Michael Pettis: Global Cooperation After the Fall

Weekly Commentary • Feb 13 2013
Michael Pettis: Global Cooperation After the Fall
David McAlvany Posted on February 13, 2013

About this week’s show:

  • Involuntary re-balancing of the world
  • More investment is not the solution for China
  • The Financial Repression “Tax”

About the Guest: Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987. Read more: click here

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we are joined today by Michael Pettis.

David: He is back on the program and we are looking at a couple of issues which he explores in depth in a new book called After the Fall: The Future of Global Cooperation.

Kevin: He co-wrote that with a number of other authors, did he not?

David: That’s right. Jeffry Frieden at Harvard, Dani Rodrik at Harvard, and Ernesto Zedillo, who is at Yale as an economist.

Kevin: He used to be the president of Mexico.

David: That’s right, so as an economist in Mexico, again, they are bringing a very unique insight into globalization themes, international cooperation, and what stands between the world working together or falling to pieces.

We began to explore some of the challenges to globalization in a conversation with Harold James two years ago. This brings us up to date in terms of the crisis, resolution, to whatever degree we have had that, and what we see as international cooperation or the lack thereof, in the present and future tense.

David: Rebalancing, these days, is most commonly associated with China, the use of that language. What you have suggested is that what we need is a broader rebalancing, in fact, a global shift in capital and trade, but not necessarily on a voluntary basis in some cases. Maybe you can frame this for us and put it in context.

Michael Pettis: I think the important thing to remember, and I think this is very often missed in a lot of the economic debates, is the automatic linkages from one economy to another. To take an example that I like to use a lot, since I was born and grew up in Spain, is the very low Spanish savings rate that has developed, especially the last decade.

Most people, if you were to ask them why the Spanish savings rate has collapsed in the last decade, or why the Spanish savings rate is so low, would give you all kinds of answers. Some of them are completely nonsensical, the typical cultural answers. “Oh, the Spanish love to have a good time, and they don’t really like to work, and so their savings rates are very low.”

That, of course, is nonsense, because if you look back over the last 30-40 years there has been tremendous variation in the savings rate and you can’t really explain that by assuming tremendous variation in Spanish culture. What is more, contrary to popular perception before the crisis until this huge surge in unemployment, the typical Spanish worker actually worked longer hours than the typical German worker. Spain ran a fiscal surplus, not a fiscal deficit.

What really explains the savings rate? It turns out that it really has very little to do with cultural attitudes or cultural preferences, and by the way, of course, this argument is very relevant to the United States, too. In the case of Spain, the main cause of the very low Spanish savings rate, it turns out, had to do with policies enacted in Germany at the end of the 1990s. This may seem like a strange thing to say; you will often hear people say, “No one put a gun to the head of the Spanish consumer, or the American consumer, and forced them to consume.” That sounds like a very solid common sense type of observation, except that it totally misses the point.

What happens is that the savings and investment balance in the world is a balance. Savings and investments are equal to each other. For the sake of simplicity, let’s pretend that there are only two countries, Germany and Spain, and respectively speaking, because of monetary union, this is a pretty good approximation of what happened in Europe.

In the late 1990s, the Germans, with their fabulous culture for savings, it turned out, weren’t really saving very much. In fact, Germany ran some of the largest trade deficits in the world almost every year in the 1990s, and it also was still suffering from the absorption of East Germany so that it had fairly high unemployment, and the steps that the German government took to address this problem involved, among other things, restraining wage growth in Germany to increase the competitiveness of German industry and in order to boost employment.

This may or may not have made sense, but it had tremendous implications for Germany’s partners within Europe because the savings rate, as you know, is simply national production minus national consumption, and what determines the consumption levels?

Basically, three things determine the consumption level in any country. One is income inequality. As you know, rich people consume a smaller share of their income than poor people, so in a very unequal country, you will have a high savings rate. That really wasn’t the problem with Germany.

The second thing is an explosion in credit card consumption, borrowing to consume. That may sound like a cultural thing, too, but in fact, it isn’t. Typically, when you have, like in the United States in the decade before 2007, and like in Spain in the decade before 2007, when you have soaring real estate prices, also soaring bond and stock prices, but mainly real estate, people feel much, much wealthier, and as they feel wealthier, they are more likely to consume more out of current income, simply because your home was worth half a million dollars, and suddenly it is worth a million dollars, so you figure that your retirement egg is up by half a million and you need to save less today to match that.

But the third and most important determinant of the percentage of GDP that is consumed is, of course, the percentage of GDP that is owned by the household sector. The higher the household share of GDP, then, not surprisingly, the higher the household consumption share of GDP. So this household income number is very, very important, and the steps that were put into place in Germany ended up forcing down the growth rate in household income through taxes on wages, etc.

Germany continues growing, but household income grew much more slowly, and since household income grew much more slowly than German GDP, the most obvious consequence, and in fact, that is what happened, is that household consumption grows much more slowly than GDP. Fair enough, but since savings is simply GDP minus consumption, that meant those policies had the force of the German savings rate, not because the Germans are boring, thrifty people who think about the future, but simply because household income in Germany grew much more slowly than GDP.

That is why we made that major shift sometime around 2000-2001, in which Germany switched from being a country where the savings rate was much lower than the domestic investment rate, in other words, the Germans didn’t save enough, to, within a few years, the savings rate being much higher than the domestic investment rate. The Germans suddenly became the frugal Germans of myth.

The current account surplus is exactly the difference between the savings rate and the investment rate. If you save less than you invest, then you must import foreign savings and so you must run a current account deficit. If you save more than you invest, you must export the balance and you run a current account surplus. As the German savings rate soared, it had to happen that the German current account deficits of the 1990s turned into German current account surpluses, which really began around 2000-2001, and they quickly became massive surpluses.

What does all this have to do with the Spanish love of siestas, so to speak? If Germany runs a current account surplus, which is exactly the same thing as saying that Germans save more than they invest, then somebody must run a current account deficit. The surpluses and deficits have to balance to exactly zero.

That meant that as Germany forced up its savings rate it would convert its current account deficit into a current account surplus and somebody, the rest of the world, had to be on the other side of that current account surplus. And it turns out, for very obvious reasons, that the rest of the world was peripheral Europe, which I will simply call Spain.

How did it happen? Because of monetary union and because of control of interest rates by Germany, Spain ended up with interest rates that were much too low, so Spain had, effectively, a real estate and a stock market boom, driven largely by excessively low interest rates and German capital exports from Germany to Spain, mainly through the banking system.

It turns out that in a two-country world, and we can go into a real world with lots of countries, but the argument doesn’t change, it just becomes much more complicated to explain, if the Germans force up their savings rate higher than their investment rate, then Spain has only a few ways it can respond, four ways, basically.

One way is that it can refuse to accept the German capital, and remember, if Germany exports capital to Spain, it must run a current account surplus against Spain’s current account deficit. So it can refuse to do so. It can impose a trade tariff. It could devalue the currency, and so on. Of course, under the euro Spain couldn’t do any of that. It had no choice but to run the corresponding deficit.

So in Germany, the surplus is the same thing as saying that savings exceeded investment and in Spain, the corresponding deficit meant that investment had to exceed savings, so somehow or the other, as long as Spain didn’t intervene in trade, its savings rate had to be low within its investment rate.

There are a few ways it can do it. One way it can do it is by significantly increasing investment in infrastructure, investment in real estate, etc. And Spain did that, and in the beginning, much of that investment was probably needed, but as often happens when you have tremendous capital inflows and extremely low interest rates, the investment becomes increasingly misallocated, so there were huge amounts of apartments built in the part of Spain where I live, and where my family still lives is dotted with empty apartment buildings. There was massive building of apartment buildings, much like what happened in many parts of the United States.

So the second thing Spain could do was to increase investments.

The third thing Spain could do was to increase consumption by borrowing, and in fact, it did that. As real estate prices soared, and as the stock market soared, Spaniards felt richer and richer, and so they increased their consumption for the same reason Americans increased their consumption with the soaring real estate, stock, and bond markets.

The fourth thing Spain could do is, and this is not a choice, but it could happen, and that is, it could let its unemployment soar. Why would that work? Because as unemployment goes up, as you fire workers, their income goes down, but their consumption doesn’t go down as quickly. They consume either out of savings, or they consume out of social welfare payments, or they borrow from their relatives.

But those are it. I have listed all the ways that Spain could adjust to a rise in German savings. It could either refuse to accept it, intervening in trade, which legally it wasn’t allowed to do; it could increase investment, it could increase investment fueled by debt; it could increase consumption fueled by debt; or it could increase unemployment.

Perhaps, not surprisingly, Spanish politicians were not very eager to try the fourth way, so they were left with the second and third ways. In a perfect world, they would have increased investment in necessary infrastructure, but that is tough to do, and for whatever reasons, they didn’t do it. They ended up increasing investment and increasing consumption, and much of this investment was tied to the real estate bubble.

As long as they could keep borrowing, they could choose to increase investment and consumption rather than choose to increase unemployment. So everything was fine and Spain experienced a massive bubble, income soared, everybody was very happy, until around 2008 when the crisis hit Spain. After it hit, suddenly they were unable to borrow.

So we are left with my list of four things that Spain could do: Attack trade, intervene in trade; borrow to invest; borrow to consume; or let unemployment go up. Since they were not allowed to intervene in trade, and since they could no longer borrow to invest and they could no longer borrow to consume, well then, clearly, that left only alternative #4, and in fact, that is exactly what is happening. Unemployment has soared.

So you will notice that what really drove changes in the Spanish savings rate had very little to do with Spanish preferences. They were largely a function of policies in Germany at the end of the decade, and of course it is not a coincidence that if you look at Ireland, Greece, Italy, and a number of other countries that entered the euro with relatively high inflation, all of them switched from countries that had excess savings in many cases – Ireland, for example, was a big surplus country in the 1990s – to countries all of whom had deficient savings.

In other words, all of them saved much less than they invested, and they ran current account deficits and they had asset bubbles. It isn’t a coincidence that all of these countries got hit at the same time, roughly the same time that Germany switched from deficit into surplus. One of the points that I really try to make in my book is that if you want to understand the sources of the financial crisis, which I think most of us agree were very much tied to the great savings and consumption and trade imbalances of the previous one or two decades, then you have to recognize the linkages between the different economies.

I have been saying for the last two years that Spain has to leave the euro. It will leave the euro. The only thing that will prevent it from leaving the euro is not good policies in Spain. It’s not in their hands any more. If you want Spain to stay in the euro, then you need the Germans to sharply cut consumption taxes and income taxes and increased investment, because the Germans can increase investment and reduce savings and force their current account surplus into a large deficit. It is only that way that Spain can then run the corresponding surplus at relatively low levels of unemployment. But the Germans are very worried about debt themselves, so they refuse to do that.

So remember, as long as Germany is running that large surplus, Spain still has only those four options: To intervene in trade, which basically means leaving the euro and devaluing; borrowing to invest, which they are no longer able to do; borrowing to consume, which they are no longer able to do; or keep very high levels of unemployment. It has nothing to do with what Spanish policy-makers do, or very little. People say that the Spanish government should be bringing down wages to make Spain more competitive, and of course, that is exactly what they are doing, and how do you bring down wages? You bring down wages through massive unemployment.

The only options for Spain, unless Germany reverses its current account surplus into a current account deficit, are very high unemployment for many more years, until finally wages are forced way down, or intervene in trade, which means leaving the euro and devaluing. Maybe we have to wait until the elections, but so far, in my opinion, there is very little evidence that the Germans are willing to reflate their economy sufficiently to allow Spain the necessary current account surplus to repay its debt. Then the only alternatives for Spain are the politically impossible alternative of keeping unemployment at 20-25% for 3-6 more years, or leaving the euro.

I think, like I said, the former is politically impossible, as the political system in Spain is under tremendous strain, so that only leaves them with leaving the euro, and the story, by the way, is true of all of the other peripheral countries. As long as Germany doesn’t reflate, their options are limited to high unemployment, or leaving the euro. And ultimately, I think they will choose the latter.

David: So, Germany is at the center of the solution for the eurozone crisis.

Michael: Absolutely, just like the United States was in the 1920s. It was the same problem.

David: And could you, by extension, say that China is, to some degree, in the same place? We are talking about two similar surplus countries.

Michael: Absolutely, so if you ask people why the Chinese save so much, you will get all the nonsensical cultural answers. “Well, the Chinese culturally are Confucians, and Confucians save a lot of money.” That is simply not true. For over a thousand years, the criticism of Confucians was that they didn’t save money, and in fact, as late as the mid-1970s, Prime Minister Li of Singapore complained that he was raising taxes on wages in order to force up the savings rate because of the complaint that there were too many Chinese in Singapore and the Chinese simply don’t save.

So what explains the very high savings rate in China? It is very easy to explain it. China has the lowest household income share of GDP maybe ever recorded in times of peace, so not surprisingly, it has the lowest household consumption share ever recorded, and GDP minus consumption is savings. So if you have the lowest consumption, you must have the highest savings.

If China runs very high savings, which exceed domestic investment and force it into a current account surplus, then somebody else must run the corresponding deficit and it must do so either by raising its investment rate, or lowering its savings rate. Since the U.S. is a very open and flexible economy, and it is capable of a financial system that is sophisticated enough that it is capable of running large current account deficits, whenever any country in the world wants to run large current account surpluses, the corresponding deficit is usually in the United States.

We saw this in the 1980s, and we saw it with the Japanese, and we see it again in the last recent years with the Chinese. Unless the U.S. intervenes in trade, it has no choice but to accept a large current account deficit if the rest of the world is going to run a large current account surplus.

David: Is it fair to say that a financial crisis is one means of correcting trade imbalances?

Michael: Absolutely. In fact, historically, I would say every financial crisis, unless it is associated with war or famine, is associated either with significant trade and capital flow imbalances, the 1930s, the debt crisis in the developing world in the 1980s most recently, or is associated with domestic financial imbalances. These are one of the two great sources of financial crises.

David: Interestingly, in this case, at least in the U.S., we have the balance of payments mechanism. As you mention, this is not a new crisis, this is almost a textbook case of global trade and capital imbalances, but we also have deregulation of financial services and high expanded use of derivatives, which maybe are just correlated, and not necessarily the cause. You would argue that they just happen to be sort of coincidental in the mix?

Michael: I wouldn’t say coincidental, I would say that this is normally what happens on the back of these great imbalances. A lot of people will say there was significant deregulation in the United States leading up to the crisis, and therefore deregulation was the cause of the crisis, in fact is a major argument in continental Europe.

My problem with that is that if you look at the history of financial crises, they are all remarkably similar. There are not too many flavors, and it is hard to find any strong evidence that crises are more likely to occur in highly deregulated financial systems than they are in the highly regulated financial systems.

Remember that the whole prestige of the so-called Anglo-Saxon financial system, the fragmented deregulated system, really developed in the last 20 years, in particular, as a response to what happened to the great exponent of the other type of financial system. We sometimes call it the Continental system.

But its greatest exponent was really Japan in the 1980s. There you had a highly regulated financial system, very close links between the government and the banking system. In fact, you could say the banks basically did what the government told them to do. There was very little in the way of derivatives, there was no such thing as securitized mortgages, and yet, Japan went through a massive financial system-inspired bubble, and over-investment, and then it collapsed.

So it is very hard to say that it is deregulation in and of itself that created the crisis, because how would you explain the Japanese crisis if deregulation was the problem? Whenever you have a massive expansion in the money base, you end up having problems in the financial system, whether it is highly regulated or highly deregulated.

David: If we have that lost decade with Japan, could we also have a lost decade with China?

Michael: I have very little doubt that we will. It will be a different kind of lost decade in the sense that Japan had 20 years of average growth of roughly half a percent. I don’t think it gets that bad in China, but when I think about the sheer arithmetic of rebalancing, it is very hard for me to make a plausible case for average growth rate over the next ten years to exceed 3-4%, so my prediction is that if the rebalancing isn’t mismanaged, that will be the average growth rate for China over the next ten years, front-loaded, more now, less later.

David: In the fourth quarter of 2012 we saw government investment, a resurgence of that, and I was thinking of Kipling’s Gods of the Copybook Headings, “the burnt bandaged finger goes wabbling back to the flame.” Can they leave it alone? Can they actually move toward a different model of growth, consumption-oriented, less investment-oriented, or in periods of insecurity are they always going to spend and spend?

Michael: For the last 30 years China has had a whole series of crises. We had an inflation crisis in 1985-1986. We had a huge inflation crisis in 1993-1994 when many people thought that the stability of the country was at stake. We had the Asian crisis of 1997. We had, effectively, a banking crisis by the end of the decade when most estimates put the total amount of nonperforming loans in the Chinese banking system at around 40%. We had the crisis of 2008-2009 and yet China never stopped growing, and the reason it never stopped growing was because it responded to every crisis in the same way. It made the banks unleash waves of investment, waves of credit growth.

For the first 20 years, when China was significantly under-invested and had very limited manufacturing capacity, that worked fine. If you don’t have any airports, then building an airport is a good idea. If you have very bad roads, then building better roads is a good idea. If you have no manufacturing capacity, then building a steel plant is a good idea. The problem is that investment levels have been so high for so long that China began misallocating investment.

The crisis that we face now is the first crisis that cannot be resolved by increasing investments. In fact, China needs to reduce investment significantly. Beijing, I think, understands that. For the last 2-3 years, they have made it very clear that they recognize that investment levels are way too high.

But the problem is you have three sources of growth. You have the current account surplus – and obviously, in today’s world, the world is in such poor shape that you can’t really expect a lot of growth coming from the current account – or you have investment, or you have consumption. Consumption in China is so low that it is hard for consumption to be an important source of growth, so you are left with investment.

Beijing wants to bring investment levels down, but every time they do so, as in the first half of last year, growth rates come down very sharply, so they step on the credit accelerator and the growth rate surges. That is what we saw in the second half of last year and we will probably see high growth in the first half of this year.

The interesting question for me is what happens in the second half of this year? As you know the party changed leaders in October of last year, and the formal change of leadership will be in March of this year, the national leadership. If they are able to consolidate power very quickly, and if they are able to force down credit growth and the investment rate as they would like, growth rates in the second half of the year should slow sharply.

But that is much easier said than done because, not surprisingly, there is tremendous opposition by the sectors and families that have benefited from all of this investment growth to a sharp reduction in investment growth. This whole debate takes place under the heading of “vested interests.” Whenever you see the phrase vested interests in China, that is basically what it means.

We know we need to bring the investment growth rate down and to remove distortions in the financial system, but there is tremendous opposition to doing so and we can’t do it. Somehow or the other, China is going to have to get its arms around this, and I think Beijing understands the problem quite well. I just think that, historically, it has never been easy to make this kind of adjustment because of powerful vested interests.

David: Let’s assume they are successful. What are the implications of Chinese rebalancing for others around the world? Commodity exporting countries would be at the top of the list, but next on the list would be perhaps the U.S. Does our budget deficit run into trouble in terms of our ability to fund it if the Chinese have less in terms of trade-surplus dollars?

Michael: No, that’s one of the big myths. Rich countries don’t need foreign financing. The reason why the United States has to borrow from abroad is because if you run a current account deficit, that must be balanced by capital input. In fact, the U.S. didn’t really go out and borrow from China and from the OPEC countries and Japan.

What happened is the other way around. Those countries aggressively bought U.S. Treasuries as a way of forcing up their current account surpluses, so the corresponding debt ended up in the United States. People very often say if the Chinese stopped lending the U.S. money, the U.S. government and the U.S. economy would be in serious trouble.

But that gets it exactly backwards. If the U.S. wanted foreigners to increase their investment in U.S. government bonds by 1 trillion dollars, it is very easy to do it. Force up the U.S. current account deficit by a trillion dollars, and by definition, there will be a trillion dollars more of foreign financing.

But it would be a very weird argument to make to say that the bigger the current account deficit, the cheaper the funding for the U.S. government, and the smaller the current account deficits, the more expensive the funding.

In fact, it is almost the exact opposite. Countries with high current account deficits tend to have higher interest rates. Countries with high current account surpluses tend to have lower interest rates, and it is because the U.S. isn’t really borrowing from abroad. It is borrowing domestically, but net foreign purchases of U.S. assets result in a current account deficit.

Imagine for a moment that the Chinese started bringing down their purchases of U.S. Treasuries, not violently and quickly, because that would be very damaging for everybody, most of all for China, so it’s not going to happen. But let’s imagine that they brought it down slowly.

First of all, that is exactly what the U.S. is demanding that they do when the U.S. asks them to raise the value of the currency. Raising the value of the currency to bring down the surplus is exactly the same thing as saying, “Buy fewer of our assets,” because remember, the current account and the capital account balance to exactly zero.

Should the Chinese start buying fewer and fewer U.S. government bonds, what would happen in the U.S.? The Chinese current account surplus would contract as the Chinese tradable goods sector becomes less competitive. As a result, the American tradable goods sector would expand, so American companies would be making more money. They would be employing more American workers, so American tax revenues would go up.

At that same time, all of those unemployed workers who are no longer unemployed, would stop receiving welfare payments, so American fiscal expenditures would go down, and that increase in revenues and reduction in expenditures would automatically finance whatever borrowing deal this government would need to do. In other words, the U.S. would be borrowing much less.

David: Your concern would not be with the U.S., but perhaps with the commodity-exporting countries, then.

Michael: No question. China is about 11-12% of the world, if the current GDP numbers clearly reflect the size of the economy. I think the real economy is actually much smaller, but still, let’s accept the numbers. In spite of being only 11-12% of the world, they consume 40% of global copper, 60% of global iron ore, cement, etc. They consume a huge amount, and the question is why?

The reason is very clear. The Chinese expenditures are not consumption, they are investment, and investment tends to be very hard-commodity intensive. Obviously, when you build bridges, you need lots of steel. So as China rebalances away from investment and toward consumption, we are going to see a big shift in the composition of its demand, so its demand for copper, magnesium, iron ore, and on and on, will drop very, very sharply.

That means if you are Brazil, or Australia, or Chile, or Peru, the great boom that you experienced in the last decade is going to reverse itself. The boom was caused by the surge in Chinese investment, and the contraction in commodity prices – which, by the way, I think are going to drop by more than 50% in the next three years – will be caused by a reduction in the investment share of China’s economy.

But it is not all bad. If you are a manufacturing country, particularly a low-grade manufacturing country like, for example, Mexico, in the last ten years you would have been killed because you simply would not be able to compete with very cheap Chinese manufacturing. But if China rebalances, the source of its export competitiveness shifts, as it rebalances it has to raise wages, which reduces its export competitiveness, and most importantly, it has to raise interest rates. That is really the secret of Chinese export competitiveness, extremely low interest rates set artificially by the central bank.

As all of these things happen, China’s export competitiveness gets significantly eroded, but, on the other hand, all of that money, effectively, is transferred to the household sector, so Chinese domestic consumption goes up. So in the best of worlds, China would export less abroad, but sell more to its own domestic consumers, if it manages the transition correctly, which is quite difficult to do.

If you are a Mexico, though – and this is already starting to happen, it has been happening in the last year or so – suddenly, your export competitiveness – which was so significantly undermined by China’s very, very competitive exports – becomes much higher as Chinese export competitiveness is eroded. I think, among the developing world, countries that rely very heavily on the hard-commodity exports are going to get creamed.

Countries like Argentina that rely very heavily on food-commodity exports, may or may not get creamed. It depends on how smoothly the Chinese manage the transition, because if they manage it well, household consumption will continue to grow. Remember, rebalancing in China means that consumption will grow faster than GDP. For 30 years it has been growing slower, so as Chinese household income and consumption grows, they will eat more wheat and soy, directly or indirectly, meat, etc.

So that could be good for a country like Argentina if the transition is smooth and well managed. Countries that have done very badly in the last decade because their manufacturing sector got eroded significantly, those countries will do quite well. Generally speaking, hard-commodity importers will do well, at the expense of hard-commodity exporters.

David: Looking at the U.S. today, it sounds as if the advantage that the Chinese have had for years with artificially low interest rates, and a preference for the tradable goods sector over the household, could you argue that we are moving into an environment where the U.S. household is at a disadvantage, but perhaps as we reduce our trade deficit, maybe not moving to surplus, but at least reducing the trade deficit, which is comparable, that we are in that new phase where the state is advantaged, the tradable goods sector is advantaged, and the household is really at a disadvantage?

Michael: Yes, but it depends on how you define household. In the days of very low unemployment, the very cheap Chinese production was good for American households, because it lowered the cost of their baskets of goods that they purchased, and so it effectively raised the real value of their incomes. Now conditions have changed. We have very high unemployment.

So if we see an increase in the cost of Chinese exports, it is true that that reduces the value of household income for those people who have jobs, because now they have the same income, but their basket of goods costs more. So Americans, as consumers, will be hurt by rising Chinese prices. But Americans as workers will benefit from rising Chinese prices. So overall household income will go up, largely because unemployment will go down. That is the key thing.

Now, many people will argue, David, that that is a totally unrealistic hope because America doesn’t produce anything that China produces, so if Chinese prices go up we are simply going to buy them from a third country, let’s call that third country Mexico, and it will have no impact on American employment. That is based on an incredibly muddled understanding of international trade.

Let’s assume a three-country world. Mexico has a zero trade balance. The U.S. has a large deficit and China has a large surplus. As China rebalances and ships its production away from export toward the domestic market, its current account surplus will come down. Some people will say, fine, Americans don’t produce what the Chinese produce, Mexico does, so Mexico will get the full employment advantage of what happens in China.

That is completely wrong for two reasons. First of all, there is a lot of overlap between what the Chinese produce and what the Americans produce. In fact, a number of industries in the United States in the last 10-20 years were hurt very, very badly, precisely because of Chinese exports, so if there were no overlaps they wouldn’t have been hurt. They were hurt. But more importantly, it doesn’t really matter whether Americans produce what the Chinese produce.

Let’s say that the Chinese produce a widget which the Americans are totally incapable of producing, but which they still need to consume, so the Chinese export fewer to the U.S., and the Mexicans begin to export more. As Mexicans export more, clearly they have to produce more, and as they produce more they have to hire more workers if they have unemployment. If they don’t have unemployment, they have to bid up workers’ wages. So either way, Mexican workers will become richer.

In addition, the Mexican currency will go up and probably Mexican interest rates will go up because you have to borrow money to build new factories to build all these widgets that the Americans want. The increase in Mexican interest rates, the increase in the Mexican peso, and the increase in Mexican wages means that the Mexicans will have to import more, to the same extent that their exports increase.

So what will they import? They will import something from the United States. Even if you think Mexicans don’t buy anything that Americans make, which of course is wrong, then we have to add a fourth country, Brazil, so the Mexicans buy it from the Brazilians. You work through the whole process and somehow or the other, just because you can’t identify it doesn’t mean it won’t happen.

But somehow or the other, the American current account deficit will come down by almost exactly the same amount that the Chinese current account surplus comes down. It must happen, one way or the other. It is hard to identify, but it must happen. There is no way around it.

David: One more point on U.S. household income, and this is just dealing with the concept of financial repression. If, on balance, it would stay the same in the context of an earlier question, what would it look like as a tax for U.S. households to deal with, an artificially low interest rate, and an income from savings which is diminished?

Michael: Good question. We hear that a lot, and the way the question is often framed is that if financial repression is such a bad thing in China, then it must also be a bad thing in the United States, and not necessarily. First of all, you never get the same level of financial repression in the U.S. as you do in China, for two reasons.

The first reason is, the amount of the hidden financial repression tax is roughly the difference between the nominal GDP growth rate and the nominal lending rate. So in the United States, if the growth rate is, let’s say, 2%, that means the most you could possibly charge on the financial repression tax is two percentage points. You can drive interest rates down to zero. Whereas in China, with a much higher growth rate, the difference is much greater. It can be much more than 2%.

In addition, bank deposits are where the bulk of Chinese savings are because the U.S. has a very flexible, very liberal, and totally open capital account, bank deposits are a much smaller share of American savings than they are of Chinese savings. I think bank deposits in China are something like 200% of GDP, whereas in the United States, I think they are 30-50% of GDP, something like that. So the financial repression tax in China is much, much higher than the financial repression tax in the United States.

But more importantly, China has the opposite problem of the United States. It saves way too much and consumes way too little, and the financial repression tax forces up the savings rate and forces down the consumption rate. The United States consumes too much, and saves too little. The financial repression tax, again, forces up the savings rate and forces down the consumption rate.

You can argue that that is good or bad for the U.S. economy based on whether you are a Keynesian or a Hayekian, or whatever you like, but raising the savings rate in China is a big problem. Raising the savings rate in the United States, not only is not a big problem, but it is necessary. The U.S. savings rate has to go up. So financial repression in the U.S. is very different from that of China.

David: That is very helpful. As we wrap up, I have one question that may be disconnected, but having taught a number of courses on central banking, I am curious how you would interpret the actions of the German Bundesbank in recent weeks, requesting the repatriation of their gold from the U.S. and from France. Do you see any similarities to de Gaulle’s efforts in the late 1960s when the French exercised the first-mover advantage, as the Bretton Woods era came to a close? Does this imply anything about our current monetary system, and the need for change, central bankers regrouping, deciding what resources they have, in an effort to rebalance the current global monetary system?

Michael: I think the timing for this was not great because it increases uncertainty in a world which doesn’t need more uncertainty. The Germans really should have done this a long time ago. The reason their gold was in the United States was because they were concerned about the possibility of a Soviet invasion and access to the gold, so they put it abroad for safe-keeping. That worry has disappeared a long time ago.

But there is a big difference between what the French did in the 1960s and what the Germans are doing now. The Germans are simply demanding, or requesting, the gold that they own, that is stored in New York, be returned, so there is no change in the wealth of Germany or the United States, or anybody else. It is simply like moving your deposit out of one bank and putting it into another.

David: As opposed to the French settling trade balances.

Michael: Yes, what the French did was to actually purchase gold, and they purchased gold because the U.S., after 1935, I think it was, pegged gold at $35 to the ounce, and they were required to buy or sell dollars at that price. By the 1960s it was pretty clear that gold was worth a lot more than that, that the U.S. simply could not maintain that kind of commitment, so the sooner you went in there and bought as much gold as you could at $35 an ounce, the better off you were.

Of course, as France and other countries did that, ultimately the U.S. wasn’t able to maintain the commitment and they had to go off the gold standard, in which case those countries that moved aggressively benefited, and those countries that didn’t lost out on an opportunity. It was a very, very different process.

Is there any signaling effect? I don’t know. I don’t really know what the thinking is behind the German move. I would have just suggested that there might have been a better time to do that than right now when everyone is worried about what is happening around the world and is not looking for more uncertainty.

David: And this ties into what you suggest at the tail end of your book, the great rebalancing, the idea that there will likely be a change to the world monetary system. Will that be the special drawing rights of old? Will it be something that has the automatic rebalancing mechanisms of the old gold standard, but not necessarily the gold standard itself? And maybe that is the issue with the Germans, it is just bad timing.

Michael: We have never had a major financial crisis, either a national crisis or domestic crisis, that wasn’t accompanied by a significant change in the financial and monetary arrangement, so although I don’t know what the global financial system will look like five years from now, I can state with absolute conviction that it is going to look very, very different. If it doesn’t, this will be unprecedented in history.

So my recommendation is that unless you have very clear rules about trade interference, and it doesn’t just mean through tariffs and through the currency, but through interest rates, through a whole number of things, unless there are very clear rules on that, and I am not sure there ever can be clear rules on that, then an open capital account means that countries like the United States and some others run the risk of very destabilizing deficits.

It’s sort of funny, but there is this big argument about the role of the dollar as the reserve currency, and there is this perception that if you are pro-American, you want the dollar to continue to be the dominant reserve currency and if you are anti-American, you want to replace the dollar, and I think that gets it exactly backward. I think there are very few advantages to the United States of the use of the dollar as the global reserve currency. There is an advantage to the world, and as the world leader, of course, that benefits the U.S.

But there are tremendous disadvantages. Most specifically, whenever a country wants to turbo-charge growth, it simply buys unlimited amounts of U.S. Treasury bonds, and it generates a large current account surplus at the expense of the United States.

So I would argue that the U.S. should really move toward Keynes’s old idea of the bancor, or it should strengthen the whole issue around the special drawing rights, the IMF’s SDR, or something, but it should make it more difficult for foreigners to acquire U.S. Treasuries, just as it was in the 1950s and 1960s when there were taxes that prevented excessive capital inflows and outflows to the United States.

David: I know that we are running out of time, but I appreciate your insights and thoughts. When we think of the book that you wrote many years ago, The Volatility Machine, it has made quite a contribution, and your most recent book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, very readable, and highly recommended as a way for people to look at relationships that perhaps they have misunderstood or have been mistaught through the years.

So thank you for adding clarity to a broader conversation and for joining us in this conversation today. We appreciate it.

Michael: Thank you very much, David.

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