The Great Rebalancing: We're all in it together

Michael Pettis interviewed by Viv Davies, 19 August 2013

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Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Center for Economic Policy Research. Today's interview is with Michael Pettis, professor of finance and economics at Peking University. We met in London on the 12th of February, 2013 to discuss his recent book, The Great Rebalancing, Trade, Conflict, and the Perilous Road Ahead for the World Economy. Pettis maintains that we are currently undergoing a critical rebalancing of world economies, and that much of the debate about the global crisis has been caught up in muddled thinking. I began the interview by asking Michael to explain exactly what he meant by muddled thinking.

Michael Pettis: There are probably two big sources of confusion. The first source is that we really lack a full understanding of the historical precedence for what we're going through. Nothing that's been happening in the last few years is really unique or unprecedented or different. We've seen this many times before, and we need to think about the resolution of both the crisis within Europe, and the global imbalances in terms of their historical precedence. That's one source of confused thinking. This is not new. We've seen it before. We sort of know how things turn out.

The second and perhaps bigger source of confused thinking is that we don't really understand the linkages between the different economies that cause imbalances within the example. For example, I would argue that when you look at problems in Europe, there's a tendency to think of the problem countries in Europe as being big deficit countries, Spain, Italy, Greece, etc.

There's also a tendency to think that there are domestic problems, the increase in debt, the large current account deficits that they're running were a consequence of either misguided domestic policies or a consequence of the wrong cultural factors, something that I'm very uncomfortable with.
I would say that's not the case. If you imagine a two country world, say Germany and Spain, and Germany takes steps to force up its savings rate, which Germany did do, in fact, not specifically not to force up the savings rate but at the end of the '90 and the beginning of the last decade they put together policies that restrained the growth in wages relative to growth in GDP in order to generate greater employment growth as they absorbed East Germany.

One of the consequences of that is if GDP grows faster than household income, then it's very possible, and, in fact, that's what happened, that GDP will grow faster than domestic consumption. Of course, savings are the difference between GDP and domestic consumption. German policies aimed at generating domestic employment had the side effect of increasing German savings relative to German investment.

If German savings go up relative to German investment, then Germany must run a current account surplus. If the opposite of that, if the counterbalancing side of that is Spain, then by definition Spanish savings must go down relative to Spanish investment.

This is going to happen not because of domestic factors in Spain or because of cultural factors in Spain. This simply has to happen. The Germans force up their savings rate. Then either global investment must go up, or Spanish savings must go down.

There are different ways that Spanish savings can go down. One of the ways is as the expansion in the German tradable goods sector occurred, we could have seen a contraction in the Spanish tradable goods sector, rising unemployment. That would have brought the Spanish savings rate down, so the two countries could balance.

The only other thing Spain could do, if you eliminate their ability to spot the German account surplus perhaps by devaluing, was a significant increase either in domestic consumption or domestic investment funded by the excess savings exported from Germany.

My point is that if you're looking at the problems in Spain, and you look only at domestic policy factors, then you're missing most of the picture. Spain had to respond to changes in the German savings rate. It had no choice.

If you really want to think about the Spanish problem, it's a Spanish and German problem. That's one of the big mistakes that we consistently make. We don't understand the international linkages between the economies.

Viv: OK. On a global level, when the issue of global rebalancing first emerged it appeared to be focused predominantly on trade imbalances between China and the US. Is this still the case?

Michael: It continues to be a very important issue, but the trade imbalances were not the problem. The trade imbalances were caused by the underlying problem. There were two underlying problems. One was we saw a very rapid contraction in the US savings rate. In part that occurred because of domestic reasons. For example, I would argue that historically whenever US enters into an unpopular war, whether it was Vietnam in the late '60s and '70s or Iraq in the past decade, we notice always that the US savings rate tends to go down.

That's probably because unpopular wars aren't funded by taxes. They're funded by borrowing. That was one of the causes of the savings imbalance in the United States. There was also a significant savings imbalance in China. That imbalance occurred because the growth model in China implicitly involved major transfers from the household sector to subsidize rapid growth.

If growth is being subsidised by the household sector, then household consumption cannot grow as quickly as China's GDP, and so the savings rate is automatically forced up. In fact, it was forced up to the extent that China probably has the highest savings rate we've ever seen.

The trade imbalance between China and the United States was not itself the problem. It was the symptom of consumption problems in the United States and savings problems in China. Those were the things that have to be resolved. Unfortunately, you can't resolve one side. You have to resolve both sides simultaneously. That's going to be a great difficulty in the next few years.

Viv: To an extent, we're already seeing signs of rebalancing across the major world economies.

Michael: It seems to me that the US is starting to rebalance. We've seen the savings rate go up. We've seen debt levels come down. I don't think that's a complete surprise. Four or five years ago, I argued that historically, the US tends to adjust fairly quickly, fairly brutally, but fairly quickly. My guess was that the US was going to be the first major economy to begin the adjustment process. I would say that if you look at the other major economies, China, the adjustment process hasn't begun. In fact, the savings imbalance has gotten worse since the crisis, not better.

Europe, the adjustment process hasn't really begun. I say that because I believe that there will not be an adjustment in Europe without devaluation against the euro some countries will be forced to leave the euro and some way of addressing the debt problem.

Japan, with the new government, there is the possibility that they begin addressing their debt imbalances, but it's not clear to me that they've done anything yet.

I would argue, we've seen some small rebalancing take place in the world, but not nearly enough, and most of that has occurred in the United States.

Viv: That's interesting, because it seems that China has eclipsed the US now, and is the world's top trader in goods for the first time. Is this ironic, given that China also appears to be rebalancing its economy away from a reliance on trade, and more towards domestic demand?

Michael: A lot of people say that the fact that China's current account surplus has come down dramatically since 2007, 2008, is an indication that China's rebalancing. That's based on a misunderstanding of the problem. The problem wasn't the large trade imbalances between China and the United States. That was simply a symptom of the underlying problem. The problem in China was an excessively high savings rate. If you look at how China's current account surplus contracted in the last four or five years, it didn't contract because the savings rate came down. It contracted because the investment rate went up. In fact, the savings rate actually has increased since 2007, 2008. China hasn't really rebalanced.

It has rebalanced the current account imbalances by increasing the investment rate, but that was the wrong thing. Everybody agrees that for China to rebalance, we need to see the investment rate come down and the savings rate come down even more quickly.

What we saw was the opposite. The savings rate went up and the investment rate went up even more quickly. The fundamental imbalances haven't been resolved.

Viv: To what extent will you say that the global situation of imbalances between economies is reflected in the current crisis in Europe? What, if any, do you see as a solution for Europe and the euro zone in particular?

Michael: For me, what's interesting about the European crisis is not so much that it was a surprise that it happened. What to me is interesting is that it's a surprise that we didn't see it coming. What's happened in Europe is a very classic type of imbalance that we saw, for example, in the 1920s and 1930s. In fact, the solution for the European problem, all we have to do is go back, and read Keynes. He explained very, very clearly what the problem was. Keynes argued that when you have these significant savings imbalances in both the surplus and the deficit countries, that an adjustment requires an adjustment on both sides.

If only Spain adjusts, it can only adjust in the form of higher unemployment. If Spain and Germany both adjust, then you can get an optimal resolution of the European crisis, but that requires that Germany reflate its domestic economy. It should cut consumption taxes and it should cut income taxes, so that as demand contracts in Spain, it expands by exactly the same amount in Germany.

Unfortunately, the Germans haven't been willing to do that, perhaps because they're very concerned about their own debt problems. Germany doesn't have a significant debt problem now. But if you believe, as I do, that we're going to see debt restructurings in peripheral Europe over the next few years, that implies that German banks have a significant debt problem. Ultimately, a problem in the banking sector is a problem for the government.

This is a very classic Keynesian type process, with Germany in the role of the United States in the 1920s and peripheral Europe in the role of Europe in the 1920s.

Viv: How big a problem is currency manipulation, and to what extent is it holding back the whole process of rebalancing?

Michael: Currency manipulation is one of the ways in which the world in a demand crisis tries to adjust. We saw this very clearly in the 1930s. For several years I've been arguing that inevitably we're going to see deterioration in trade, and we're going to see trade wars and currency wars which are basically the same thing. The important point to remember is that the currency war is not driven by typical protection. Typically protectionism is driven by domestic manufacturing, and agro business interests. But it isn't really driven by that.

Douglas Irwin has a wonderful book that he published last year in which he argued that in the 1930s it wasn't the typical sectors of the economy that demanded protection that drove protectionist tendencies in Europe. He said that it was monetary constraints that drove the currency war process.

We're seeing the same thing again today. In other words, the impetus or the causes of currency depreciation aren't really policy captured by the groups that benefit from protection. What's really driving it is monetary policy constraints just like it was in the 1930s.

This is inevitable, and this continues. The interesting question for me is not, "Will we see more currency war?" The interesting question is, "How do you decide who are the losers and the winners in the currency war?" Obviously we can't all depreciate our currency.

I'm not sure I have an answer to that question, but one of the things that I would suggest is that one of the constraints on your ability to depreciate your way out of a deficient demand is external debt. Countries that have a significant amount of external debt, countries in Latin America, etc., their ability to wage currency war is very constrained. Obviously, depreciating the currency means an increase in the external debt burden. And the financial distress costs of higher debt may more than compensate for the benefits of depreciating the currency.

I would argue that as these currency wars continue, and I believe they will continue, one of the ways to think about the winners and the losers is to think about the capital structures of the various countries involved and specifically external debt.

Viv: Finally, what are the key messages of your book in terms of finding a solution to the world crisis? What kinds of rebalancing will have to take place in order to bring the crisis to an end? How far does this solution depend on cooperation and international policy coordination?

Michael: It depends very heavily on international policy coordination, but we're unlikely to get that. That's the pessimistic argument. The point that I try to make in the book shouldn't be controversial. It's very common sensical. That is that unsustainable imbalances by definition have to reverse themselves. When we think about the causes of the current crisis, a significant component of those causes are distortions in savings rates, both in high savings and in low savings countries. Those have to be reversed.

Any "solution" to the global crisis that doesn't implicitly involve a rebalancing of the savings distortions cannot possibly be a solution. Whatever policies that we engineer, they have to be consistent with rebalancing. If they're not they will fail almost by definition.

Viv: Michael Pettis, thanks very much indeed.

Michael: Thank you.

Topics:  Global crisis International trade

The Great Rebalancing: Trade, Conflict and the Perilous Road Ahead for the World Economy (Michael Pettis). Published 21 February, 2013 (Princeton University Press)

Senior Associate, Carnegie Endowment for International Peace; Finance Professor, Guanghua School of Management at Peking University


CEPR Policy Research