: Let’s wrap up, and maybe end with a comment on Europe, because it is, as you say, an interesting parallel between the monetary sovereignty which was given up on a voluntary basis by the EU members. There is now an interesting feedback loop into China. The eurozone is one of the largest export destinations for Chinese goods, and current weakness in the eurozone underscores the importance of some sort of a rebalancing in China, although investment is far more important for Chinese GDP even than exports. But where do you see the eurozone going? Toward tighter fiscal and political union, or toward disunion? In a nutshell, what is your sense of Spain, Italy, Portugal, and then the core countries, as well?

Michael: I have never really believed that the euro would survive. Currency unions have a history, and not a very good history. Typically, the only successful currency unions are those like that of the United States after the Civil War. They can survive under conditions of fiscal union, but they almost never survive otherwise. So I was never particularly impressed with the survivability of the euro.

But what we are seeing recently is a very classic change in type of crisis, and there is a lot of name-calling and blame back and forth, whoever’s fault it is. Germany put into place policies that forced up the savings rate in Germany, and there had to be an automatic correspondence somewhere else, and given monetary union, that somewhere else ended up being within Europe. So it automatically forced down the savings rate in countries like Spain, etc.

Now Spain needs to adjust, and what Keynes pointed out is that you can’t have adjustments on one side. You must have adjustments on both sides. While we are forcing up the Spanish savings rate, we must simultaneously force down the German savings rate. In other words, if you want Spain to repay Germany, then Spain must run a current account surplus, and Germany must run a current account deficit. Otherwise, it is impossible for there to be net capital flows in that direction.

So the argument is, and quite a number of people are making this argument – Krugman, Martin Wolf, etc. – that it is meaningless to call for austerity in Spain without calling for a massive reflation in Germany, because if only Spain adjusts – and when I say Spain, I mean all the peripheral countries, but it is the country I was born in so I usually refer to it – then the adjustment must take place through a significant rise in unemployment. And then Spain is faced with a choice. It can intervene in trade and force the unemployment into Germany, or it can not intervene in trade, and keep the unemployment at home, and under those conditions, Spain would probably intervene and leave the euro.

There is really where the problem is. If both Spain and Germany make the right kind of adjustments that cause the German surplus to turn into deficit, and the Spanish deficit to turn into surplus, then it is at least theoretically possible that we can get out of the European crisis without a significant rise in unemployment – theoretically. Practically, it could be quite difficult. But if Germany doesn’t make an equally big adjustment as Spain does, then it is even theoretically impossible for the adjustment to take place without a significant rise in unemployment, and that is like what we are seeing in Spain – unemployment is at 20-something percent – but that had to happen, there was no way around that.

So my view is that since there is very little evidence that Germany, rightly or wrongly, is willing to take the necessary steps to reflate the domestic economy to bring the savings rate down to run into a large enough current account deficit that allows peripheral Europe to survive the crisis, then there are only two other possibilities. One is that Spain accepts very high levels of unemployment for many, many years, but I think in a well functioning democracy that is impossible, and rightly so.

That just leaves the other possibility, and that is that Spain devalues the currency, which means leaving the euro. So one way or the other, I am convinced the euro breaks, and I am convinced that several countries will have to leave the euro. Just from a purely arithmetic point of view, I really don’t see any way around that, absent a major change in attitudes in Germany. If that happens, we are going to have a year of panic and chaos.

But it might end, for the peripheral countries, much more quickly than that, because once they are able to adjust their domestic currencies, if they don’t completely mismanage the process, we could see fairly decent growth. After all, remember after the Asian crisis, after the Mexican peso crisis in 1994, after the Argentine crisis in 2001, there was a very, very difficult year, but after the adjustments were made, all of those countries grew quite quickly.

So it is not necessarily bad for the peripheral countries to break and leave the euro. In fact, I would argue that the sooner they do it, the better. But the country that will suffer the most, and this is very clear from the historical precedents, is the leading surplus country, which in this case is Germany. If the peripheral countries leave the euro, Germany will be the one that suffers the most, so it is in their interest to do whatever it takes to reflate the domestic economy, but that is just politically a very hard sell, so I don’t expect it to happen. That is a long way of saying, David, that I really don’t think the euro survives, and I have never really believed it would.

David: So then coming back to China, if we have a year of panic and chaos, as a result of dissolution of relationship in the eurozone, is that a great temptation for the Chinese to, essentially, put in place what they did in 2009 and 2010 – a massive stimulus to the economy? Can they avoid that temptation and perhaps take the energy of the moment, negative as it may be, and look at it as an external motivating factor pushing them toward rebalancing on a faster time frame? Which would you suggest the direction will be? Will the Chinese try to stimulate the economy and do what they did a few years ago?

Michael: I think they will try to stimulate the economy, but nowhere to the extent that they did in 2009-2010. I think that that is now widely seen as having significantly worsened the imbalance within China and they are simply not going to do it again. But if a problem in Europe causes a very rapid growth contraction in China, then the Chinese will be forced to respond one way or the other, or else they will see a massive run-up in unemployment, which of course, nobody wants to see. So I think if we get a collapse in Europe, there will be a tendency, a very strong temptation, to step on the investment accelerator once again, although not to the extent of 2009.

This highlights part of the problem, and that is that this is the worst possible time for China to go through the adjustments. The way I think about it, if I can add a little bit more gloom here, is that we know historically how you clean up a banking crisis. It is always the same. The household sector pays to clean up the banking sector. They can pay directly, for example, in the U.S. we bailed out the banks and now we have to raise taxes to repay those loans. They can do so indirectly through financial repression, which is occurring in the U.S., and in Europe, and in China.

But one way or the other, the household sector must pay to clean up the banking system. So if you look at the enormous bill that European households have, the very high bill that American households have, what promises to be an enormous bill for Chinese households, and the Japanese are still cleaning up their banking mess of the 1980s, that suggests to me that in the major economies, and lots of minor ones, households are going to be busy cleaning up banking disasters, and if that is the case, we can’t really count on growth in consumption. They are not going to have the money left over to increase their consumption significantly.

So it is a really tough problem that we have, because I don’t see any consumption growth anywhere. In the U.S., maybe that is not such a bad thing, because we over-consume, so it will be painful, but at least we will be adjusting in the right direction. But in countries like Japan, China, and Germany, it is going to be very, very painful.

David: Let’s leave it there until we are having a more in-depth conversation in Beijing in a few weeks’ time. We have more questions and topics to discuss, and part of our effort is to seek perspectives from other parts of the world, a different geography, a different vantage point, and we appreciate your contribution to our understanding. Let’s carry on the conversation in a few weeks’ time. Thanks for joining us.

Michael: Thank you very much.

Kevin: David, obviously that was a fascinating interview, but the thing that I really liked was the twist that he had on globalization. We look at globalization as a phenomenon unto itself, and sometimes it grows, sometimes it shrinks, we have looked at that over the last five years. But as it applies to liquidity and availability of credit…

David: And that is, in fact, what fuels change. That is what allows for innovation and technological improvement. It is fascinating that liquidity cycles, and ultimately, debt cycles, or credit cycles, do impact that globalization cycle.

Kevin: David, the sobering thing about that is that we are at just about the lowest interest rates that we can possibly have. We have a lot of printed money right now that is not doing anything.

David: We are at the end of a major credit cycle, and that is what is put into question here. If you are a new listener and unfamiliar with the interview that we did with Harold James a year or so ago, go back and listen to the archives. We did a number of interviews with Harold James, and we dealt with the end of globalization, and what he viewed as a crackup in terms of consolidation and improvement in global relationships, not unlike what we saw in 1914, something that he saw, actually, in decline, not only over the last few years, but on an accelerated basis over the next few.

Kevin: David, I thought it was interesting when you shifted over to Europe, that he actually used Argentina as an example of what not to do.

David: Exactly. The book that he recommended, Frieden’s book, was one that I have looked at before, too. The test cases that are in there, the examples given of Mexico, of Chile, of Argentina, are models of what it means to work through a debt crisis. In fact, what Argentina attempted to do was keep the flow of capital between London and Buenos Aires open. They were doing at least ten times the amount of trade as anyone else in South America at the time, and they were dependent on European trade, so to be in a debtor relationship and default, they assumed would cut them off from the capital markets, and so they did their best to maintain that creditor relationship, when, in fact, everyone else in Latin America…

Kevin: All the other countries cut and ran, and then they recovered much quicker.

David: They recovered much quicker, which brings us to Greece and Spain, and the idea that austerity under these circumstances is the issue. While we may philosophically champion the idea of austerity, or just living within your means, one of the things that you have to realize is that they don’t have monetary authority, they don’t have monetary sovereignty. That would allow them to ease the pressure of the debts that they are carrying.

Kevin: David, I think we have to look at the political side of things, too. Michael Pettis did a brilliant job on talking about liquidity and credit availability, those are financial and economic elements. But we have talked about this before. The political and the geopolitical also factor in, so this is going to drive us to our guest next week.

David: That’s right, our conversation with Minxin Pei, from Claremont McKenna College.

Kevin: Just like this week, David, I am sure that will be a fascinating interview.

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