The source of the global crisis through which we are living can be found in the great trade and capital flow imbalances of the past decade or two. Unfortunately because balance of payments mechanisms are so poorly understood, much of the debate about the crisis is caught up in muddled analysis.
Ever since the U.S. subprime crisis began in 2007-8, caused in large part by an uncontrolled real estate boom and consumption binge, fueled in both cases by overly abundant capital and low interest rates, the world has been struggling with a series of deep and seemingly unrelated financial and economic crises. The most notable of these is the crisis affecting Europe, which deepened spectacularly in 2010-11.
But it is not the just the United States and Europe that have been affected. The global crisis has also accelerated pressure on what was already going to be a very difficult transition for China from an extremely imbalanced growth model to something more sustainable over the long term. The crisis that began in the United States, in other words, has or will adversely affect the whole world, from countries as far apart as Brazil and Australia, although not at the same time.
There is a tendency, especially among Continental European policymakers and the nonspecialized Western media, to see the crisis as caused by either the systematic deregulation of the financial services industry or the use and abuse of derivatives. When this crisis is viewed, however, from a historical perspective it is almost impossible to agree with either of these claims. There have been after all many well-recorded financial crises in history, dating at least from the Roman real estate crisis of AD 33, which shared many if not most characteristics of the 2007 crisis.
Earlier crises occurred among financial systems under very different regulatory regimes, some less constrained and others more constrained, and in which the use of derivatives was extremely limited or even nonexistent. It is hard to see why we would explain the current crisis in a way that could not also serve as an explanation for earlier crises. Perhaps it is just easier to focus on easily understandable deficiencies. As Hyman Minsky explained,
Once the sharp financial reaction occurs, institutional deficiencies will be evident. Thus, after a crisis, it will always be possible to construct plausible arguments – by emphasizing the trigger events or institutional flaws – that accidents, mistakes, or easily correctible shortcomings were responsible for the disaster.
Minsky went on to argue that these “plausible” arguments miss the point. Financial instability has to do with underlying monetary and balance sheet conditions, and when these conditions exist, any financial system will tend toward instability – in fact periods of financial stability, Minsky argued, will themselves change financial behavior in ways that cause destabilizing shifts and that increase the subsequent risk of crisis.
Why do underlying monetary conditions become destabilizing? Charles Kindleberger suggested that there are many different sources of monetary shock, from gold discoveries, to financial innovation, to capital recycling, that can lead eventually to instability,but the classic explanation of the origins of crises in capitalist systems, one followed by Marxist as well as many non-Marxist economists, points to imbalances between production and consumption in the major economies as the primary source of monetary instability.
Underconsumption
According to this view growing income inequality and wealth concentration leave household consumers unable to absorb all that is produced within the economy. One of the consequences is that as surplus savings grow to unsustainable levels, and because declining consumption undermines the rationale for investing in order to expand productive facilities, these excess savings are increasingly directed into speculative investments or are exported abroad.
Countries have historically exported capital as a way of absorbing foreign consumption. With the exporting of these excess savings, and the concomitant importing of foreign demand, international trade and capital flows necessarily resulted in deep imbalances.
This argument, which we can call the “underconsumptionist” argument, is the most likely cause of global trade distortions. Trade imbalances, of course, don’t always lead to crisis. In any well-functioning global trading system there are always likely to be small and temporary imbalances in trade flows. In some cases, primarily in the case of countries in the midst of a long-term investment boom like the United States for much of the nineteenth century, trade imbalances can be sustainable and even persist for many years without necessarily leading to crisis.
But even otherwise sustainable trade imbalances can lead to crisis when they create fragile national balance sheets. This can happen because trade flow imbalances, of course, require their obverse, capital flow imbalances and capital flows can be and often are structured in ways that are unstable and lead to fragility in national balance sheets.
The reversal of the trade imbalances occurs as either the cause or the consequence of a reversal in capital flows. Countries that repay foreign investment must run current account surpluses, just as countries that run current account surpluses must be net exporters of capital. In other cases, a country that runs trade deficits for many years not driven by surging domestic investment necessarily sees anyway a rise in foreign capital inflows (trade deficits must always be funded by foreign investment). In this case, however, the liabilities generated by the inflows are not associated with an increase in domestic asset growth, and so foreign obligations rise at an unsustainable pace.
So none of what is happening today is new, but what is often forgotten is that policies in the country or countries that first suffered from the crises – usually the trade deficit countries – have not always, and perhaps not even usually, caused the distortions. It is important to recognize that these imbalances had their roots in policy distortions in both the countries that ran large trade deficits and those that ran large trade surpluses. For the former, the large deficits led to unsustainable increases in debt and, ultimately, to the deleveraging process necessary to restore balance. It is this deleveraging process that is at the heart of the global financial crisis.
We Have the Tools
The crisis will not be truly over until the policies and institutional framework that led to the large trade imbalances have been sufficiently modified. And yet it seems that few aspects of the political and economic debate surrounding the resolution of the various crises are as confused as our understanding of the balance of payments mechanisms that govern trade and capital flows. As a result, much of the debate on what to do and how to avoid similar crises in the future is muddled and usually misses the point.
This, however, is not because we do not have adequate tools with which to understand the functioning of the global balance of payments. On the contrary, the basic economic principles underlying international trade and capital flows are fairly well understood, but they are at times so counterintuitive that even economists who should know better are seduced into saying things that make no sense.
We know for example the relationship among savings, investment, and current account imbalances in any particular country, but we fail to apply this knowledge logically to the full range of policies and institutions that affect the components of the global trade and capital balances.
The global system is a system in which every part is affected by every other part through the capital and current accounts. For example, we often hear that the current account deficits of peripheral Europe and the United States have little to do with German or Chinese policies but are rather primarily the consequence of the very low savings rates in the deficit countries.
However, the savings rate and savings level of any country are determined largely not by the thriftiness of its citizen but by policies at home and among trade partners.
If we misunderstand the root causes of the global imbalances that led to the global crisis, then it is unlikely that we will choose optimal policies that will allow us to work our way out of the imbalances in the least painfull way possible. On the contrary, as John Maynard Keynes so urgently argued nearly eighty years ago, we are likely to choose policies that maximize global unemployment and lead directly to trade conflict.
We can see the consequences of our muddled thinking most strikingly in the European crisis. Thanks to a general inability to understand why the advent of the euro spelled trouble for much of peripheral Europe, the policies needed to save the euro are largely ignored. What is worse, only Germany can save the euro, but this will require a dramatic, and improbable, shift in Berlin’s understanding of the root causes of the crisis.
Saving the euro will not require that Berlin make funding more easily available for peripheral Europe, as too many policymakers believe. Nor will the euro be helped if foreign central banks, including China’s, buy more European government debt. The euro can survive only if Berlin reverses policies that forced German savings to grow at the expense of households. German policymakers refuse to take the necessary steps because they refuse to pay the cost of the adjustment.
No matter how wrongheaded current policies are, Europe, like the rest of the world, will adjust from its trade imbalances one way or the other. It has no choice. But if Europe rebalances in a suboptimal way – that is, without a policy reversal in Germany – its rebalancing will ultimately become far more costly for Germany than a reversal of policies today.
Why the Confusion?
There are three very large areas of confusion and muddled thinking when it comes to discussing trade and global imbalances. The first area has to do with the causes of significant trade imbalances. Very large persistent surpluses and deficits are almost always the result of distorted policies in one or more countries.
There are many ways in which these distortions can occur. It is easy to think of trade tariffs and currency manipulation as forms of trade intervention, but although they certainly do cause distortions in trade, they do not do so for the reasons we generally assume. Their impact on trade is not directly though relative price changes but rather indirectly by changing the relationship between consumption and GDP.
The second large area of confusion and muddled thinking has to do with the relationship among trade, the savings rate, and international capital flows. The three are linked, of course, but the way they are linked is more complex and subtle than most analysts recognize.
It is important to understand these relationships in order to understand how policies in one country can force corresponding changes in another country, and it is important to understand that the savings rate is not an independent variable that can be altered at will, or with the right moralistic exhortations.
The third area of confusion has to do with the role of the U.S. dollar as the global reserve currency and with the role of central bank reserves more generally. There is a tendency to believe that global trade is denominated primarily in U.S. dollars because of sinister or not-so-sinister designs of the U.S. government, and that countries are forced to accumulate U.S. dollars if they want to accumulate foreign currency reserves. In fact I argue that reserve currency denomination has little to do with U.S. power or dominance and much more to do with trade policy in foreign countries and an accommodating financial and monetary system in the United States.
This book is broadly divided into three sections that mirror and address these three areas of confusion.
Some Accounting Identities
It is useful to remember that every country’s current account surplus is by definition equal to the excess of domestic savings over domestic investment. If a country saves more than it invests domestically, these excess savings must be invested abroad, and one of the automatic consequences of net foreign investment is an excess of exports over imports. Every country that has net investment abroad (i.e., it invests abroad more than foreigners invest domestically) must generate more revenues from the export of goods and services and from foreign interest and royalty payments than it pays out.
The Inanity of Moralizing
The fact that a change in the relationship between savings and investment in one country must force an obverse change in the relationship between savings and investment in another country is a very important point. A country whose policies cause a change in its savings or its investment will automatically force a change in its current account. Because a change in its current account must mirror the change in the current account of the rest of the world, this means that those policies must force a change in the total savings or total investment of the rest of the world.
When moralizers laud the thrifty habits of Germans and criticize the spendthrift ways of Spaniards, in other words, they may be wholly missing the point. It is very possible that both German and Spanish savings rates are determined not by cultural preferences but by government policies in either Germany or Spain that have altered the domestic relationship between investment and savings.
For example, if the European crisis was caused because Greeks and Italians aren’t as thrifty and hardworking as Germans, then the solution to the crisis is simply an exhortation that Greek and Italians act more like Germans. Take away from the Italians and Greeks their good food, their sense of fashion, and their smiles, according to this way of thinking, and they, Europe, and the rest of the world will be much better off.
Similarly, how do we explain China’s high trade surplus? China runs a trade surplus because, as nearly everyone knows, Chinese households value thrift and hard work more than their trade competitors. In fact more generally we are told, as Kishore Mahbubani, a Singaporean academic and one of the more excited proponents of Confucian values, put it in his book Can Asians Think?, countries with “Confucian” value systems include “attachment to the family as an institution, deference to societal interests, thrift, conservatism in social mores, respect for authority.”
However, I argue that high Chinese and German savings rates are both necessarily caused by institutions and policy, whether these are policies and institutional frameworks in the deficit countries, policies and institutional frameworks in the surplus countries, or both.
What’s more, exhortations that deficit countries become thriftier are not only useless in resolving the imbalances, but to the extent that they are acted upon, they are likely to worsen the impact of the crisis.
Excerpted with permission of the publisher, Princeton University Press, from The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy by Michael Pettis.
About the Author
Michael Pettis is professor of finance and economics at Peking University, a senior associate at the Carnegie Endowment, and a widely read commentator on China, Europe, and the global economy. He is the author of The Volatility Machine: Emerging Economies and the Threat of Financial Collapse. His latest book is The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy and is published by Princeton University Press in 2013.
