Alphachat: Michael Pettis on current accounts and the Chinese economy

Transcription

1 Alphachat: Michael Pettis on current accounts and the Chinese economy PART 1 Cardiff Garcia So here's where I want to start, and I'm taking a bit of a risk here that all of our listeners are going to flee, because we need to begin with accounting identities and why they matter so much to the framework that you talk about in The Great Rebalancing. So let's start here: When a country runs a current account surplus, at its most basic level, what exactly does that mean? Michael Pettis There are two ways of looking at it. One way is to look at it from the income side and a country's GDP is defined - this is in a closed system - is defined as a total consumption plus savings. From the other side, from the supply side, it's defined as consumption plus investments. So in a closed system savings is equal to investment. But of course the world is a closed system. But individual countries aren't, and so there are open systems within the global economy and if there's a mismatch between savings and investments, then they are either exporters or importers of capital. And because the balance of payments is an accounting identity, it must balance to zero, if there is a capital accounts surplus there must be a current account deficit. The basic rule is the current account surplus means that you have an excess of savings over investment; you save more than you invest. So you export the excess savings and you run a current account surplus. And of course if you run a deficit that means investment exceeds savings. Cardiff Garcia I want to actually get even more basic than that though. So to summarise what you've just said, a country's production minus its consumption equals its savings. I think that part is intuitive enough. If the businesses in a given country make, let's say, 100 basketballs and each basketball costs $1, but that country's own people only buy 80 basketballs and then sell the other 20 basketballs abroad, then that country has a savings of $20, right? I think that makes sense.

2 And a country's savings minus investment is the current account surplus. So let's say that same country's businesses had instead made 95 basketballs, again each one sold for $1, but these businesses also invested $5 in factory equipment or buildings or whatever to make basketballs for next year. So, its overall production was the same, $100, just as in the first example. And again its own citizens had bought only 80 basketballs. Well in this case the country's savings is again $20 because the country had overall production of $100 and its people only consumed or bought $80 worth of basketballs, but in this example, remember that its businesses invested $5, and so the $20 in savings minus the $5 invested leaves you with a current account surplus of $15, which, you will also notice, is also the difference between the value of the basketballs that were made in the country, which was $95, and the value of the basketballs it sold inside the country. So that's a very simple example stripped of a lot of complicating details obviously, but again the point is that if a country makes more than it consumes and invests, it has to do something with those extra goods and services that it makes, and typically what it does is it sells them abroad. In exchange for that it accepts money and it uses that money to buy either foreign financial assets, like government bonds, or in some cases real assets like foreign real estate or a foreign business or whatever. And again it does that because it has sold more than its own people have consumed or invested. Michael Pettis Exactly right. There is never a net inflow or net outflow of dollars into the US or of euros into Europe or renminbi into China; it always balances to exactly zero and that's what drives that process. Cardiff Garcia Okay, now that we have those mechanisms in place, let's make it a little bit more concrete, or make it concrete again. Let's take an example of an economy this time that primarily makes basketballs and shovels, so we can have an investment category, and it is running a current account surplus. How would that work? Michael Pettis If it's running a current account surplus that means, let's assume basketballs are 100% consumption and shovels are investment. If it's running a current account surplus, that means the total amount of shovels and basketballs that it uses, in the form of consumption or investment, is less than what it produces. So let's assume it produces $100 of both: $60 of basketballs and $40 worth of shovels. What would happen in that case is that Americans would consume $60 of basketballs but they might only invest $30 of shovels. So now they've got ten extra dollars of shovels they have to do something with, and that they either export, in an open economy, or they have to

3 stop producing shovels and they have to fire workers that make shovels. Those are the only options. In an open society. In a globalised economy, they'll export those shovels. Cardiff Garcia in... So they export those shovels and they are paid for those shovels Michael Pettis They are paid for those shovels in dollars, but they lent the dollars to the foreigners. So the money was exported, the excess American savings of $10 was exported to the foreigners who used those $10 to buy shovels. Cardiff Garcia Explain the mechanism by which they exported the $10. Michael Pettis What ends up happening is you export the shovel, your foreign client now has to pay you $10. Your foreign client isn't going to be able to pay you until he sells the shovels so he goes to his bank and his bank contacts your bank. His bank will then effectively have borrowed $10 from your bank with the agreement that when the shovels are sold, the importer will pay the equivalent of $10, let's say, in euros to his bank and his bank would then buy the dollars and repay the loan. So an American bank would have had to lend the European $10 in order to buy the shovels. Cardiff Garcia Got it. Okay, this is a mythical world in which America is running a current account surplus. We're unlikely to see that for some time. But the mechanism is what matters here. Here's what I want to follow that example with: types of trade interventions, and specifically ways that countries can manipulate their current accounts and in this case, since we're talking about current account surpluses, how they can drive up the balance to create a current account surplus. Now, there are obvious examples here that we don't have to get too much into, like tariffs and non-tariff barriers, import quotas or subsidies to specific sectors. There are some non-obvious ones that you also talk about. I want to start with currency manipulation because it sounds intuitively clear how that might work, but actually it works in ways that are not necessarily as obvious as people think. Tell us about that. Michael Pettis That's right. Most people think that if you artificially lower the value of your currency you run a trade surplus because your goods are now cheaper in the international markets and foreign goods are more expensive. That's not really how it works. The way it works is if you depreciate your currency, all households are net importers so you have reduced the real value of disposable income relative to GDP.

4 So the household share of GDP goes down and as the household share of GDP goes down, the consumption share typically goes down. And savings is simply GDP minus consumption. So if the consumption share goes down, the savings share goes up. And if there's been no change in investment then savings has risen relative to investment. So let's say you started with balanced trade and then you depreciated the currency. By doing so you forced up the savings rate and because savings now exceeds investment, you export your net savings and you run a current account or a trade surplus. Cardiff Garcia The reason I started with currency manipulation is also because we've often heard the argument from either economists or economic observers that even though China, for instance, has appreciated the value of the renminbi in the last decade or so, the trade balance hasn't changed as much as you might have thought and so a lot of people have concluded therefore that the exchange rate simply doesn't matter. What you've said is that's not right. It's just that it's not the only thing that matters. Michael Pettis Exactly. From July 2005 the currency, the renminbi has appreciated quite a lot but the trade surplus has grown instead of shrink, which is what a lot of people would have expected. This is the same thing that happened by the way in Japan after the Plaza Accords. Both the Japanese yen and the deutschmark went up. They were forced to appreciate. And the Japanese current account surplus grew; it didn't shrink. Germany's shrank. And the point there is it's not true that the currency doesn't matter. The currency matters a great deal but it's not the only thing that matters. So to go through the Chinese or the Japanese case, because they both did the same thing, the currency appreciated. That increased the real value of household income, of disposable household income because it lowered the cost of foreign imports. That caused the savings rate in China or in Japan to go down because consumption grew as a share of GDP, so by definition savings contracted. If that had been the end of the story then we would have seen a decline in both countries' current account surpluses, and that's in fact what happened in Germany. But both Japan and China did something else. They expanded credit at very low, in the case of China, at negative real interest rates. Why does that matter? Because when you have negative real interest rates you're basically transferring wealth from net savers, and the net savers in a country like China were depositors, householders putting most of their money in the bank and the bank does all the lending, net savers of the

5 household sector. So you transferred money from households to borrowers, which in China were producers of GDP. So that counter-affected the change in the value of the currency. It reduced the household share of GDP by more than the appreciation increased the household share of GDP. So the net result was that the savings rate actually went up, not down, in both countries, and so their current account surpluses went up, not down. Cardiff Garcia Right. Let me take the next two, financial repression, and this usually takes the shape of mandatory low interest rates for household savings, so for instance if you cap, if you put a maximum cap on the interest rate that you can get for your deposits at the bank, that would be financial repression, and then the other one is wage growth repression. You can take those in either order. Michael Pettis Well financial repression was what I discussed last time which is the transfer of wealth from households to producers of GDP. Slow wage growth has exactly the same impact. If wages grow more slowly than productivity or more slowly than GDP, that means households as workers are getting a smaller share of what they produce. So the household share of GDP once again is contracting, and as the household share of GDP contracts, the consumption share contracts and the savings share goes up. So if wages lag GDP growth there's a tendency to force up the savings rate and to run a trade surplus or a current account surplus. Now, a lot of people say that's intuitive because as you lower wages you make your goods cheaper in the international markets. And it's true; both of those statements are true. Cardiff Garcia And then I want to give you one final actually unintuitive one, until you start thinking about it but it's an example that I think very few people bring up, which is environmental degradation and specifically the idea that if a country has very weak environmental standards, it's similar to a subsidy to the companies that operate in that country relative to the companies that operate abroad. Michael Pettis Right. That's why it's so useful to think in these terms because when you think in terms of the savings/investment balance it becomes much clearer. Environmental degradation is also a transfer of wealth from households to businesses. Why? Because if you can dump your chemicals in the river that lowers your cost. However, it raises healthcare costs for the household sector so they have to save more for future health purposes. So it's a straight transfer and once again you get an increase in the savings rate driven by a reduction in the household share of GDP. Eminent domain works the same way. In China if you want to build an airport you just throw

6 everybody off the land. That's another transfer of wealth from households to producers of airports. Cardiff Garcia Right, and that transfer from one part of the economy to the other is the most fundamental part of what we're discussing here I think. There is something interesting included in the paper that you sent me recently which is that a lot of people frequently like to say that a country's current account, whether it runs a deficit or a surplus, is the result of that country's savings or investment decisions. But that's only true as a kind of tautology because actually savings and investment changes because of these other, what you might call, exogenous decisions or shocks, not because a country collectively decides to save more money. Michael Pettis Right. Again, one of the big problems in this discussion is that we tend to think of savings as something that households do and households are one of three groups that save. And we tend to think of changes of saving as reflecting changes in thriftiness or all that stuff, prudence etc. Cardiff Garcia The other two groups by the way in addition to households are the corporate sector and the government. Michael Pettis Yes, exactly. So if you look for example at Germany, Germany was running current account deficits in the 1990s, quite large. And then after the labour reforms of , they started running huge current account surpluses, the largest in the world. Many people said that was because German households, seeing an uncertain world, became thriftier, more prudent etc, but if you look at the numbers that's not the case. Their household savings rate was unchanged. What happened was that the labour reforms, which is usually a euphemism for reducing wages, caused, and you can see it clearly in the numbers, the household share of German GDP contracted. And because the household share contracted, consumption contracted and savings went up. Who was responsibility for the higher savings? German corporates, because their profitability went up as wages went down, so it was business savings that went up and business savings went up simply because wages went down. Cardiff Garcia Okay, so now that we understand the technical aspects of how a country's current account surplus actually operates, let's talk about some of the reasons why countries do this deliberately and when they do it deliberately and not as an accident or because it was responding to the way other countries function, right?

7 So traditionally there are three possibilities. I'll give the first two and then I'll let you explain the third one which is in fact what your dominant theory is. So the first possibility is mercantilism. Traditionally this just meant that a country wanted to have a lot of savings so that it had enough money to raise an army, to pay soldiers, to build equipment, in case it had to go to war. More recently mercantilism might be as a precautionary measure in order to potentially fight off a financial crisis that's caused by currency mismatches. So a country might want to have a lot of foreign currency in case its private sector starts to have serious problems because of a rapid depreciation in the domestic currency. That's one possibility. A second possibility is known as the infant industry argument which is when a country effectively wants to have a very strong manufacturing sector and so effectively what it does is it transfers resources, as you've just discussed, from the household sector to the manufacturing sector so that it can build the technological capacity to compete with other countries, and also because it tends to work well as a rapid employment mechanism. It lets you hire a lot of people really fast. That's the second argument, and I think there is quite a lot to that in some cases, but your argument is that actually the countries right now that have been running large current account surpluses, primarily Germany and China, are doing so because of the under-consumptionist theory, right, so tell us what that is please. Michael Pettis Under-consumption is something that we've known about for a while. It really began probably in the late 19th century and the British economist, John Hobson, and the American economist, less well-known, Charles Arthur Conant, explained it extremely well. The way Hobson explained it is because there was significant income inequality in England at the end of the 19th century, one of the impacts of income inequality is to reduce consumption. Why? Because if you transfer $100 from an ordinary household to a rich household, you get a net reduction in consumption because rich people consume a much smaller share of their income. If you've got everything and you get additional money, you're probably not going to buy much more. So what does that mean? That means that you can find yourself in a position where you are producing far more than local households can afford to consume and that's usually worsened, and we saw this clearly in Germany after 2003, that's worsened by a reduction in private sector investment because if households cannot consume

8 everything that you're producing, then you're not going to invest. You're going to reduce your investment. So you get a reduction in consumption and a reduction in investment. Now, what are the options there? There are two things you can do. If you were in a closed economy there would be only one thing and that is you would have to find some way of reducing the savings rate, and the typical way of doing that is firing workers. So you produce more than can be consumed; that's not sustainable. At some point you fire workers, and the savings rate goes down. So you have a new equilibrium but at a much lower GDP. In a globalised world you have an alternative and that is you can export the excess production, and that's typically what happens. That's what happened in Germany, that's what happened in China. In other words, because of problems with the distribution of income, partly a result of income inequality but also because of policies that have increased the government share in China or the business share in Germany, those have reduced the consumption share of GDP. In that case you're running current account surpluses because the alternative is to fire workers, which of course they don't want to do. Cardiff Garcia Now this is where I want to transition into talking about the impact of these deliberate policy decisions of current account surplus countries on their corresponding current account deficit countries and how it affects them. Michael Pettis Right, but before that let me just remind what I said because this is the key point; when you run large current account surpluses it's not because households have become prudent. It is almost always because of distortions in the distribution of income. Cardiff Garcia Michael Pettis It's not a cultural thing in other words. It's not a morality play. Exactly. Cardiff Garcia And to recap a bit of what you just said also, for the household sector it tends to pressure consumption down when a country runs a current account surplus. Obviously it puts upward pressure on the country's overall savings. On investment the pressures can be a little bit tricky but typically it raises the pressure for investment on the corporate sector because it's had resources transferred to it and because it has the ability to borrow a lot of money and therefore to invest a lot of money

9 which it then can make goods that it will sell abroad in particular, especially in the cases where the currency is depressed for instance. Michael Pettis That's right. Cardiff Garcia Now, let's talk about what happens to current account deficit countries when they have, let's say, a neutral policy stance and these other countries are deliberately running up their current account surpluses. I would imagine that the mechanism works in exactly the opposite way. Michael Pettis Yes. Let's talk about two states of the world; one state which characterises really the middle of the 19th century is when you have a big difference between desired investment and actual investment. And there the main player was the United States; it was a rapidly growing economy, it had huge investment needs and it had a very low savings rate. So because of its low savings rate, American investment was constrained by the low savings rate plus whatever capital it could import from England or any other capital exporting country in Europe, mostly England and the Netherlands. In that case the world had a trade imbalance that was positive for growth because excess British savings were exported to the US and because the investment needs of the US were much greater than the actual investment in the US, because of lack of domestic savings, that import of savings caused American investment to go up. So the US grew more quickly and the British grew more quickly. Great. But what happens when you are in a world in which there is no longer a significant excess of desired investment over actual investment? And that was basically the world of the end of the 19th century. For most of economic history we've operated under a regime of savings scarcity. For the first time there was not a problem of savings scarcity and the result is that if, and this is the case today, if, it's not England but if Germany exports savings to the US, remember that if Germany is running a current account surplus that means savings is greater than investment, and it is exporting that excess savings, which funds the German trade surplus or current account surplus, it goes to the US. Now, because the US has completely opened capital markets, if there are excess savings in Germany or anywhere else and you don't have a place to put them, you put them in the US. Now, there are many countries that need investment, developing

10 countries, but they have very low credibility so we don't put money there. So a lot of that ends up in the US. So the US runs automatically a capital accounts surplus, not because of anything that happens in the US but simply because there is excess savings in Germany and very open and liquid capital markets, so the money goes to the US. If the US runs a capital accounts surplus it must run a current account deficit. Now, that means that in the US investment must be greater than savings. So let's pretend that the US has balanced trade, investment is equal to savings, and then we shift to a period in which German money flows into the US and the US now runs a current account deficit and a capital accounts surplus. By definition that means American investment is higher than American savings. The way most economists think, and it made sense 150 years ago in a regime of savings scarcity, is that as foreign savings entered the US, American investment goes up because the implicit assumption is that America suffers from a savings scarcity. But as soon as you say that most economists know it's not true. American companies that want to invest have unlimited access to cheap savings. In fact American corporations are sitting on huge piles of cash which they refuse to invest. What does that mean? That means that desired investment in the US is equal to actual investment. What the private sector wants to do it can do in terms of investment. So when foreign money comes into the US, American investment does not go up. It didn't need that foreign money. It has unlimited access to cheap savings. So you still need that gap between investment and savings. So if investment doesn't go up, by definition savings went down. A lot of people are really shocked by that. We all know that the US has a low savings rate because Americans are spendthrift. Not true. If the investment rate doesn't go up, the savings rate must go down and there are several mechanisms that force it to go down. One way is it could strengthen the US dollar, and remember we discussed earlier that as the currency strengthens that reduced savings and it increase consumption because it increases the household share of GDP. But there are other things that could happen. One thing that could happen, which we're most worried about, is that because we are importing foreign goods that used to be produced in the US, you have to fire the American workers. Remember, firing workers reduces the savings rate because when you work you consume out of your income. When you're fired you still consume but your income is now zero, so you have a negative savings rate. What else could happen?

11 Well, when tons of money pour into your country, and this is very typical of peripheral Europe, the banks have to respond and the way they respond is by lowering credit standards. Now, if you assume that in the US or in any country in the world you have households with a wide range of risk appetites, you have prudent households, you have imprudent households, you have optimists, you have pessimists, if you lower the lending standards it is iron law that you are going to see more borrowing from households that are more willing to take on debt. Whether they're optimists or just foolish, who knows? But that's what causes the savings rate to go down. By lowering credit standards you increase household borrowing which is negative savings. Other things could happen. As money comes into the country, and we see this over and over again, you typically get real estate booms and stock market booms. That's when you have the so-called wealth effect. As the stock market goes up, as real estate prices go up, households feel richer. And when you feel richer you tend to save less for your retirement, so you increase your consumption and you reduce your savings. These are all fairly mechanistic processes that occur when you run a capital account surplus and your investment doesn't go up. One way or the other savings must go down and it's usually in a bad way. Cardiff Garcia Although there is one other option which advanced economies chose not to pursue. In order to make up for that arithmetic gap, that necessary arithmetic gap between investment and savings, if private sector investment didn't go up and you don't want household savings to plummet, the government could raise its investment rate. And by the way, the signals were all there with long term interest rates being held down extremely low by something called the savings glut, which we can get into; the signals were all there that the government should have been investing in things that would have raised the productivity potential of the economy. It chose not to, maybe because it misread the signs or because there's a kind of stigma against running large fiscal deficits, but in any case it didn't do that, did not enough to raise interest rates back to having a healthy looking yield curve, and by choosing not to do that, the gap ended up being accounted for by plummeting savings. Michael Pettis Exactly right. You're absolutely right. Now, we've had an old debate in American history, we've had really two debates about this issue. One is should the government be involved in investing, and then the second debate is if the government is involved in investing, should it be the federal government or the state government?

12 These are really old debates in American history. My personal prejudice is that the government does have a role to play in investing in needed infrastructure but I want to keep this discussion politics free in that sense. Let's make no assumptions about whether it's right for the government to invest or not. The point is that if the government responds to a capital account surplus by increasing investment then you won't have the problem of a reduction in savings through unemployment or through debt. The question though is should the investment program of the US government be driven by the inability of foreigners to consume everything they produce; in other words should we invest because we're running capital account surpluses or should we invest because it makes sense? And in the US the decision about government spending is independent of the capital flows. We don't spend; we don't invest because money is coming in. Now, what I would argue here is if you believe that there ever is a time for the government, whether at the state level or the federal level, to invest in infrastructure, presumably you want to do it at a time when global demand is weak and when capital is being given away almost for free. Those are the conditions today. So there's a very strong argument, if you believe there is a role for government investment, there is a very strong argument for the government doing it now. Cardiff Garcia Matt Klein, welcome to the conversation my friend. Matt Klein Thanks. Cardiff Garcia You heard everything that Michael just said. I want to now turn the conversation to what's happening in Europe. You've written a lot about Germany, I think often embracing the same or a similar framework that Michael uses. Can you tell us what the mechanisms are by which German deliberate policies have affected what's happened in the peripheral countries of Europe? Matt Klein Sure. So to be clear, the deliberate policies weren't to deliberately create large current account deficits in the periphery but they were deliberately, I think, in their perspective, to make Germany what they would call competitive in global markets. As far as I can tell from reading about this and looking at the data and reading what German analysts have said, the two big things they're reacting to are, on the one hand how you deal with reunification after communist East Germany is brought into the federal republic in the early 1990s, and at the same time, very much related to this, how you deal with the integration of Central and Eastern Europe, the other communist

13 states, into what you could think of as a broader European supply chain while maintaining employment. And what they essentially decided to come up with is a system of we will help people get jobs but they won't necessarily pay very well and they won't necessarily involve a lot of raises, but there's this social compact of we'll boost employment. And so what you see is that basically the total number of hours worked in Germany has been more or less flat for the past 20-plus years but the number of people with a job has gone up by something like 15%. That's intimately tied with the labour market reforms that Michael was talking about but it's also part of, it goes back a little bit further I think to the mid-1990s as well where you have massive outsourcing of German auto parts and other manufacturing components to places like the Czech Republic and Slovakia and Hungary and Poland, and you move that supply chain out and essentially it improves the competitiveness of companies based in Germany but it also means obviously that people who are working in Germany have no leverage for getting pay rises, so they didn't. And at the same time you have a whole lot of workers coming into the German economy initially at essentially excessively high wages but who weren't necessarily as productive as the people who are already in West Germany, so you have a long period of adjustment there. And so you deal with those twin forces and you can understand those are big challenges they had to deal with. They imposed a solidarity tax to help deal with the cost of adjustment and transfers to East Germany that is still ongoing, they are still much poorer almost 30 years later, and that I think can lead to a lot of the phenomena that Michael is describing. It doesn't fully explain however a key point which is that the profitability of the German corporate sector has actually gone up tremendously in the past years in a way that you haven't seen in other parts of Europe. There was a really interesting analysis done I believe by the Bruegel think tank a few months ago that was essentially saying that the real difference between places like Germany and Italy, in terms of competitiveness, had nothing to do with what we think of as labour costs but it was about the share of national income going to the corporate sector and to profits. Where in Italy essentially you had actually workers more or less were paid in line with productivity or maybe a little more than productivity. France, they were paid in line with productivity. In Germany they were paid way less than productivity, and that is the thing that they attributed as the source of these imbalances.

14 Cardiff Garcia Yes, what's interesting about this, Michael, is that it's a pretty stark example of your point that morality should not be brought into this, that this is not about Germans preferring to save more and Italians preferring, or Spaniards preferring, to save a lot less. These were decisions that were taken by the German government, in some cases for understandable reasons, but that over time their effects ended up accumulating both inside of Germany but, crucially from the standpoint of the last half decade, other countries in Europe as well. Michael Pettis Yes, in a way it's hard to know what else Germany might have done because Germany did have a problem after unification. The consensus is that they unified at an excessively high exchange rate which caused the labour costs of low productivity Eastern Germans to be too high. So they had to make an adjustment. Now, there are two ways you can become competitive in the international markets. The high road is to invest in productivity increases and the low road is to reduce wages or to reduce the value of your currency which is the same thing. Clearly Germany should have done the former but there's an argument to be made that in a globalised world it is very difficult to improve productivity because much of the benefits of the greater demand bleed abroad. It's very difficult to raise wages because the benefits bleed abroad. So what Germany did was effectively lower wages through the Hartz reforms. Now, everyone I think was surprised by how powerfully effective that was and I would argue the reason it was so effective was probably because of the creation of the euro, because normally what should have happened is that the deutschmark should have strengthened and the currencies of the rest of Europe should have weakened, partially to offset the reduction in German wages, but thanks to the euro that couldn't happen. Countries that entered the euro with higher inflation compared to Germany, which had no inflation, ended up seeing a real appreciation in their currency rather than a real depreciation which would have been the normal result. So the German wage policies had enormous traction. And there's one other thing that we should consider and that is what happened to all of that excess German savings? Why did, if the Spanish and the Italians weren't being spendthrift, why did they take it all and consume it? Well once again inflation differentials matter because this German savings was offered to German companies and German households at more or less the same interest rates as was offered in the rest of Europe as interest rates converged. But since peripheral

15 Europe entered the euro with much higher inflation and it continued, that meant that that capital had a negative real cost in peripheral Europe and a very high positive real cost in Germany. So not surprisingly the capital flew into the rest of Europe. Cardiff Garcia And Matt, this is where I want to transition to talking about the example of Spain, and there's a reason I'm choosing Spain instead of Greece. In the case of Greece everything tends to get a little bit confused in part because the government really did lie about what was going on there for many, many years, and because Greece has legitimate structural problems in addition to these imbalances that Michael's talking about. Spain, you can't say that about them, and as you've written, before the crisis Spain ran by all accounts what would be considered a, and I'm putting in air quotes, responsible macroeconomic policy. Give us the example of what happened in Spain and tell us essentially what has been happening since. Matt Klein Yes, I think Spain is a fantastic example because when we look at the debates that have happened since the crisis and people who talk about how the euro isn't really the issue because there are a lot of things that countries can do, even within the framework of a single currency, if you look at the policies they suggest, they're all things that Spain actually did at the time. They say oh, if you have too much private capital inflows from abroad, you need to have the government offset that with budget surpluses. Well the Spanish government did do that. They were running surpluses on the order of 3% of GDP on the eve of the crisis; their government debt to GDP I think fell by something like 40 percentage points during the boom years. They say oh, you need to offset it with tighter regulation; you have to have higher capital requirements for banks. Spain again innovated on that front. You could argue they could have done more but they had this idea of the counter-cyclical provisioning which is basically, nowadays people talk about macro-prudential capital requirements for banks where you essentially say banks should be relatively less indebted when asset prices are going up. Spain innovated on that front. They were doing that. Clearly it wasn't enough but then it leads to the question of if they were already doing those two key things that people were saying they should have been doing more so at the time than what any other country was doing, what are the kinds of things that would have been necessary to actually offset this? I don't know. Maybe, sometimes there are economists who do models and they say in theory you should have a 10% budget surplus or something. That's not something that you see as being realistic. The only countries that do that are generally oil exporters.

16 Since the crisis, [Spain] and other countries are very limited in terms of the size of the budget deficits they can run. Those limits are not symmetrical. So in theory they [could have run before the crisis] a bigger surplus if they want, which is a separate problem, but the fascinating thing is the government was doing, I think within the limits of what we would consider reasonable, what it could to offset it, but the flows of private capital were just enormous. And so what happened was they basically, in the 1990s the Spanish current account balance was something like negative 1% of GDP, so it was a slight deficit but it wasn't crazy. Spain was growing faster than other European countries. They probably did have legitimate investment needs so it's not particularly unreasonable. That grew as you get closer to the creation of the euro. Again, it's not necessarily unreasonable; the population was growing, you had millions of people coming in from Latin America for jobs, there was a housing boom, some of it was, construction was probably legitimate because again you had millions of people coming into the country. However, then it gets pretty wild as you get into the mid to late 2000s. On the eve of the crisis I think their current account balance was something in the order of negative 10% of GDP which is almost without precedent in terms of a developed economy that... the investments that they're doing, again you start getting these beautiful airports that are in the middle of nowhere. The FT has written some great stories about this, and they're being sold for I think 1 a now because no-one wants to run them. So that's clearly an excess of savings that were being available to invest in anything. You can argue that there were some levels of mismanagement in some local regional banks or whatever but it wasn't fundamentally a case of nefarious local governments and businesses abusing the rules. It was a function of the fact that there was just this inflow of capital and if you have that much money coming in, what are you supposed to do with it? Michael Pettis When you look at the flows from Germany to Spain there are two possible explanations. One explanation is that capital was pushed from Germany to Spain. Why? Because of excess savings driven by income inequality and the inability to use it domestically for consumption or investment. The other explanation, which is the preferred explanation in many places, including among many of my friends in Spain, is to blame an explosion in just the siesta mentality; everyone in Spain went out and had a

17 big party and because of this consumption boom they forced Germany to provide the capital to supply this big consumption boom. The difficulty with those arguments are two things; if Germany, or if money is being pushed from Germany into Spain, you would expect the way that would happen is through lower interest rates. And if it was being pulled, you would expect that through higher interest rates. Clearly interest rates went down. But there's also a timing problem because the big capital exports began roughly after the Hartz reforms and then we had a case in which Spain, Italy, Portugal, Greece, France and several other countries all simultaneously decided to go on a party. And it's possible; it's just very hard to believe that that's the way it happened. It would be an amazing coincidence. So to me it's much easier to think of money being pushed into these countries, and the amounts were huge, 20-30% of GDP in a short period of time. I cannot find a single case in history of a country that received anywhere near that level of inflows without, including Germany, without having stock market bubbles, consumption booms and crises. Cardiff Garcia Michael, this brings up another issue which is what can current account deficit countries do to defend themselves when some of their counterparts abroad start deliberately running current account surpluses? In the case of Europe this is complicated by the fact that they share a currency but let's say the example of the US, the UK which have their own currency and also run large deficits; what can they do the next time or actually even in the present moment with China and Germany still running very large surpluses? What do they do in order to have some kind of a healthy adjustment? Michael Pettis If you listen to the Trump administration, and in fact I think if you listen to a lot of traditional economists, the way you fix the US current account deficit problem is you look at the countries with whom the US is running large deficits, so that's China, Japan, Germany and Mexico, those are the big four, and you intervene directly in trade by changing relative prices, maybe through tariffs or whatever you like. That was an approach that made sense again 150 years ago when trade was done bilaterally and capital flows responded to trade. Most capital flows in those days, something like 90%, were simply trade finance. So in that case what happened is that you had a trade imbalance driven by price differentials and trading was mostly in finished goods, and the capital imbalance was simply the financing of the trade

18 imbalance. But that's clearly not the case today. Today, because of the collapse in transportation costs, most trade is in intermediate goods. So the US has a bilateral deficit with Mexico that could originate in Mexico but it's just as likely to originate somewhere else. The way to find out is to look at the overall Mexican balance. But more importantly, remember I said that if you run a capital account surplus, you must run a current account deficit. So the problem at the level of the US on the capital account, not on the current account, let's say that the US impose tariffs on everybody; would the US current account deficit decline? Well it depends on what happens to the capital account. And I would argue that if the US were to impose tariffs we would see more money coming into the US rather than less because the assumption would be that you would see an increase in American production and so therefore the profitability of American investment would go up. If more money comes into the US, if the US capital account surplus is bigger, then its current account deficit must be bigger. Now, I can't tell you, I can't predict exactly how that will occur. It could occur in many, many different ways. But I can predict with absolute certainty that it must occur. If the capital account surplus rises, the current account deficit must rise. So if you really want to address the problem, if the problem is, if it originates on the capital side by the need of a world of excess savings to invest that money in some place that is safe, deep and liquid, then you have to intervene on the capital side. So I can't really give you specifics because it depends on a whole bunch of legal structures but they're not covered under WTO. But if the US were to intervene in the ability of foreigners to dump excess savings in the US, the US current account deficit would automatically decline. Matt Klein Just to follow up on this question, because I'm struck by the difference between your estimates of the impact of a broad tariff versus currency suppression because it sounds like... I mean obviously there are a lot of different effects that go in both directions but one impact I would think of higher tariffs across the board is that, as with the currency depreciation, it hits household real incomes and so from that perspective it would boost the savings rate in the same extent we've seen in China. Can you give a sense of how you see those things offsetting or, put another way, why the cheaper exchange rate in China doesn't lead to an increase in investment that offsets the increase in savings?

19 Michael Pettis Right. Let's say the US impose tariffs across the board, and you're absolutely right, if you impose tariffs across the board you raise the price of foreign goods, so you reduce the household income share of GDP because you reduce the real disposable income of American households. So if you do that shouldn't the savings rate go up? It depends. If investment goes up the savings rate will go up. Investment will probably go up. Let's assume that more foreign money comes into the US after it erects all of these tariffs. You're in the funny position where the tariffs itself forced up the savings rate but there are more inflows into the US which means the gap between investment and savings is greater than ever. There are two ways you can explain that. One is because the tariffs are going to cause Americans to buy more goods, American factories need to produce more so there will be more investment in American factories and that will probably occur. It's hard to imagine it would occur to a significant extent if there was a significant increase in inflows, in which case some mechanism has to drive the savings rate down. Again, there are many mechanisms that can do so but the most obvious mechanism is a raise in the value of the dollar, an increase in the value of the dollar. So the benefits generated by the tariff, or rather the effect of the tariffs on household income is not simply the tariffs; it's the tariffs minus the strength in the dollar that's a result of increased inflows into the US. There are so many moving parts it's hard to figure out exactly what would happen, but the point that I would make is that if capital inflows into the US increase, the US current account deficit must increase and it could increase for good reasons, it could increase for bad reasons Part 2 Cardiff Garcia Michael, here's what I thought we would do this 30 minutes: we're going to give you a break to start and I'm going to ask Matt to bring us up to speed on the Chinese economy, just to give us a little bit of a breakdown. So Matt, you recently wrote this post that essentially explained what was happening in the years up to the end of 2015, which was a time when there were a lot of really

20 gloomy predictions about what would happen to the Chinese economy in Those predictions have not yet panned out, but why don't you just give us a sense of what's been going on in the last five years or so? Matt Klein Sure. I'm going to start the clock basically right after the financial crisis. China, unlike many other countries, really goes gung-ho on the idea of reflationary stimulus. The way they choose to do that is by having the government-controlled big banks lend to state-owned enterprises that then go on a really big investment spending -- you can call it binge -- you can call it bonanza, whatever it is... Cardiff Garcia... there's a lot of it. Matt Klein There was a lot of it, right. Some of that spending clearly led to excess capacity in things like steel and there were airports in places that didn t need them, but there was also spending on things that maybe people will look down the line and say it was useful. Either way, there was a lot of it. And in that period from, say, , you have a lot of people outside of China who react to that and think that is going to be a baseline for the foreseeable future, both in terms of the growth rate of Chinese GDP and in particular the growth of Chinese demand for raw materials, because in order to do all this spending you need a lot of coal, you need a lot of iron, and you need a lot of copper. That forecast turned out not to be right. So basically we get to 2011 or so and China's begun switching gears, for a variety of reasons, and you start seeing the prices of these industrial commodities turn down. They all peak sometime around the first half of And there's a very long and, for some places, a very painful adjustment as China begins to retrench. The growth rate of China's GDP, if you take the official numbers at face value, basically halves between then and the next few years. The prices of things like iron ore and coal and such, they fall by well over half. Cardiff Garcia to fall quite precipitously. Specifically because Chinese demand for these goods has started