China: Choosing More Debt, More Unemployment, Or Transfers

I have often written in this blog and elsewhere about the three policy choices Beijing faces as it tries to manage through the adjustment process. My argument is that subject to two very plausible assumptions, every economic policy Beijing implements ultimately can be abstracted to one choice among three options. These two assumptions are:

  1. China has overinvested in infrastructure and manufacturing capacity to such an extent that in the aggregate the cost of additional public sector investment exceeds the present value of future increases in productivity generated by the investment. China’s public-sector investment, in other words, is value destroying, and because it is funded by debt, additional investment causes China’s real debt servicing costs to rise faster than its real debt servicing capacity.
  1. China’s long-term sustainable growth rate is substantially below the economy’s current GDP growth target, and so the economy is only able to meet the growth target by increasing its debt burden.

I was discussing this earlier today with a friend of mine who asked if I would post on my blog a piece I wrote last year for my clients. I am not able to post the full piece, but I decided to post the following edited abstract. I have not had time to read though it to remove incongruities or anachronisms:


Since 2010-11, and even more so in the past year or two, it has often been difficult to evaluate the consistency of Beijing’s policies within China’s economic rebalancing. This shouldn’t be surprising. For one thing, as I have tried to show many times before, rebalancing is an intensely political process and almost by definition it must undermine the so-called “vested interests” who were previously the great beneficiaries of decades of unbalanced growth. For this reason it must be driven by the constant give-and-take of the political process.

For another thing, there continues to be a lot of confusion about just what it is that Beijing must do, and there are still far too many economists who believe that certain types of reforms will allow Beijing to sidestep some of the politically difficult decisions involved in rebalancing. For example many economists still argue that the right combination of interest rate reforms and reforms to financial-sector corporate governance can transform the Chinese banking system quickly enough and radically enough that Beijing can allow investment growth to remain high without a commensurate growth in the country’s debt burden.

This is almost absurd. Many countries under easier circumstances – in which interest-rate distortions were less extreme, for example, as was moral hazard, or the links between parts of the banking system and the political distribution of power – have tried to do just that, and none has succeeded nearly quickly enough, if it has succeeded at all, to matter.

A country’s financial system, after all, can only change in ways that are consistent with changes in the political system and with the distribution of political and economic power, and it is hard to imagine how this would happen in China quickly enough to break the link soon enough between investment growth and growth in the debt burden. Among other things a reform of this nature would require the elimination of moral hazard, but moral hazard has become so fundamental to the stability of the Chinese banking system and to the way credit, and with it wealth and political influence, has been distributed during the past two or three decades, that it is hard to believe that its rapid elimination would not be too disruptive for Beijing to allow.

For these reasons it isn’t at all surprising that Beijing’s policies will appear inconsistent from time to time. To make it easier to evaluate policymaking amidst this confusion, however, I have said a number of times that any policy Beijing chooses must involve, usually implicitly, some combination of three outcomes. In every case, in other words, we will see as a consequence of the policy one or more of the following:

  • Higher unemployment, the limit of which is largely a political issue involving social instability, with the added wrinkle that certain types of unemployment are likely to be perceived as more politically costly than others – e.g. because returning to family farms acts as a kind of safety valve, even though a significant fall in living standards, unemployment among migrant workers is likely to be less costly, or because university graduates are presumably more communicative and have higher expectations, their unemployment might be more costly.
  • Higher debt, by which I really mean a higher debt burden, or an increase in debt relative to debt-servicing capacity, and this can rise until credit growth can no longer be forced up to the point where it can be used to roll over existing debt with enough margin fully to fund as much new economic activity that Beijing targets.
  • Higher wealth transfers, in which governments – and because the Xi administration is seeking to centralize power this is most likely to involve local governments rather than central government entities – must liquidate assets and use the proceeds directly or indirectly either to increase household wealth or to pay down debt, with the main constraint on Beijing’s ability to direct this process likely to be the tremendous political opposition of the so-called “vested interests”, for whom government control of these assets is an important source of power, patronage, and wealth.

The trade-offs between a higher debt burden, higher unemployment and greater wealth transfers to the household sector may come into sharper relief in 2016 because although unemployment still seems to be fairly low, in spite of much lower growth in the past three years, there is now reason to worry that any additional reduction in growth may begin to show up in the unemployment numbers.

Although I have explained this framework many times before, I don’t think all of my clients understand what I mean by it. I recently met with a senior European official who is a long-time subscriber to my newsletter, and although he has always been very supportive of my work, even when my analysis of the Chinese economy was widely considered outrageously contrarian, he confessed that he was a little skeptical that something so simple could provide much value in describing something as complex as the Chinese economy.

I explained to him that the unemployment-debt-transfer framework was not so much “simple” as it was “flexible”, and to show him what I meant, I went on to describe a series of recent adverse shocks to show how the framework clarified the various scenarios. The exercise seems to have worked. After I had finished he seemed to be much less skeptical and in fact seemed pretty ready to embrace the framework I had recommended.

Working through the scenarios

I thought it might be useful if I replicated the exercise by positing some adverse event, and then working through the consequences. No matter what the adverse event or policy decision, it is almost always easy to show that except for a very limited number of easily-specified and highly improbable scenarios, every response Beijing chooses, including that of no response, must result in some combination of higher unemployment, higher debt, and higher wealth transfers.

To move from the abstract to something specific, I will assume, as occurred in 2009-10 as a consequence of the global crisis, that for reasons external to China there is a sharp contraction in its current account surplus, mainly caused by a sharp fall in exports. I will the try to list every logically possible outcome, even those that seem obvious or obviously implausible, to show how flexible this framework and how useful in allowing us to evaluate policymaking:

  1. Let us assume, then, that a sharp fall in exports causes a reduction in demand relative to the quantity of goods and services China produces. Either Beijing responds to the sharp fall in exports or it does not. In the latter case one or more of three things must happen. First, exporters can close down production facilities and fire workers. Second, they can close down production facilities and retain the workers. And third, they can keep production facilities running. There is no other possible outcome if Beijing does not respond to the sharp fall in exports.
  1. We can work through these three outcomes. In the first of the three cases, if exporters close down production facilities and fire the workers, then clearly unemployment rises. Second, if they close down production facilities and retain the workers, because they can no longer pay the workers out of the revenues they generated they must borrow, sell assets, or draw down savings, in all of which cases effectively the debt burden rises (in the latter two cases because assets decline with no change in debt). And finally, third, if they do not close down production facilities, they must finance rising unsold inventory and, again, the debt burden rises.
  1. These are the three possible outcomes if Beijing does nothing in response to as sharp fall in exports. It is far more likely however that Beijing would respond to counter the decline in demand. Any economy has three sources of demand, consisting of net exports, consumption and investment, and Beijing can respond with policies that counter the fall in demand by promoting each of these sources of demand. First, it can attempt to rebuild exports by becoming more competitive – most likely by devaluing the RMB, by forcing down wages, or by reducing interest rates. Second, Beijing can also counter the impact of lower net exports on demand by boosting government consumption, which causes the debt burden to rise because it must be financed, or by implementing policies that boost household consumption. Finally, Beijing can counter the impact of lower net exports on demand by boosting investment.
  1. Rebuilding exports by devaluing the RMB, by forcing down wages, by reducing interest rates, or by any other subsidy of production costs effectively reverse the rebalancing process, and it is precisely because of the deep imbalances that Beijing is in the position of being forced to choose among the three outcomes. These policies ultimately boost exports by indirectly transferring wealth from households to subsidize the tradable goods sector. The result, of course, of reversing the rebalancing process is that contrary to Beijing’s explicit goals Chinese demand relies less on household consumption and more on investment, and because the financial sector misallocates capital systematically. Unless China is able, very improbably as I have argued, to reform the financial sector deeply enough and quickly enough, the cost of a more competitive (i.e. more highly subsidized) export sector is ultimately a rise in the debt burden, unless of course Beijing is willing to tolerate higher unemployment or to implement greater wealth transfers from the state to the household sector. I have discussed this many times before in other issues of this newsletter so I will not explain why again beyond the above, but it should be quite obvious.
  1. If rather than make exports more competitive Beijing chooses instead to boost household consumption, there are two ways it can do so. The sustainable way is to boost household income or household wealth. Less sustainably it can also encourage households to increase consumer debt, the result of which, of course, is a rising debt burden. If however Beijing wants to boost household consumption by boosting household income or household wealth, even as export growth is falling sharply, it can only do so by transferring wealth directly or indirectly – in the latter case, for example, by improving the social safety net or by socializing transportation, medical or other costs – from local or central governments. The impact this will have on China’s overall rebalancing depends on how the wealth transfer is funded. If these costs are funded by government borrowing, the debt burden rises. If they are funded by the sale of assets, there is a transfer of wealth from the government to households.
  1. Finally, as it did in 2009-10, Beijing can counterbalance the sharp fall in exports by initiating a major investment program. Again, needless to say, the impact this will have on China’s overall rebalancing depends on how the wealth transfer is funded. If these costs are funded by government borrowing, as they were in 2009-10, the debt burden rises. If they are funded by the sale of assets, there is a transfer of wealth from the government to households.

This rather simple exercise can easily be repeated for any other set of conditions, and it shows what it means to say that every adverse economic event and every set of policy choices Beijing might implement ultimately boils down to choosing among these three options. I have used a fall in exports to show how constrained Beijing’s policy choices are, but I could just have easily done the same using as an example any change in the currency regime, the reform of the hukou system, the de-industrialization of the bankrupt northeast provinces, the development of the OBOR and Silk Road projects, changes in interest rates or minimum reserves, protecting the stock market from crashing, the provincial bond swaps, changes in the tax regime, improving energy and environmental policies, and so on. In every case Beijing is implicitly forced to choose among these three options.

Many research pieces and analyses, and perhaps Beijing policymakers themselves, implicitly assume that there are other possible outcomes. But because they do not specify these alternatives, except vaguely and unrealistically, they conceal more than they reveal. In fact there are only two other outcomes that are logically and practically possible, but neither is highly plausible or sustainable.

The first alternative assumption is that there is a sharp drop in the household savings rate, so that household consumption rises as a share of household income. Proposals to rebalance the economy by improving retail distribution, for example, implicitly assume that this will happen. But it can happen only if either Chinese households on average decide to become less thrifty, which is unlikely in a period of rising economic uncertainty (and anyway most likely requires rising consumer debt), or if there is a significant redistribution of wealth from the higher-saving rich to the higher-consuming poor, which might be politically very difficult to accomplish in a short enough time period.

The second possible alternative assumption buried in most analyses – but which again is neither highly plausible nor sustainable – is for a radical reform of the financial sector and a major re-channeling of capital away from its existing uses and into productive uses that do not entail a faster rise in debt than in debt-servicing capacity. Aside from the fact that the most productive users of capital are actually reducing their demand for capital in the face of weak Chinese and global conditions, the type of transformation required in the financial sector, and the transformation in the political institutions needed to accommodate this financial-sector transformation, are far more radical than any country has ever been able to manage. I have explained why I believe this outcome is extremely implausible several times in other issues of this newsletter.

Clearly from an economic point of view it is easy to see that Beijing should always prefer policies that transfer wealth from the state sector to the household sector, because every other policy implicitly or explicitly involves something which is either unsustainable, like rising debt, or politically unacceptable, like rising unemployment. In fact it does. The most widely praised economic reforms proposed during the Third Plenum in 2013 do exactly that.

The problem, of course, is that local and provincial “vested interests” strongly oppose the concrete steps needed to achieve this transfer in large part because their economic and political power depends directly or indirectly on control of local government assets, or on their abilities to transfer wealth from the household sector into their own projects. The alternative to rising debt or rising unemployment, in other words, requires that power be sufficiently centralized in the Xi Jinping administration that it is able to overcome these vested interests.

This suggests very clearly what we should be watching for in 2016 as the most important indicator of whether or not Beijing will be able to manage a successful economic adjustment, with growth slowing sharply but gradually and in a non-disruptive way. China’s success will depend on the extent to which Beijing in 2016 is able to centralize power, to begin to sell off government assets (probably local and provincial, and not central, government assets), to rein in credit growth, and to accept much lower GDP growth rates while keeping household income growth from dropping too sharply. If it cannot do this, China’s adjustment is likely to be much more difficult, much longer lasting, and perhaps much more disruptive.


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The impact in China and abroad of slowing growth

This blog entry is largely something I wrote a year ago about the impact of a Chinese rebalancing on the global economy, and except for this first paragraph nothing has been changed. The entry on my blog that had been posted a couple of weeks earlier was an attempt to explain why it is important to consider both sides of a country’s balance sheet in forecasting growth. At one point in that essay I discuss the difficulty most economists seem to have in incorporating persistent imbalances into their economic models. There seemed to be among them, I wrote,

… a failure to understand the economy as a dynamic system in which a)imbalances could persist and grow for many years before eventually rebalancing, b)the more rigid the institutional structure of the economy, the deeper imbalances were likely to get, c)the longer they persisted, the more disruptive the rebalancing was likely to be, and the less significant the “trigger” that set it off, and d)there are many ways rebalancing can occur, and the way it actually occurs depends on institutional constraints and rigidities. These economists seem to find it difficult to understand that an economy can have a very unbalanced debt structure, with debt growing at an unsustainable rate, so that there will be a significant reduction in future growth, but a crisis is only one of the ways, and not the only way and certainly not imminent, that this reduction in future growth can happen. It is only when debt is subject to a “sudden stop” that a crisis can be inevitable, but in many if not most cases there is no crisis.

A friend of mine sent me an article a few weeks later from the Financial Observer about the views of someone by the name of Brian Singer, head of the dynamic allocation strategies team at William Blair, in which Singer discusses his outlook for China and makes a passing reference to my views:

“Everyone is aware of China’s horrid debt levels and [Chinese financial markets analyst] Michael Pettis has done some great work, but he is China’s ‘Chicken Little’,” Singer said, referring to his panic-style predictions. “He discovered through his research that China has built up a lot of debt and he is right. China’s debt to gross domestic product (GDP), however, is pretty close to the United States’ and Germany’s.

“If we’re all so terribly concerned about China’s debt to GDP levels, why aren’t we equally as concerned about the US?” In reality, the US would like to have the debt to GDP levels and growth dynamic China had, he said. “The US is growing at 1.5 per cent and would take an eternity to absorb that debt,” he said. 

I don’t think Singer is referring to my having long argued that once China began rebalancing, its growth would drop by roughly 100-150 bps a year. I have been very consistent about the timing and this is exactly what has happened, and presumably a Chicken Little would have made the same prediction over and over again and was wrong each time. I assume that Singer is making the same mistake that a number of other analysts who were blindsided by China. He is probably assuming that because I have been warning since 2006-07 that Chinese growth had become structural dependent on an unsustainable increase in debt, in spite of my nearly always adding that I did not expect a financial crisis (which I began to do precisely because Singer’s confusion about imbalances and misunderstanding of China’s growth model was so widely shared), I must have also been predicting an imminent financial crisis.

Singer, like most analysts, doesn’t understand how deep imbalances and unsustainable debt increases can be consistent with institutional constraints that keep the process going on for many years. When he read my work about Chinese debt, at a time when like most analysts he was probably bedazzled by China’s growth model, I suspect he immediately assumed that I could only be predicting an imminent collapse, and so the fact that I very explicitly rejected the idea of an imminent collapse was not something he was able to process.

His confusion about debt is more general. His idea that a debt level which might be problematic for China must also logically be considered problematic for the US suggests, of course, both a poor understanding of why debt matters and very little familiarity with the history of debt across developing and developed countries. I have explained the former many times before, but almost any graph that shows current debt levels for countries ranked according to GDP per capita, or shows debt levels for countries that have defaulted, restructured their debts, or otherwise indicated financial distress, again ranked according to GDP per capita, makes it very clear that wealthier countries can sustain much higher debt levels.

Singer goes on to make growth forecasts for China that are, in my opinion, very unrealistic and which, if they turn out to be correct, would be almost wholly unprecedented in history, and it is not clear to me why something so unprecedented is not considered extraordinary enough to warrant an explanation:

“At the margin, things have slowed down and when you add all these things together, in our view double-digit growth is not viable for China, but does not mean it will grow at 1 per cent like the developed world either,” Singer said. “[We think China’s growth] will be something around 5 per cent, which is a reasonable assumption over the coming 10 to 20 years…Yes [the combined issues creating uncertainty for China] are a concern, but it is not the end of China as we know it.”

The assumption that Chinese growth will average around 5% for the next ten to twenty years is not “reasonable” at all. Given the relationship between GDP growth and credit growth that has been obvious for at least a decade, GDP growth above some sustainable level, a level almost certainly below 3-4%, requires that debt grow faster than debt-servicing capacity, and as the debt burden grows, that sustainable level will itself decline further. Even a decade of 5% growth would require that Chinese debt levels rise from the current 250% of GDP to something north of 400%, which for a developing country would be almost unprecedented (I say “almost” because there may have been cases of developing countries in which debt was higher, but only after a currency crisis forced up external debt).

More importantly, as Singer and most analysts have failed to understand, the only way credit can rise to those levels is if it is purchased and effectively monetized by the central bank, in which case the consequence would be downward pressure on household consumption growth. Simple arithmetic suggests in that case that the only way to keep GDP growth at 5% would require wealth transfers from local governments at probably 5% of GDP or more, and given the political difficulty of even generating wealth transfers of 1-2% of GDP, which I hope to see begin in next year, I doubt this is one of Singer’s assumptions.

I don’t mean to beat up on Singer. The friend who sent me the article included it among several others because he thought it showed the strategies used by analysts who were late to see the Chinese adjustment coming, even though it should have been obvious years ago. But as I explained later in the same blog entry, I am less cynical about the motives of these analysts because I think they genuinely fail to understand how imbalances are created, how they can persist, and how they affect and are affected by the structure of balance sheets. That is why they cannot distinguish between deep imbalances and unsustainable credit growth on one hand and imminent crisis on the other.

What does a rebalancing China mean for the world?

While the chances of a disruptive adjustment – including a financial crisis – are clearly rising, for now I will assume, as I have since 2009-10, that China is able to pull off a non-disruptive rebalancing. In that case I expect GDP growth rates will continue to decline by about 100-150 basis points a year until some level at which during the 2012-22 period growth will average 3-4% at best. Growth in household income and consumption, of course, must be higher as China rebalances and should average around 5-6% during this period. This can only occur as wealth is systematically transferred, either implicitly or explicitly, from the state sector to the household sector.

Because I have explained many times before how this process might work and where it is vulnerable to disruption, the rest of the newsletter will focus on trying to work out the impact of a non-disruptive Chinese rebalancing on various parts of the Chinese and global economy. Before addressing each of the sectors I think relevant, I thought it might be useful to present a table I stole from John Mauldin’s blog, which he takes from Barry Ritholtz, that shows the sheer extent of China’s presence in commodity markets. The table leaves out China’s consumption share of global iron ore production, which I believe was 63% in 2012, but it includes most other major commodities.

Population 20%
Economy 13%
Concrete 60%
Aluminum 54%
Nickel 50%
Copper 48%
Steel 46%
Gold 23%
Coal 49%
Uranium 13%
Oil 12%
Rice 30%
Corn 22%
Wheat 17%


  1. Effect on metals

    The table above suggests why it turned out to be quite easy to make what I think was my only China-related “Chicken little” prediction. In late 2011 and early 2012 I argued that because China’s rebalancing had become difficult to postpone much longer (indeed it began, I would argue, in 2012), the prices of most industrial metals would fall by over 50% within three years and iron ore would test $50 by 2017. This would happen whether or not China’s adjustment happened non-disruptively.

Metal prices did indeed fall as expected, and there is now a pretty substantial debate over whether, as a recent Financial Times headline put it, “mining is at rock bottom”. I am not as confident today as I was in 2011-12 about overriding my basic ignorance of the metals industry and predicting metal prices largely on the basis of my China expectations, but I continue to believe that metals prices will fall – probably to levels not very far from those typical at the turn of the century (adjusting for inflation and the strength of the dollar).

I say this because China has only begun its adjustment process, and investment growth still has a long ways to fall. Global demand is structurally weak, probably because of high levels of income inequality which tend to reduce both consumption growth and growth in private investment. Unless we were suddenly to see roaring growth in India over the next few years, which is not out of the question given how its poor infrastructure guarantees an obvious productive destination for investment flows, I don’t expect any counterpart to China’s continued declining demand for metals.

  1. Effect on energy

I am often asked how I expect China’s rebalancing to affect demand for energy, but I find my framework not especially useful in answering this question. As China’s growth slows and demand switches from investment to consumption, I assume there will be slower growth in China’s demand for energy because except for automobile purchases, which have probably peaked even in the best of cases, consumption tends to be less energy intensive than the kinds of investment that has dominated Chinese activity in the past.

I have to confess, however, that I am much less certain about this, and given how politics can interrupt the supply side, I am largely mystified by energy price swings. Perhaps the only thing I can say with some confidence is that if China attempts to maintain current growth in economic activity, and with it even faster growth in debt, there is a rising probability of a disruptive adjustment in which economic growth suddenly collapses, in which case I expect energy prices would fall sharply.

  1. Effect on agricultural commodities

Unlike with the demand for metals, Chinese demand for agricultural commodities is likely to be highly sensitive to whether or not China is able to adjust non-disruptively according to the assumptions I list above. If it does, household income growth in China will remain strong – rising by 5-6% a year – while income inequality stabilizes or even declines. Chinese demand for food would continue to rise sharply, and so would probably support the prices of agricultural commodities, and this is even more likely to be the case if India performs as well as some expect.

In the case of a disruptive adjustment, however, demand for agricultural commodities would not hold up. In that case I would expect growth in demand for food to fall sharply, at least for a few years, because China’s rebalancing would then take the form of a sharp drop in investment combined with a drop in household income – one that is less brutal than the drop in investment, but a drop nonetheless. In that case along with lower consumption we would probably see a reversal of the shift in recent years towards more grain-intensive forms of food (i.e. less meat consumption).

  1. Effect on labor-intensive manufacturing abroad

A rebalancing China must be accommodated, for mainly arithmetical reasons, by a relative shift of wealth from the state sector to the household sector. If Beijing does not take steps to promote this shift, it will occur more painfully, at lower and even negative levels of GDP growth and household income growth levels perhaps two or three percentage points higher. If Beijing implements policies that accelerate this transfer, both GDP growth and household income growth will be that much higher.

There are many ways, however, that wealth can be transferred, and it is important to remember that the way in which it is transferred is ultimately a political decision more than an economic one. After many years in which it lagged productivity growth, wage growth began to pick up around 2010, and while I expect it will continue, most of the forms of wealth transfers that are implicit in the reforms proposed in the Third Plenum are likely to increase household income indirectly rather than in the form of higher wages. What is more, slower growth, especially in the real estate sector, will reduce upward pressure on wage growth.

For this reason I suspect that we may have already seen much of the relative adjustment that was likely to take place in the form of rising wages. As China continues to rebalance, then, although I think the manufacturing sectors in other developing countries will continue to benefit, especially in countries, like Mexico, that were hardest hit by Chinese competition in the last decade, I believe that rising Chinese wages will no longer provide as much support for low wage economies that compete with China as they had in the past.

I say this without great certainty because, as I want to stress, although we can be reasonably confident about relative wealth transfers from the state to Chinese households, we have to think about the forms in which these transfers take place largely as the outcome of political decision-making, based, of course, on political conditions that hold at the time. A Beijing that is more concerned for example about workers, including migrant workers, than about the urban middle class is more likely to favor wage growth than an appreciating RMB, higher deposit rates, or other forms of transfer that benefit the urban middle class.

The key for any analyst should be to pay attention to political signals emanating from Beijing. For now however I expect that labor-intensive manufacturing abroad will benefit less than it has in the past 3-4 years from China’s rebalancing.

  1. Effect of capital-intensive manufacturing abroad

 The same logic holds for capital-intensive manufacturing abroad, but with different consequences. Nominal GDP growth in China, along with the GDP deflator, began falling very rapidly in 2012, one of the most important and beneficial consequences of which was effectively a collapse in the financial repression tax. This tax heavily penalized households for whom savings in the form of bank deposits and, to a somewhat lesser extent, interest-bearing wealth management products, is an important source of income, and is probably the single most important cause of China’s deteriorating imbalances before 2011-12.

There was a second important and beneficial consequence, and this of course was the elimination of the massive borrowing subsidy made available to borrowers with preferred access to bank lending. It was this subsidized lending rate, negative in real terms for much of this century, that more than anything else explains the wanton misallocation of capital during the last decade.

Not surprisingly, however, as interest rates have risen sharply in relative terms since 2011-12, borrowers who had taken out the most debt and invested in the lowest yielding projects, including most of the country’s provinces and municipalities, are suffering from painful debt-servicing costs, and there is enormous pressure on the authorities to reduce borrowing costs. SOEs that once seemed to be well-managed money-making machines are among the worst hit as we learn, which we always seem to do when the economy shifts into its liquidity contraction phase (the case of Enron, for example), that unexpectedly high profitability was often driven not by brilliant management so much as by highly speculative balance sheets.

For all the bellowing by desperate borrowers, China has managed to refrain so far from the easy expedient of slashing interest rates, and rumors are that the PBoC has been especially opposed to doing so. By so refraining, Beijing reduces the overall cost of China’s adjustment and improves the economic outlook for the country over the longer term, but of course this means absorbing the pain today.

I expect that Beijing will continue to use interest rates to force borrowers into better investment decision-making, and while unless there is a jump in inflation, which isn’t likely, we may start to see interest rates drop, I don’t think they will drop sharply in real terms.

If I am right, the implications are clear. One of China’s great competitive advantages for much of the century has been extraordinarily cheap capital, and while SOE managers in capital-intensive industries liked to claim that their success in international trade was explained by superior management techniques, like their Japanese counterparts in the 1980s, in fact in both cases it was more likely that access to artificially cheap capital was far more relevant.

As China continues to rebalance in the ways set out above, in other words, capital-intensive manufacturing abroad will continue to benefit disproportionately as Chinese exporters no longer benefit from heavily subsidized capital. But as in the case of labor-intensive manufacturing abroad, whether or not this continues to be the case is ultimately subject to political decisions about how wealth is to be transferred, and so it is important to note again that we must pay attention to political signals emanating from Beijing.

  1. Effect on consumption of luxury and super-luxury goods in China

It is almost part of the definition of rebalancing that after three decades in which they received a disproportionate share of growth, the elite and the rich must pay a disproportionate share of the adjustment costs, in favor of the middle and working classes. In the case of a non-disruptive rebalancing income inequality in China must decline. This means the halcyon days of luxury consumption in China are over and will not return under almost any plausible scenario for many more years. Those who think luxury consumption is down only because of President Xi’s anti-corruption campaign, and that once the latter ends we will return to the days of spectacular growth, will be very disappointed.

The exception might be in in the market for super-luxury goods – so that anyone selling $50 million yachts, super conspicuous art, European football teams, etc. might do well. This is because ultimately if China is to rebalance non-disruptively, it is hard for me to work out any scenario that does not involve at least partial privatization of SOEs, most likely those owned and managed by local governments. There are many ways in which this privatization can occur, including ways designed to overcome the inevitable opposition from vested interests. In that case some of these may be especially beneficial to the highest levels among the elite, whose opposition must be bought out one way or another.

  1. Effect on middle class consumption in China

Again because it is almost part of the definition of rebalancing that after three decades in which they received a disproportionate share of growth, the elite and the rich must pay a disproportionate share of the adjustment costs, in favor of the middle and working classes, in the scenario of a non-disruptive Chinese rebalancing, the growth rate of median Chinese household income is unlikely to slow very sharply. This means that middle class consumption growth in China, in other words, probably will not slow by much unless the rebalancing is postponed long enough for it to disrupt the economy.

  1. Effect on real estate prices abroad

Unless the PBoC were to impose much sharper restrictions on capital outflows, and this may not be easy to do either politically or technically, it is hard to imagine many scenarios in which capital outflows do not remain high for several more years. Because much of this will be driven by wealthy Chinese looking to acquire secure assets abroad, the demand for premium real estate in places popular with wealthy Chinese will probably remain strong.

  1. Effect on investment abroad

In the previous issue of this newsletter I explained why declining reserves, and declining purchases by the PBoC of US government bonds, was unlikely to force up US interest rates.

  1. Effect on EM

I have long argued that the emerging-market decoupling thesis was always patently absurd. EM growth was maintained after the 2008-09 crises undermined US and European demand not because demand had become self-sustaining in the developing world but because China had responded to the crises with massive increase in already excessively high levels of investment and mu8ch of the resulting demand, especially for hard commodities, benefitted EM.

But because the global crisis exacerbated already-high excess capacity, the Chinese stimulus, which only increased capacity further, was always unsustainable and would inevitably result in a more difficult ultimate adjustment for EM. In my opinion we are clearly at the end of another convergence period for developing countries, and historical precedents suggest we should be prepared for a decade or more of both sovereign debt defaults and economic divergence. Developing countries that most urgently recognize the change in underlying circumstances and focus most heavily on institutional reforms that unlock productivity growth, and who pay especial attention to efficient capital allocation, are the least likely fall behind in relative terms and the most likely to be in a position to benefit when global demand finally recovers.

For all the seeming predicting embedded in this issue of the newsletter, the key point I would make is that rebalancing can only occur in a limited number of ways, and each of these has a fairly predictable impact on the various economic sectors described above. What is more, many of the alternative paths Beijing can choose to follow, especially in the way in which it implements wealth transfers to the household sector, are likely to be determined as the outcomes of political decisions.

That is why rather than pay attention to the standard kinds of predictions economists often make, it is far more useful to work through the various rebalancing paths and to try to understand the changing plausibility of each of these paths. Above all we must recognize the ways in which imbalances can deepen or recede according to institutional constraints, and this means at a minimum rejecting the false dichotomies in which imbalances necessarily adjust quickly and disruptively in the form of financial crises. A financial crisis, while always a real possibility in a deeply unbalanced economy in which debt levels are high enough to create uncertainty about the allocation of debt servicing costs, is simply one of the many ways in which debt and imbalances can be resolved.


Aside from this blog, every month, sometimes more often, I put out a newsletter that covers some of the same topics covered on this blog, although there is very little overlap between the two and the newsletter tends to be far more extensive and technical. Academics, journalists, and government officials who want to subscribe to the newsletter should write to me at, stating your affiliation. Investors who want to buy a subscription should write to me, also at that address.

Does it matter if China cleans up its banks?

I’ve always thought that Shirley Yam of the South China Morning Post has a great nose for financial risk, and this shows in an article she published last week on mainland real estate. For anyone knowledgeable about the history of financial bubbles and crises, much of the following story will seem extremely familiar. The point to remember is that what is normally recorded as business operations in activities described in the article results in fixed payments that are inversely correlated with underlying conditions, and so is really no different than debt in the way it will begin to generate financial distress costs when the economy turns, goosing economic activity on the way up while exacerbating the contraction when it comes.

Yam discusses how building contractors must pay developers to build real estate projects and write about one such contractor, whom she calls “George”:

This is how the system works. Say an apartment building costs 1 billion yuan to build. George will provide the developer 300 million yuan as “facilitation money” at an interest rate of about 4 per cent to win the job. The latter will then give George 80 million yuan for the services rendered.

George, however, does not have any shareholding in the project, whatsoever to cover his back. Neither is he assured that the facilitation money would not end up in the stock market. All George can do is pray and hope that the apartments sell well and he gets his money back with interest plus the construction costs. Despite the risk, there has been no dearth of interested players. As George puts it, it has been getting worse. His state-owned rivals are now offering “facilitation money” of up to 50 or even 60 per cent of the construction cost. Some are even pitching in with zero interest, while others are promising to help in eventual sales.

She goes on to talk about the desperate competition among developers to get new projects, and what is driving the record beating real estate prices:

The obvious question that comes to the mind is why are developers willing to pay record amounts to own a piece of land, or as some suggest pay more for the flour (land) than the bread (flat). But then the land parcels are not really meant to be the flour for the bread. A good case is China Cinda Asset Mangement, which has invested more than 61 billion yuan in property during the past 12 months.

Among its acquisitions was a piece of land in suburban Beijing that was so expensive that will break-even only if the property prices are four times higher. But Cinda has piles of liquidity to splash about. Its debt to equity ratio rose by a third to 368 per cent in 2015 and it paid just a quarter of the loan rate of its private rivals. For Cinda property seemed the best bet. After all, the real economy was not going anywhere and the stock market was twisting and turning. On the other hand, property investment promised huge returns and was more self-fulfilling in nature. The record-breaking land prices support the property market and therefore the repayment of the multi-billion yuan of loans via shadow banking that Cinda and other state firms are loaded with. So overpayment seemed perfectly okay.

Keep all of this in mind when thinking about stepped-up efforts to clean up China’s banking system. There has been a flurry of reports recently about steps taken to clean up the banking system, but from an economy-wide point of view, it is not clear that any reduction in debt burdens for the banking system actually reflect a reduction in the debt burden for the economy as a whole, and anyway new kinds of debt are growing quickly enough that even if it did, the country’s debt burden is almost certainly rising.

Here is Bloomberg on a UBS report two weeks ago on the topic of bank clean-ups:

The good news is that the capital raises have begun. The bad news is that they need to continue. An analysis of 765 banks in China by UBS Group AG shows that efforts to clean up the country’s debt-ridden financial system are well underway, with as much as 1.8 trillion yuan ($271 billion) of impaired loans shed between 2013 and 2015, and 620 billion yuan of capital raised in the same period. But the work is far from over, as to reach a more sustainable debt ratio the Chinese banking sector will still require up to 2 trillion yuan of additional capital as well as the disposal of 4.5 trillion yuan worth of bad loans, according to the Swiss bank’s estimates.

I think a lot of this misses the point, and not just because there is a lot more debt out there than we think. I think the optimism with which this news has been received reflects a failure to think systemically about the Chinese economy. The fact that bad loans overwhelm the capital of the banking system should not blind us to the fact that China’s problem is excessive debt in the economy, and not a banking system that risks collapse because of insolvency. The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

Debt matters, not merely its location

Cleaning up the banks is much less important, however, when lending incentives are driven mainly by policy and there is widespread moral hazard. What matters is the impact of overall debt on Beijing’s ability to implement policies that work as expected, and its impact in generating economy-wide financial distress costs.

The key in China, in other words, is not whether the banks have been cleaned up. It is how the losses are going to be allocated, and that remains no clearer today than it ever has been. Until the losses are allocated, they will simply show up in one form or the other of government debt, either on bank balance sheets as a contingent liability for the government or as a direct liability of the government. Because debt itself is constraining growth – I expect it to force economic activity to drop to less than half current levels well before the end of this decade – the debt must be written down or paid down and its costs must be allocated, the sooner the better for China.

But that is of course easier said than done. I have already discussed many times why the losses should not be allocated to the household sector or the SME sector. Allocating it to the former worsens the imbalances and makes economic activity more dependent than ever on increases in investment, to which China will soon reach limits. Allocating it to the latter would undermine the only really efficient part of the economy and so disrupt any chance China has of long-term growth. The losses also cannot be allocated to the external sector because it isn’t large enough and it will not be allocated to the central government as long as the leadership believes it necessary to continue centralizing power. In the end the losses can only be allocated to local governments, but that has proven politically impossible.

I warn my clients that while all the excited chatter about reformist froth in the formal and informal banking sectors may seem like progress is being made or not made, and of course will have some impact on the stock selection process, in the end they should not take their eye off the ball. China’s problem is that to keep unemployment low the government must rely on a rising debt burden powered by surging non-productive investment, and the only way to constrain the growth in the debt burden and keep unemployment from soaring is to allocate the debt-servicing and adjustments costs to whichever sector of the economy is able to bear it with the least damage to China’s longer-term economic prospects.

This process is not being helped by a slowdown in the growth in household income. A July article in Bloomberg explains how, and presents a graph that shows growth in cumulative disposable income per capita dropping quarter by quarter over a two year period from 8.5% to 6.5% as GDP growth drops over that period from 7.5% to 6.7%:

Chinese consumers, whose spending helped underpin the first-half expansion this year, may not be able to deliver a repeat performance in the second as income growth slows. Household income growth slumped to 6.5 percent in the first six months from 7.6 percent a year earlier, data released Friday showed. Headwinds on consumer spending may increase as officials signal they will step in to curb pay gains to keep manufacturing competitive with rival nations that have cheaper production costs.

As shoppers become an increasingly crucial growth driver, any erosion of their strength would weaken the ability for the consumer-led expansion to offset weakness in exports and investment. That threatens the government goal of raising gross domestic product by 6.5 percent a year through 2020 and slow the rebalancing away from factory-led growth.

The conclusion is inexorable. Beijing must find a way of generating domestic demand without causing China’s debt burden to surge, which basically means it must rebalance the economy with much faster household income growth than it has managed in the recent past, and it must begin aggressively writing down overvalued assets and bad debt to the tune of as much as 25-50% of GDP without causing financial distress costs to soar. Everything else is just froth.

Can China “grow out” of its debt burden?

After many years of assuring the leadership that the debt burden was easy to manage and that reforms would resolve the problem of growth, economic policy advisors have still not been able to prevent the balance sheet from deterioration. They continue to promise that with the right combination of efficiency-enhancing reforms – and there seems to be a dispute among one group arguing for “demand-side” reforms and another for “supply-side” reforms – Chinese productivity will rise by enough to outpace the growth in debt.

But this will almost certainly not happen. Simple arithmetic indicates that the amount by which productivity must rise to resolve debt servicing is implausibly large and requires an unprecedented amount of efficiency enhancement. In the newsletter I sent out to clients on June 28, I calculated that if we believe debt is equal to 240% of GDP, and is growing at 15-16% annually, and that debt-servicing capacity is growing at the same speed as GDP (6.5-7.0%), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity Beijing’s reforms must deliver an improvement in productivity that either:

  1. Causes each unit of new debt to generate more than 5-7 times as much GDP growth as it does now, or
  2. Causes all of the assets backed by the total stock of debt (which we assume to be equal to 240% of GDP) to generate 25-35% more GDP growth than they do now.

If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity Beijing’s reforms must deliver an improvement in productivity that either:

  1. Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or
  2. Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

These levels of productivity enhancement do not seem very plausible to me and I do not think it is possible for reforms to improve efficiency by nearly enough to solve the country’s debt problem. What is worse, the historical precedents indicate that while many debt-burdened countries have attempted the same or similar efficiency-enhancing reform strategies, there does not seem to be any case in which this strategy has actually worked. No highly-indebted country, in other words, has been able to grow its way out of its debt burden until after it has explicitly or implicitly paid down or written down the debt. There are different ways in which this history has been exemplified:

  • In some cases, as in Mexico in 1989, after many years of struggling unsuccessfully to implement productivity-enhancing reforms and suffering from low growth and economic stagnation, governments finally obtained explicit write-downs of the debt when the debt was restructured with partial debt forgiveness (35% of the nominal amount, in the case of Mexico). In this case the cost of the write-down was allocated to foreign creditors, although during the many years of stagnation workers paid for financial distress costs through unemployment and suppressed wage growth.
  • In some cases governments never restructured their debt, and so never explicitly obtained debt forgiveness, but they did monetize the debt and so obtained implicit debt forgiveness through high levels of inflation (as was the case of Germany after 1919) or through financial repression (as was the case of China’s banking crisis at the end of the 1990s), or both (as was the case of the UK after 1945), in which the cost of writing down the debt was mostly absorbed by household savers. This last point is important because iit creates a great deal of confusion among analysts who think that China can resolve its debt problem the same way it did fifteen years ago. China effectively forced the debt-servicing cost onto household savers mostly during the first decade of this century. With nominal GDP growth ranging between 16% and 20% and a GDP deflator between 8% and 10%, lending rates should have probably been at least 13-15%, but instead they were set much lower, between 6% and 7%, and deposit rates even lower, between 2.5% and 3.5%. Negative real lending rates effectively granted insolvent borrowers debt forgiveness every year equal to at least 6-9 percentage points for a decade or longer. Depositors effectively paid for the full amount of the debt write-down as well as to recapitalize the banks. Forcing the cost of the write-down onto household savers worsened China’s imbalances significantly, however. The household consumption share of GDP fell from a very low 46% in 2000 to an astonishing 35% in 2010. This was not a coincidence.
  • In other cases in which governments never defaulted or restructured their debt, and so never explicitly obtained debt forgiveness, they implicitly wrote down the debt not by monetizing it but by means that involved allocating the costs to the wealthy in the form of expropriation or to workers in the former of wage suppression. Romania in the 1980s is an especially vivid case of the latter, and the way the Ceausescu reign ended suggests why this isn’t a model to be repeated.
  • Finally in other cases, the most obvious example being Japan after 1990 and now parts of Europe after the 2009 financial crisis, governments never explicitly or implicitly wrote down the debt, and have instead spent many unsuccessful years attempting to implement reforms that will allow them to grow their ways out of their debt burdens. They have failed so far to do so, and after so many years it is hard to see how they will succeed.

Resolving the debt burden

Debt must be paid down or written down explicitly, or it will be implicitly amortized over time in an unplanned way and at great cost to the economy. A fundamental part of Beijing’s reform strategy, in other words, must be to reduce the debt burden as quickly as it is politically able in order to minimize the economic costs of economic adjustment and to allow for the most rapid economic recuperation. Reducing the debt burden means selecting the sectors of economy that are best able politically or economically to absorb the cost, and forcing them to absorb the cost of the debt write-down, however reluctant they are to do so.

We typically think of the economy as consisting of four sectors: the external sector, households, businesses, and the government. In China however it is more practical to subdivide these further into the following:

  • Creditors. Creditors are forced to absorb the losses associated with writing down the debt when the borrower defaults on its debt and restructures it with a principle or interest reduction. Much of China’s debt burden has been extended through the banking sector, however, and because the debt that must be written down exceeds the banking industry’s capital base, ultimately the cost will be passed on to some other economic sector – for example Chinese households ultimately absorbed the cost of the banking sector losses generated in the late 1990s.
  • The external sector. To pass on costs to foreigners requires that they have significantly larger exposure to China than they actually do, and would also probably require defaulting on external debt, a path Beijing is unlikely to choose to follow.
  • Ordinary households. Most banking crises, like the recent US and European crises and the Chinese banking crisis at the end of the 1990s, are resolved by hidden transfer mechanisms that pass the cost of writing down debt to households. China today however must increase household wealth, not reduce it, if consumption is to rise fast enough to allow investment to decelerate, which means ordinary households cannot be allowed to absorb the cost.
  • Wealthy households. Given high levels of income inequality, and the low propensity to consume of the wealthy, forcing them to absorb the costs of writing down debt – in the form of highly progressive income taxes, for example – is likely to be among the less costly ways economically for Beijing to pass on the costs of paying down debt. As their income or wealth is reduced, the wealthy are likely to convert most of that reduction into lower savings and very little of it into lower consumption, thus minimizing its adverse impact on domestic demand.
  • Small and medium enterprises. Chinese SMEs are among the most efficient economic entities in China and are likely to be the main source of innovation and value creation in the future. Their long-term success is vital to China’s long-term growth. Like ordinary households they should be protected from absorbing the costs of Beijing’s debt-management policies.
  • Local and provincial governments. These have amassed a considerable amount of assets whose liquidation would most efficiently absorb debt write-down costs and would entail the lowest medium and long-term economic costs, although not perhaps the lowest political costs. As their assets are liquidated, total Chinese savings will decline and Chinese consumption will remain largely unchanged, thus minimizing the adverse impact on domestic demand.
  • The central government. Beijing too could pay for the cost of writing down debt by liquidating central government assets, although this may conflict with other economic policy objectives, including overcoming vested-interest opposition to the reforms.

These are the major sectors of the Chinese economy within which the cost of debt-management policies can be absorbed, and although there is likely to be a great deal of reluctance on their parts, the most efficient way economically is for the costs to be underwritten by the liquidation of local and provincial government assets and, perhaps to a lesser extent, by taxes on very wealthy households. It is important to recognize that if debt-servicing costs are not covered by the higher productivity generated by the relevant investment, the process by which the debt will be implicitly or explicitly written down and allocated will necessarily happen anyway, and according to only a limited number of ways. The only question is the extent to which it is directed by Beijing:

  1. Chinese borrowers can default or otherwise restructure debt such that the cost of the write-down is allocated to creditors in the form of a haircut on the debt. Because the creditors for the most part are the banks, which are insufficiently capitalized to bear the full brunt of the losses, these losses will still have to be allocated to some sector of the economy.
  2. If the regulators avoid defaults, there are three further potential outcomes. First, the authorities can implement efficiency-enhancing reforms that cause economic productivity to surge to the point at which excess debt-servicing costs can be covered by the additional productivity.
  3. Second, the authorities can implement reforms that specifically assign excess debt-servicing costs to targeted economic sectors in order to minimize the economic or political costs. For example it can force local governments to liquidate assets, or it can use taxes to appropriate the wealth of the economic elite, the proceeds of which are then used to absorb excess debt-servicing costs.
  4. Finally, if the authorities do not move quickly enough, excess debt-servicing costs, along with financial distress costs, will be allocated to those least able to protect their interests once debt-capacity limits are reached. There are many ways these costs can be allocated in an unplanned way. One way, and among the most likely, is if the debt is effectively monetized by continuous rolling-over of principle and accommodative monetary policy. While part of the cost may be paid out of an increase in productivity, this is likely to be a small part and can only happen to the extent that unemployment is already very high and the costs of increased production are low. Otherwise eventually either financial repression or unexpected inflation (with the former more likely than the latter because of the structure of debt in China) will force most of the costs onto household savers and others who are long nominal monetary assets, while unemployment and real wage suppression will force additional financial distress costs onto workers.[1]

Put simply, to the extent that Beijing refuses to follow the first path, and cannot follow the second, it must choose the third path or eventually the fourth will be imposed.


[1] Contrary to what many believe, the PBoC cannot simply monetize the debt. There seems however to be a huge amount of confusion about why it cannot. The standard objection is that “China’s ability to monetize this debt will only severely hurt households if it results in a hyperinflation.” This is simply not true, and reflects a misunderstanding of economies whose financial systems are structured in a very different way that of most Western countries, especially the US. See Michael Pettis, “Thin Air’s Money Isn’t Created Out of Thin Air”, Carnegie Endowment for International Peace, October 19, 2015

Rebalancing, wealth transfers, and the growth of Chinese debt

For the past ten years much of what I have written about debt in China was aimed mainly at trying to convince analysts and policymakers that the Chinese economy was structurally dependent on an unsustainable increase in debt in order to generate GDP growth rates above some level. This level might have been around 5-6% ten years ago but it has steadily declined with the rising debt burden and is currently probably not much above 2-3%.

Today it no longer seems necessary to explain that Chinese debt levels are far too high. On May 9 the People’s Daily published a major front-page interview with an “authoritative figure”, thought to be very close to Xi Jinping, warning that the Chinese economy was in much worse shape than many believed largely because debt had risen far too quickly. Here is the South China Morning Post:

A People’s Daily article published yesterday showed that China’s leadership is trying to make a grand shift in the nation’s economic policies in a bid to say goodbye to debt ­fuelled growth. In a sign of distaste for the credit-pumped growth in the past couple of months, the Communist Party mouthpiece cited an unidentified “authoritative” figure as saying that boosting growth by increasing leverage was like “growing a tree in the air” and that a high leverage ratio could lead to a financial crisis.

“The whole world”, according to the China Daily the next day, “seems to be talking about the People’s Daily interview on May 9.” It went on to say:

The People’s Daily article is good for all local officials to study and to follow. The message cannot be clearer. If it is from the top leadership, as some readers speculated, then what it represents is a requirement on the policy level – cut the debt level, by whatever means. Deleveraging, or cutting down indebtedness, is in fact listed as one of the five tasks of China’s supply-side reform for 2016. Now that half a year already has passed, at least some action should be taken during the remainder of the year, as the interview suggests.

Probably the real indication that the argument over whether or not China has a debt problem has been resolved is a May 7 article in the Economist. For years I had been extremely frustrated by the magazine’s coverage of the Chinese economy as being far too credulous and altogether too willing to assume away problems that other countries in similar circumstances had been unable to resolve.

Not all periodicals were so frustratingly cheerful. The Financial Times had long been writing about China’s balance sheet risks, with the FT Alphaville blog in particular zooming in on the key monetary and balance sheet vulnerabilities that by now have become so familiar to everyone else. Every time new evidence came out that suggested debt levels in China were becoming worrisome and needed to be addressed, however, the Economist responded by dismissing concerns over the debt as overblown. It consistently seemed to argue that China could easily manage it rising debt burden.

Last month, however, in a much-commented departure, the Economist suddenly reversed positions, warning that debt levels had become so extreme that “it is a question of when, not if, real trouble will hit in China.” In an alarming, but not alarmist, piece, the magazine acknowledged how serious China’s balance sheet distortions had become:

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

The article ended with what all of us should have been saying for nearly a decade: China’s debt burden would have been relatively easy to manage had Beijing started doing so much earlier, under Hu Jintao’s presidency. It is no longer easy to manage, but the longer Beijing waits to begin the deleveraging, the more difficult it will be:

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.

Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

Finally there is consensus

This, I think, is really the key point. There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Not that most analysts understand how important it is to constrain credit growth, the task is to explain exactly why debt is a problem, how it will undermine growth, and why many of the “solutions” that economists propose are simply not solutions at all. These “solutions” include a number of especially treacherous ideas: China’s rising debt can be managed for quite a long time before it becomes a serious constraint, countries have near-infinite capacity for domestic debt when it is “backed” by even greater amounts of savings (this is an especially foolish conceit), China can easily monetize the debt at no significant cost, or the right solution is to improve productivity to the point at which economic growth can outpace credit growth (it is nearly impossible to find a trained economists who doesn’t think this last is self-evidently the only way to approach the problem of debt management).

A little over a year ago in the newsletter I send out to my clients I tried to explain how debt constrains growth. In that issue of the newsletter I discussed debt generally, as it affects any kind of macroeconomic balance sheet, but of course the focus was on China. In the newsletter I posited a number of rebalancing scenarios in order to try to work out the implications fro debt. I have made some small adaptations to these scenarios but most of the rest of this blog entry is taken from that newsletter. One obvious consequence or revisiting this one-year-old exercise is to make clear just how optimistic were the assumptions I made in designing the various scenarios.

Economists are trained with models in which the structure of the balance is barely relevant to growth except to the extent that fear of a debt crisis undermines confidence. Of course this completely circular reasoning cannot be true except if we assume that the fear of a debt crisis is totally irrational – as it must be if growth is not otherwise affected by the structure of the balance sheet. Still, the implications of these totally unrealistic models seem to dominate the kinds of reforms that policy-making advisors have proposed even since Xi Jinping has come to office, and if my suspicions are right, and Xi and those closest to him have become intensely frustrated by the advice both Chinese and foreign advisors have proffered, we may be in for a much needed change.

The first implication of the balance sheet approach to reforms is that given extremely high debt levels there really is no easy way to rebalance the Chinese economy. It is foolish to think that China’s adjustment will be anything other than extremely difficult, and it is in the best interest of China that the challenges facing the Xi administration are not minimized.

Examining China’s debt scenarios

To show why, I thought it might be helpful to summarize the various scenarios for rebalancing and non-rebalancing that I presented to my clients over a year ago. In the table below I look at three possible scenarios in which China is able to maintain current GDP growth rates of 6-7%, with three different amounts of government transfers to the household sector expressed as a share of GDP. This is followed by three possible scenarios in which GDP growth rates drop to 3-4%, with the same three different amounts of government transfers to the household sector expressed as a share of GDP.

I divide each of these scenarios into two time frames. The first is the next three years under President Xi Jinping, and the second is the last three years of his administration (assuming, of course, that Xi, like his predecessors, serves two five year terms).

These scenarios are very rough, and I have tried to select the most optimistic and least disruptive conditions and assumptions. I assume that debt is easily refinanced, that rising debt imposes no financial distress costs, that the amount of unrecognized NPLs is too small for their refinancing to have a significant impact on the growth in credit, and that the growth in household income is not highly correlated with investment growth. I think these assumptions are very optimistic, to the point of seriously underestimating the difficulty of the rebalancing, but they nonetheless help us frame the set of possible outcomes by pretending that all those costs that are hard to quantify are negligible, even zero.

In the first of these three scenarios I will assume that it is politically very difficult for the Xi administration to transfer significant amounts of wealth from the state sector to the household sector – either directly, in the form of transfers of assets to household or to the social safety net, or indirectly in the form of houkou reform, the sale of assets to pay down debt, and so on. In this scenario in other words I assume total transfers are negligible.

Growth remains at 6-7% 2016 -2019 2020-2023
·   No government transfers







·    Debt growth is steady at 12-14%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing


·    Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP

·    Debt growth rises to 15-18%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing

This scenario posits no consequent changes in any of the main variables. Investment and consumption continue growing at current rates, with no change in overall GDP growth (I am ignoring possible changes in the current account). For this to happen, debt must continue growing at current levels of roughly 12-14% annually. I have argued many times before that China is now in a stage – similar to that of the late stages of every other country that has experienced a growth “miracle” – in which so much bad debt remains unrecognized within the banking system that credit growth must accelerate simply to maintain current levels of debt financing for economic activity.

This means that even maintaining current levels of investment, consumption and GDP growth implies accelerating credit growth. Since I sent out the newsletter last year I have already been proven vastly optimistic on this assumption because the latest data just one year later suggest that debt has been growing by 15-17% to maintain 6-7% GDP growth. I suspect that within another year debt will be growing by much closer to 20%.

But I want to be extremely conservative so as to give the optimists every chance for the arithmetic they implicitly use (but don’t seem explicitly to recognize) to work. I will assume, then, that there is no need to accelerate credit growth from levels at the beginning of last year and I will assume that the acceleration we have already seen this year was somehow an aberration that can be reversed (I assume this for the sake of conservatism. Of course, and not because I think it is remotely likely). I also ignore the financial distress effects I discuss above, even though there is an overwhelming amount of evidence that suggests that as debt levels grow and create increasing uncertainty about their resolution, economic growth slows fairly automatically and rapidly.

The key point about this scenario is that if we maintain current levels of consumption, investment and GDP growth, at the end of three years even conservative assumptions imply that China’s already high debt levels rise, as the table shows, by at least a quarter (i.e. if debt is currently equal to 200-240% of GDP, it rises to 250-300% in 3 years). I don’t show in the table that at the end of six year, debt would rise again by at least one-third, so that it would amount to perhaps 330-400% of GDP.

Debt probably already amounts to more than the 200% of GDP recorded in the June 2015 release of the World Bank’s China Economic Update (pp. 23), with many claiming that it is closer to 250%. Whatever the actual debt ratio, it is hard to imagine that the growth in Chinese debt, already among the fastest ever recorded in the developed or the developing worlds, can be maintained at anywhere near current levels for more than two or three years. The same World Bank report suggests (pp. 6) that there may already be strains in Beijing’s ability to maintain credit growth:

Policy interventions are increasingly focused on unlocking new funding sources. Besides promoting public–private partnerships (PPPs) as a new funding model for infrastructure funding, there have been efforts to intensify use of policy banks. Further, in April the State Council expanded the use of the Social Security Fund to buy local government bonds and other financial instruments. The new rules allow it to invest up to 20 percent of its portfolio in local government debt and corporate bonds.

It may very well be that Beijing’s credibility is so strong that even substantially higher debt levels won’t matter, but I would argue that it will not be easy to manage another three years of debt rising much faster than debt servicing capacity, let alone six, and if this happens it must undermine confidence, even without more credibility setbacks, like the stock market panic earlier this month.

The new normal with government transfers

The “muddle through” scenario, in other words, in which current investment and consumption growth rates are maintained, and with them current GDP growth rates, is an extremely risky one and, in my opinion, makes the possibility of a hard landing as China runs into debt capacity limits very high. Debt capacity limits are reached, as I have long maintained, when debt cannot grow fast enough to cover its two main functions: First, it must grow at a geometric rate to roll over old bad debt as well as new bad investments whose principle and interest cannot be met by increases in productivity, and second, it must grow at a linear rate to invest into new projects that generate the targeted growth in economic activity. This will be made worse if rising debt uncertainty causes wealthy Chinese residents to disinvest locally and send money abroad at even faster paces than they have in the past, but as I point out above, I am ignoring this possibility so as to present the most optimistic scenario.

But Beijing can tray another strategy. Instead of simply muddling through, Beijing might try to maintain current growth rates while transferring wealth to the household sector to force up consumption growth. I posit two scenarios, one in which Beijing is able to transfer 1-2% of GDP every year, and a second in which Beijing is able to transfer 3-4% of GDP every year. The first scenario will be hard enough to pull off politically, and the second extremely implausible, but I include both to give a sense of the range of outcomes.

In the two transfer scenarios I assume that the decline in investment has no adverse impact on household income because its impact on employment is more than counterbalanced by the rise in consumption. With household income at a little more than half of GDP, the transfers would cause household income growth to rise by 2-3 and 6-7 percentage points respectively, and I assume that this translates directly into equivalent increases in the consumption growth rate (i.e. I assume, perhaps very optimistically, that rising debt does not create enough economic uncertainty in the minds of Chinese households to cause them to raise their savings rate).

Growth remains at 6-7% 2016 -2019 2020-2023
·   Annual government transfers of 1-2% of GDP







·   Debt growth drops to 9-10%

·   Investment growth declines by 2-3 percentage points

·   Consumption growth rises by 2-3 percentage points

·   Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly

·   Minimal rebalancing


·   Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·   Debt growth rises to 11-13%

·   Investment growth declines by another percentage point

·   Consumption growth is steady

·   Growth in household income is steady and household share of GDP rises

·   Gradual rebalancing


The key point to which I would want to draw attention is the impact on the country’s balance sheet. In both cases the surge in household income would allow Beijing to bring down investment growth much more aggressively and so to rein in debt growth.

Growth remains at 6-7% 2016 -2019 2020-2023    
·   Annual government transfers of 3-4% of GDP








·    Debt growth drops to 8-10%

·    Investment growth declines by 6-7 percentage points

·    Consumption growth rises by 6-7 percentage points

·    Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher

·    Material rebalancing


·    Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·    Debt growth rises to 6-8%

·    Consumption growth declines by 1-2 percentage points

·    Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher

·    Material rebalancing



In both scenarios debt continues to grow, but in the second scenario it is now almost in line with the growth in GDP, which we are assuming is no higher than the growth in debt servicing capacity. While the first scenario implies that the debt-to-GDP ratio has increased by 10-15% (or, if debt is currently equal to 200-250% of GDP, it will rise to 220-290% of GDP in three years and 260-340% in six years), the second scenario implies a gradual rise in the debt-to-GDP ratio. The lower end of the estimate, I think, might be sustainable, although no developing country has managed to sustain such high levels of debt as the higher end, and it requires an implausibly high annual transfer of wealth from governments to households of 3-4% of GDP.

Adjustment with slower growth

What happens if Beijing reins in credit growth and forces down the investment rate much more aggressively, so that GDP growth rates drop to 3-4%? The decline in investment growth will cause growth in consumption to decline too, but not by as much, given that the decline in investment would affect the more capital-intensive public sector. I will assume that there is no significant rise in unemployment because Beijing will allow debt to rise to keep unemployment down while it manages the transition to a more consumption-driven economy, in which demand tends to be more labor-intensive.

Again I will consider three scenarios, the first of which involves no transfers of wealth from the government sector to the household sector. The second two will include a manageable transfer of 1-2% of GDP annually and a highly implausible transfer of 3-4% of GDP annually.

Growth drops to 3-4% 2016 -2019 2020-2023
  • No government transfers









·    Debt growth drops to 6-8%

·    Investment growth declines by 4-6 percentage points

·    Consumption growth declines by 2-4 percentage points

·    Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher

·    Material rebalancing



·    Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·    Debt growth is steady at 6-8%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady at current levels and household share of GDP is materially higher

·    Material rebalancing


As in the first three scenarios I would argue that the key point is what happens to debt, as this, more than anything else, determines the sustainability of the growth model and how much time Beijing has to manage the rebalancing. In this scenario the debt burden continues to rise, but after three years the debt-to-GDP ratio is likely to be only 10-15% higher than it is today.

Growth drops to 3-4% 2016 -2019 2020-2023
  • Annual government transfers of 1-2% of GDP










·   Debt growth drops to 5-6%

·   Investment growth declines by 7-9 percentage points

·   Consumption growth is flat

·   Growth in household income is flat and household share of GDP is higher

·   Material rebalancing




·   Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth is steady at 5-6%

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is materially higher

·   Material rebalancing




If Beijing is able to combine lower growth with government transfers equal to 1-2% of GDP annually, the growth in debt will barely exceed GDP growth (under admittedly optimistic assumptions), and finally, if Beijing transfers 3-4% of GDP annually, the debt-to-GDP ratio begins to fall almost immediately.

Growth drops to 3-4% 2016 -2019 2020-2023
  • Annual government transfers of 3-4% of GDP








·   Debt growth drops to close to zero

·   Investment growth is zero

·   Consumption growth rises from current levels

·   Growth in household income rises from current levels and household share of GDP is materially higher

·   Substantial rebalancing


·   Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth drops to well below GDP growth

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is substantially higher

·   Substantial rebalancing


Clearly the more wealth is transferred to the household sector, or the more Beijing is willing to allow the economy to slow, the more stable is China’s economic adjustment and the less painful economically over the long term. Greater transfers and slower growth, however, both come at the expense of the vested interests who oppose the reforms, and so it is politics, more than economic logic, that will determine the success of China’s rebalancing strategy.

I should note that there are so many moving parts to this analysis and so many simplifying assumptions, that the scenarios listed above should not be taken as predictions. There are important points, however, that I think emerge from this scenario analysis.

First, even after overwhelming the analysis with implausibly optimistic assumptions – discounting the disruptions caused by shifting strategies, for example, assuming financial distress costs are close to zero, and ignoring the impact on debt sustainability that results from rolling over a significant share of total loans that cannot be repaid – it is pretty clear that without a major change in policy or a tolerance for slower GDP growth it will be hard to prevent debt from becoming unsustainable. At some point, and my guess is that this would occur within the next two to three years at current growth rates, China runs the risk of a very disruptive adjustment as it reaches debt capacity limits, perhaps even the risk of negative GDP growth rates.

Second, any analysis of future growth that doesn’t tie changes in the growth rates of investment, consumption and government transfers to changes in debt levels misses out on perhaps the most important constraining factor. I think failure to understand this point explains, by the way, why over the past few years very few economists had expected GDP growth to slow as sharply as it has, and debt to rise as quickly, or allowed for either in their projections.

My guess is that the same economists will continue to make the same mistakes. To avoid doing so, as we continue to make projections about growth in GDP or in any of the drivers of GDP, we must estimate their impact on debt and how this further constrains our assumptions about growth in GDP or in its drivers. This requires a deeper understanding of how balance sheets affect growth.

What is inevitable and what is possible

Unfortunately, much of the analysis we have seen on China in the past two decades almost completely ignores the balance sheet. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still easily manageabble, there was a chance, no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers. Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.

The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of that consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.

I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable and that debt was already constraining policymaking.

To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth and was underestimating how difficult it would be for the new administration to break out of this process. There is in other words a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system.

I think this was exemplified last year when the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s very detailed and carefully argued book, Markets over Mao. I was one of the five analysts who were asked to participate in the reviews. Lardy is one of the best informed and most knowledgeable of the economists covering China and so I was honored to be invited to review the book. In my review I praised his book for the quality of its analysis, and it well deserves that praise.

But there was a fundamental disagreement in how he and I interpreted the data. Lardy believes China is in good shape economically and concludes with very optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth at the time, I think, was around 6-7%. Lardy thinks this is a low number, and has said that with the right reforms “China could grow at roughly 8% a year for another 5 or 10 years.”

I believe, however, that he is wrong. The reforms he means consists largely of productivity- or efficiency-enhancing reforms aimed at boosting growth by implementing what I refer to as “asset-side management”. But to me these asset-side reforms are barely relevant at this stage, although had they been implemented a decade ago China might not be in the difficult balance-sheet position it is in today. I have argued instead that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%, no matter how aggressively Beijing implements the standard grab-bag of orthodox reforms offered by orthodox economists.

These are the same reforms offered not just in the case of China today but during nearly every debt crisis in modern history, including to policymakers in peripheral Europe following the 2009 crisis. As far as I can tell there is not a single case in modern history in which the reforming country was able to grow its way out of its debt burden. Instead the debt burden has always increased until the country either engineers or is forced into explicit or implicit debt forgiveness.

That is why we disagree so strongly in our forecasts even though I largely accept his analysis of the Chinese economy. We disagree for the same reason I disagreed with the Standard Chartered China strategist who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement rather than an inevitable consequence of a structural dependence on debt. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.

As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst seem to recognize how the balance sheet might affect growth in the future and how it affected growth in the past. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review:

Rebalancing is often harder than expected, in other words, not just because of opposition by vested interests, but more importantly because highly inverted balance sheets cause policymakers to overestimate potential growth during the miracle years. But when growth during the rebalancing phase contracts more than expected, the same balance sheet inversion that exacerbated the expansion phase will also exacerbate the slowdown, especially as declining credit quality reinforces, and is reinforced by, slower growth.

I made a similar argument a few weeks later in a Wall Street Journal OpEd about why it is so important that Beijing maintain its credibility, which is the only way of ensuring that China’s substantial balance sheet mismatches can be managed and rolled over:

History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.

…Over time, this means the entire financial system is built around the same set of optimistic expectations. But when growth slows, balance sheets that did well during expansionary phases will now systematically fall short of expectations, and their disappointing performance will further reinforce the economic deceleration. This is when it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise.

Financial distress can be worse than a crisis

The second misunderstanding is about why “too much” debt matters. For most economists, the main and even only problem with too much debt is that it might lead to a financial crisis, and that the fear of crisis undermines confidence and so can cause spending to drop. But while these are important problems, these analysts are mistaken in limiting their concerns to these two issues. While a financial crisis is certainly a risk, the damage debt does to an economy occurs long before any crisis, and for debt to be terribly damaging to an economy’s long-term growth doesn’t even require a crisis.

In fact one can easily make a case that while a financial crisis may be spectacular, it nonetheless limits the damage caused by excessive debt by forcing a recognition of the losses, only after which does the system begin to allocate capital efficiently. Until this happens, the adverse impact of debt on growth can persist for decades. A case in point is Japan. Japan never had a financial crisis or a banking sector collapse, but from 1990 to 2010 the amount by which its share of global GDP has declined far exceeds the damage caused to any other country by a financial crisis. Or consider the heavily indebted countries of Europe, like Spain, Italy and Portugal, who have avoided crises without showing convincingly that they are better off economically today and over the rest of this decade than they might have been had they suffered a financial crisis in 2009 or 2010.

In my review of Lardy’s book I try to explain why debt constrains growth, whether or not it leads to a crisis:

The second way liability structures can constrain growth, while often poorly understood by economists, is actually well understood in finance theory. An economic entity will suffer from “financial distress” if debt has risen so much faster than expected, or growth is so much lower than expected, that economic agents become uncertain about how higher debt-servicing costs will be assigned to different sectors of the economy. This uncertainty forces these agents to react in ways that unintentionally but automatically intensify balance sheet fragility and reduce growth. This uncertainty is intensified if the debt burden rises and falls inversely with debt-servicing capacity, which almost always happens when economic growth is highly credit-intensive, and which seems to be happening in China.

Because this seems so counter-intuitive for many people, it bears repeating. The problem with too much debt is not just that it might cause a crisis. The problem is, first, that debt may be structured in a way that systematically enhances volatility, which means good times appear better and bad times worse. This automatic leveraging-up of volatility has seriously adverse impacts on long-term growth. Second, when debt levels are higher than expected and growth lower (one of the nearly inevitable consequences of highly volatility-enhancing balance sheets), if this divergence causes uncertainty about how the debt servicing will be resolved, the uncertainty itself forces agents to behave in ways that automatically reduce growth and increase balance sheet fragility further.

Lardy’s response to my discussion of debt indicates, I think, just how much confusion there is here and how easy it is for most economists to misunderstand the relevant issues – although in fairness it should be noted that he is responding to five separate reviews, and so this is unlikely to be his full response:

Contrary to Michael Pettis’s assertion, the book does give some attention to the liability side of the Chinese economy. I note the huge buildup of debt starting in the fourth quarter of 2008 and analyze the challenges this debt poses for financial stability. But in Markets over Mao I point out that China differs in several critical respects from other countries where rapid debt buildups have precipitated financial crises.

To begin with, China’s national saving rate, reflecting the combined savings of households, corporations, and the government, approaches 50% of GDP, significantly higher than any other economy in recorded history. Like households, countries that save more can sustain higher debt burdens. Second, the vast majority of this debt is in domestic rather than in foreign currency…Thus, its debt does not involve any significant currency mismatch, a major contributor to many financial crises. Third, the majority of this debt has been extended by banks, and China’s systemically important banks are financed entirely by deposits rather than through the wholesale market…Finally, the government has enormous scope to further increase bank liquidity should that become necessary. Other factors, too numerous to list here, also suggest that a banking crisis is far from certain in China.

But Lardy is not actually disagreeing with anything I said. In fact I fully agree with him that a banking crisis is unlikely, and have written many times that while it is possible, and the risk of its happening should not be dismissed out of hand, I do not think China is likely to have a banking collapse, any more than Japan in the late 1980s and early 1990s was ever likely to have a banking collapse. This doesn’t mean however that China’s debt burden is irrelevant.

A system of interlocking balance sheets

Japanese GDP growth, after all, did indeed collapse as it was forced to rebalance its debt-laden economy, and this collapse in growth has lasted an astonishing 25 years, with, as I see it, still no end in sight. During the first wave of excitement over “Abenomics”, for example, I wrote in this newsletter and elsewhere that just trying arithmetically to work through the consequences on the country’s debt burden of the success of Abenomics made it hard for me to see how Abenomics could possibly succeed in generating inflation and real growth without an explosion in its current account surplus that the world would not be able to absorb.

It was precisely because of China’s debt dynamics that I began arguing in 2006-07 that China’s growth model was unsustainable, that its debt was rising too quickly and could not be reined in without a significant drop in growth, and that China had urgently to rebalance. The same logic made me argue in 2008-09 that China’s adjustment was going to be brutally difficult and would entail at least a decade of GDP growth that could not exceed 3-4% on average. And yet I have always also argued that China’s banking system is very unlikely to collapse, and if one excludes things like the credit crunch in June 2013 or this month’s stock market panic, we are unlikely to see a financial crisis unless GDP growth – and with it credit growth – remains at current levels for another 3-4 years at most.

It is neither enough to note the amount of debt a country has or to speculate on the probability of a debt crisis. What matters is the systemic role of debt in generating economic activity, the feedback processes that are embedded in debt structures, and the uncertainty that may arise about the resolution of debt-servicing costs. To summarize, there are at least four important issues to consider:

  1. It is possible to structure an economy in such a way that excessive debt creation is not a “choice”, not even a bad choice, but is instead the automatic consequence of institutional constraints within the economy, and in fact it is very rare that a country experiencing many years of “miracle” growth hasn’t created such constraints. This is why it should have been possible to see well over a decade ago that China’s excessive indebtedness was inevitable. Economists who warned of the possibility of a deterioration in the balance sheet, but who thought nonetheless that China could avoid this outcome without a major restructuring of its growth model and a significant reduction of its growth rate, were always fundamentally mistaken. Excessive debt levels were never a “possibility”. They were a necessity as long as the growth model was not fundamentally transformed.
  1. The structure of the balance sheet, by which I mean the types of mismatches between assets and liabilities when debt levels are high enough, can systematically enhance volatility, so that periods of expansion, real productivity growth, or benign global conditions can result in many years of growth that exceed expectations. This comes however at a cost. First, the same balance sheet structures that enhance growth during the expansion phases will cause growth to slow much faster than expected during the contraction phases, and second, enhanced volatility always reduces value, although not always perceptibly at first, because it increases gapping risk. This process is perhaps counterintuitive to those who think all economic activity is driven by fundamentals, but is well understood by traders and investors, who know how it works in margin buying, leveraged positions, and derivatives that directly quantify leverage and gapping risk.
  1. Apart from enhancing volatility, high debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be resolved, i.e. to which sectors or groups they will be explicitly or implicitly allocated. This uncertainty will affect the behavior of any sector of the economy to whom the costs might be allocated, in the form of either direct taxes, indirect taxes (e.g. inflation or depreciation), appropriation or expropriation, or wage and consumption suppression. These sectors, all of whom will alter their behavior in order to protect themselves from bearing the costs of debt, comprise most of the economy, including foreign creditors, small business owners, savers within the banking system or in other forms of monetary assets, workers, wealthy owners of financial and non-financial assets, the agricultural sector, importers and exporters, the mining sector, and many others. The wealthy might take their money out of the country, for example, and creditors might shorten maturities and raise interest rates, business owners might disinvest, the middle class might dis-intermediate savings, workers might organize, local policymakers may engage in protectionist activity, borrowers might invest in riskier projects, banks might reduce the scope of their lending to the most protected sectors, etc. The point is that it is a mistake to assume that the only or main cost of excess indebtedness is a financial crisis.
  1. The balance sheet can embed strong feedback mechanisms within the economy that make it almost impossible to predict the growth of debt. The balance sheet mismatches that during the expansion phase could be refinanced in ways that created unexpected profit, can easily lead to rising debt instead as the mismatches become harder to refinance or require government guarantees.

This is why I would argue that once a country’s balance sheet reaches a certain critical point, any analysis is fundamentally mistaken if it simply acknowledges the existence of a great deal of debt, or sees a debt buildup as unlikely, or as the consequence of bad policy, when already institutional constraints make it a necessary corollary of growth.

Debt was already a problem in the Chinese growth model more than ten years ago (and is a problem in several advanced economies too, who are going to find it nearly impossible to grow out of their debt burdens without debt forgiveness). Those analysts who do not understand why this is the case probably do not understand why the balance sheet will continue to be a heavy constraint on Chinese growth and will underestimate the difficulty of the challenge facing Xi Jinping and his administration, which means among other things that they will be too quick to criticize Beijing for failed policies when growth drops below their projections.

Transforming the financial system

Related to the failure to understand the balance sheet constraints, there is another argument that has made the rounds in the past year or two as economists covering China slowly have come to recognize just how misdirected investment allocation has been. This argument remains optimistic about growth prospects while nonetheless warning of ways in which things can go wrong, but I think it is based on a similar kind of misunderstanding.

It is well understood that Chinese growth relies excessively on investment, and that consumption is too low a share of GDP to drive demand mainly because household income is too low a share of GDP. But with so much misallocated investment driving the surge in bad debt, China must bring investment growth down as rapidly as it can. I have long argued that the only sustainable way to do this without a surge in unemployment is to transfer wealth from the state sector to the household sector. If this is done forcefully enough, continued consumption growth can drive enough demand to prevent a rise in unemployment as Beijing gets its arms around credit growth.

The main constraint is likely to be the political difficulty of transferring wealth to the household sector from the state sector, where it is managed and controlled by the so-called “vested interests”. Historically for the many developing countries that have faced a similar rebalancing problem, this constraint is a powerful one.

But according to this new, and optimistic, argument, China doesn’t need to rebalance nearly as quickly as we might think. China’s soaring debt burden is not caused because investment levels are high, according to this argument, but rather because Chinese banks systematically channel credit to SOEs, municipal and provincial governments, and infrastructure projects, and that these are no longer able to generate debt servicing capacity in line with debt servicing costs.

All Beijing has to do, consequently, is to implement the right financial sector reforms that will result in a significant re-channeling of credit away from the old recipients and towards new recipients who are able to use this credit to fund productive investment. These new borrowers include China’s very efficient small and medium enterprises (SMEs), and as credit is redirected towards them they will invest it in projects that generate more than enough debt servicing capacity to stabilize or even reduce the country’s debt burden and so give it far more time to rebalance its economy.

Would redirecting credit to more efficient users solve China’s credit problems and give Beijing more time to manage a very difficult rebalancing? Of course it would, but it is completely absurd to expect that this will happen. There is no question that if the Chinese financial system were reformed so substantially and quickly that is was able to channel savings into productive investments, and not into nonproductive ones, there would no longer be any urgency to rebalance. But for Beijing to pull this off would require too profound a transformation of the way the financial system allocates credit to make this a very likely outcome. Many countries have tried to do so and none have come close to succeeding.

Such a dramatic reform of the financial sector is politically almost impossible to pull off without first implementing very rapidly extremely implausible politically reforms. In that context I have regularly cited a line from a book Fragile by Design, co-authored by Charles Calomiris and Stephen Haber. According to the authors, “a country does not choose its banking system: rather it gets a banking system consistent with the institutions that govern its distribution of political power.”

The point is that banking systems do not allocate credit on the basis of a set of well-understood rules that can easily be manipulated or redirected. The credit allocation process is the outcome of a complex set of institutions that are at least as much political as economic in nature. To transform this process requires a long and difficult transformation of these political institutions.

It would also require, in China’s case, the creation almost from nothing of a credit culture, replacing a banking culture in which loan officers paid very little attention to credit risk because money was mostly lent directly or indirectly to government or government-related entities (most or all of which enjoyed implicit or explicit guarantees). Beijing would have to transform this banking culture into one that is driven by the credit evaluation of businesses that are often not very transparent and that operate in complex systems of ownership. But it is not easy to build a credit culture, and it is a virtual certainty that any attempt to do so quickly will, very soon after it began, generate large amounts of NPLs.

The political challenge

Even assuming that in a world of declining demand, falling profits, and excess capacity, Chinese SMEs and other potentially productive investors were willing to borrow and invest at nearly the scale necessary for China to postpone rebalancing, the process of reforming the banking system would be incredibly complicated and would require far too long for anyone to propose this realistically. Offhand I cannot think of any country in history that was able to implement a similar transformation of its banking system, with the possible exception of Chile perhaps in the early 1980s, and even that took a decade and included a political crisis followed by a severe financial and economic crisis in which nearly the entire banking system collapsed as GDP declined by 14%.

To suggest that this is a viable path for the Xi administration would, once again in my opinion, severely understate the challenges that Beijing faces. To imply that only poor policymaking on the part of Xi Jinping’s administration could explain Beijing’s failure to pull it off would be extremely unfair, and would blame Beijing for failing to implement a wholly unprecedented level of financial sector reform.

China, in that case, would essentially be expected to do something that I think no other country has ever been able to do, and certainly no large one, and while this does not mean that China cannot do it, it does mean that at the very least we should be well aware of how difficult it is to accomplish and rather than simply recommend that Beijing do it we must specify what the conditions are that make us so confident that Beijing can do what no other country has been able to do. A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.


Aside from this blog, once a month or more I write a newsletter that covers some of the same topics covered on this blog, although there is very little overlap between the two and the newsletter tends to be far more extensive and technical. Academics, journalists, and government officials who want to subscribe to the newsletter should write to me at, stating your affiliation. Investors who want to buy a subscription to the newsletter should write to me, also at that address.



How Much Investment is Optimal

A few years ago I wrote an essay on my blog that received a lot of attention and in which I tried to explain what the underlying assumption was for analysts who considered that China’s low level of investment relative to that of, say, the US proved that China could not possibly have reached the point of investment saturation. I then argued that there were two very different models that explained what made advanced economies advanced. One model assumed that there is an optimal capital frontier appropriate to all countries, and that the further a country is from that frontier, the more profitable and productive would be any increase in investment. The other model assumes that each country has a different optimal capital frontier based on its level of what I called “social capital”. Poor countries are usually countries with low levels of social capital and, therefore, a low optimal capital frontier, and any investment past that frontier is likely to be non-productive.

I have found myself discussing this essay a lot recently, both with analysts who had read it back then and wanted to discuss it and with analysts who hadn’t read it and wanted to know why I assumed that investment in China had long ago reached its saturation point. I am working on a new essay on trade for my blog, but I thought it might be worthwhile to some of my readers, especially new readers, to re-post the essay. I made a few changes, mainly because I was not able to reproduce two graphs and a table that come in the original.


In a May, 2013, entry on my blog I referred to a very interesting IMF paper written by Il Houng Lee, Murtaza Syed, and Liu Xueyan. The study, “China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”, attempts among other things to evaluate the efficiency of investment in various provinces within China. I argued in the newsletter that the paper supported my contention that China has overinvested beyond its capacity to absorb capital.

This argument is in opposition to claims made by many analysts that China has not overinvested systematically, and that in fact, with much less capital stock per worker than advanced countries like the US or Japan, China has a long ways to go before it begins to bump up against the productive limits of investment. For example in a September 3, 2012, issue of Asia Economics Analyst, Goldman Sachs makes the following point:

China is often criticized for investing too much and too inefficiently, and for consuming too little…However, focus on the investment/GDP ratio risks confusing flows and stocks and we believe is not the right metric for assessing whether a country has invested too much. For that, we also care about the capital stock rather than the investment flow—on this metric, on a top-down approach, China still has a long way to go—its capital stock/worker is only 6% of Japan’s level and 16% of Korea’s.

The Economist has also made a similar argument. This, for example, was published about a year ago:

The IMF says so. Academics and Western governments agree. China invests too much. It is an article of faith that China needs to rebalance its economy by investing less and consuming more. Otherwise, it is argued, diminishing returns on capital will cramp future growth; or, worse still, massive overcapacity will cause a slump in investment, bringing the economy crashing down. So where exactly is all this excessive investment?

…The level of fixed-capital formation does look unusually high, at an estimated 48% of GDP in 2011 (see left-hand chart). By comparison, the ratio peaked at just under 40% in Japan and South Korea. In most developed countries it is now around 20% or less. But an annual investment-to-GDP ratio does not actually reveal whether there has been too much investment.

To determine that you need to look at the size of the total capital stock—the value of all past investment, adjusted for depreciation. Qu Hongbin, chief China economist at HSBC, estimates that China’s capital stock per person is less than 8% of America’s and 17% of South Korea’s (see right-hand chart). Another study, by Andrew Batson and Janet Zhang at GKDragonomics, a Beijing-based research firm, finds that China still has less than one-quarter as much capital per person as America had achieved in 1930, when it was at roughly the same level of development as China today.

Leaving aside the rather strange claim that China today is at roughly the same level of development as the US in 1930, because China’s capital stock per capita is so much lower than that of much richer countries, claim Goldman Sachs, the Economist, and many others, Chinese investment levels overall are still much lower than they optimally ought to be. While it is of course always possible for China to misallocate individual investments, which everyone agrees is a bad for growth, these analysts strongly disagree with the claim that China has overinvested systematically.

Since the newsletter came out I have had a number of conversations with clients who wanted to pursue a little further the issue of how to think about an optimal level of capital stock per capita. In my central bank seminar at Peking University we recently spent a couple of sessions hashing this out in a way that we found very useful, and I thought it might be helpful to summarize those discussions in order to explain a little more schematically how I think about this issue.

The two models of investment

To begin this discussion it is worth remembering what the IMF paper suggested about investment in China. The abstract of the paper is:

This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.

If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.

In contrast to claims cited above suggesting that Chinese investment levels are too low, among other things the paper argues that although investment levels as measured by capital stock per capita are obviously lower in the poor inland provinces in China than they are in the richer coastal regions, in fact investment in the former areas may be less productive than investment in the latter areas. This implies that the regions with less capital are also less able to absorb additional capital efficiently.

Should this be a surprise? For those who argue that China is poor because capital stock per worker in China is much lower than in the advanced countries, and that China should aggressively increase investment to close the gap, the findings in this paper ought to be surprising. If the further an economy is from US levels of capital stock the more appropriate it is to increase investment, then investment in the poor inland regions should have a higher return than investment in the richer coastal regions.

But whether or not the findings of this and other similar studies should surprise us depends on how we decide what the optimal level of capital is for any economy. I would argue that there are basically two different models for thinking about how much investment is optimal:

  1. The capital frontier constraint. One model suggests that the most advanced and capital-rich countries have developed, perhaps through trial and error, the appropriate level of capital investment given the state of technology, trade, and managerial organization, and they effectively represent the frontier for investment.

According to this model it is pretty easy to figure out what an appropriate investment strategy is for a developing country – more investment is almost always good. Because in this model what separates poor countries from rich countries is primarily the amount of capital stock per worker, poor countries should always increase their capital stock until they begin to approach the frontier. Until they do, an increase in capital stock automatically causes an increase in workers’ productivity that exceeds the cost of creating the capital stock, and so the country is economically better off because the benefit of investment exceeds the cost of investment. This model implicitly underlies claims made by many analysts that because China’s capital stock is much lower than that of the US, Japan or other rich countries, it is meaningless to say that China is overinvesting in the aggregate.

  1. The social capital constraint. The other model suggests that for any economy there is an appropriate level of investment or capital stock per worker that depends on the ability of workers and businesses in that economy to absorb additional capital stock. I am going to call this ability to absorb capital stock “social capital”.

The implication is, then, that the higher a country’s social capital, the higher the optimal amount of capital stock per worker. The fundamental difference between rich countries and poor countries, in this case, is not the amount of capital stock per worker but rather the institutional framework that gives workers and businesses the ability to absorb additional capital productively. Advanced economies are understood simply to be those economies that are able to absorb high levels of investment productively. Backward economies are constrained in their abilities to do so.

What determines the level of social capital? Lots of things do. The right institutions matter tremendously, but because there is no easy way to quantify what the “right” institutions are, we tend to ignore their importance in favor of more easily measurable factors, such as broad measures of capital stock. I would argue, however, that economies are much better at absorbing and exploiting capital if they operate under an institutional framework that

  • creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights),
  • encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses, and
  • maximizes participation in economic activity by the whole population while minimizing distortions in that participation.

Measuring social capital

Perhaps in the early stages of what Alexander Gershenkron called “economic backwardness” these institutions matter less if the there are clear and obvious steps that need to be taken to increase productivity rapidly – if manufacturing capacity and infrastructure levels are non-existent, for example. As economies become large and complex, however, economies with greater flexibility, higher levels of participation, and correctly aligned incentive structures seem to be much better at squeezing value out of investment.

I should point out that the term “social capital” already has a meaning. The World Bank defines it this way:

Social capital refers to the institutions, relationships, and norms that shape the quality and quantity of a society’s social interactions. Increasing evidence shows that social cohesion is critical for societies to prosper economically and for development to be sustainable. Social capital is not just the sum of the institutions which underpin a society – it is the glue that holds them together.

The term was apparently first used in 1916, by the American Progressive Era educational reformer, LJ Hanifan, and he described it in terms of social relationships:

The tangible substances [that] count for most in the daily lives of people: namely good will, fellowship, sympathy, and social intercourse among the individuals and families who make up a social unit. . .. The individual is helpless socially, if left to himself. If he comes into contact with his neighbor, and they with other neighbors, there will be an accumulation of social capital, which may immediately satisfy his social needs and which may bear a social potentiality sufficient to the substantial improvement of living conditions in the whole community. The community as a whole will benefit by the cooperation of all its parts, while the individual will find in his associations the advantages of the help, the sympathy, and the fellowship of his neighbors.

I am using the term much more broadly than either Hanifan or the World Bank, to mean the constellation not just of social relationships that affect the economy but also the full range of legal, institutional, and economic relationships that can make an economy more or less productive. It is this complex mix of institutions, I would argue, and which I call social capital, that drives advanced economic growth, and not simply additional labor or capital.

This is not to say that labor and capital inputs are not part of growth. Of course they are. I am simply arguing that an economy requires both the inputs and the ability efficiently to absorb and exploit those inputs for it to grow. If its level of inputs is too low, as Chinese infrastructure almost certainly was twenty years ago, then the easiest way to achieve growth is to increase the necessary inputs – airports, bridges, roads, factories, office space, and so on in the case of China twenty years ago.

But if social capital is too low or, to put it another way, if capital stock exceeds the ability of an economy to absorb it efficiently, then the best way to achieve growth may be to focus not on increasing inputs, which may end up being wasted and so may actually reduce wealth, but in improving the ability of the economy to absorb the existing inputs. The point is not whether we can easily define these institutions but rather whether there is evidence that they matter to economic growth.

In a sense what I mean by social capital is what William Easterly and Ross Levine might call “something else”. “The central problem in understanding economic development and growth,” they say, “is not to understand the process by which an economy raises its savings rate and increases the rate of physical capital accumulation.”

Although many development practitioners and researchers continue to target capital accumulation as the driving force in economic growth, this paper presents evidence regarding the sources of economic growth, the patterns of economic growth, the patterns of factor flows, and the impact of national policies on economic growth that suggest that “something else” besides capital accumulation is critical for understanding differences in economic growth and income across countries.

The paper does not argue that factor accumulation is unimportant in general, nor do we deny that factor accumulation is critically important for some countries at specific junctures. The paper’s more limited point is that when comparing growth experiences across many countries, “something else” – besides factor accumulation – plays a prominent role in explaining differences in economic performance.

They go on to argue in their paper that

While specific countries at specific points in their development processes fit different models of growth, the big picture emerging from cross-country growth comparisons is the simple observation that creating the incentives for productive factor accumulation is more important for growth than factor accumulation per se.

It is these various institutional and social “incentives” for productive factor accumulation that I am calling “social capital”. Daron Acemoglu and James Robinson, the authors of Why Nations Fail, believe that there is very strong evidence in favor of the importance of social (i.e. economic and political) institutions and on their blog they write:

Our theory isn’t that political institutions directly determine economic prosperity. Rather, we claim that economic institutions determine economic prosperity, and explain why the link is between inclusive economic institutions and sustained economic growth — not necessarily short-run economic growth. We then argue that inclusive economic institutions can only survive in the long run if they are supported by inclusive political institutions. On the way, we provide explanations and examples for why for extended periods of time economic institutions with fairly important inclusive elements can coexist with extractive political institutions.

This is all brought together under our discussion of extractive growth under the auspices of extractive political institutions. This is either because, as in the Soviet Union or the Caribbean plantation economies, extractive political and economic institutions can reallocate resources in a way that brings economic growth — typically when the elite expects to be the main beneficiary from such growth. Or because as in South Korea or Taiwan, extractive political institutions permit a certain degree of inclusivity to develop. In both cases the logic is clear: the elite, all else equal, would prefer more output, more revenue and more growth. It is the fear of creative destruction that often prevents it from adopting economic arrangements favoring growth or even blocking new technologies. When it feels secure or deems that it doesn’t have any other option, the elite will encourage economic growth.

Clear rules

To me one of the most obvious pieces of evidence that it takes a lot more than increases in capital stock to achieve sustainable wealth is the experience of previously advanced economies that have been laid low by war. It is noteworthy that – excluding trading entrepôts like Hong Kong and Singapore or small, commodity-rich entities like Kuwait or 18th Century Haiti – very few poor and undeveloped economies have made the transition from poor to rich. The exceptions may be South Korea and Taiwan, both under very favorable circumstances during the Cold War. “Poor” but advanced countries, however, like Belgium and Germany after WW1, or Germany and Japan after WW2, saw their GDP per capital soar after devastating wars as they made the transition from newly poor to rich with relative ease.

The reason, it seems to me, is that although war may have destroyed physical capital in these countries, because it did not destroy social capital these countries were able sustainably to increase investment at a rapid pace after the war and see their per capita incomes soar permanently. Why is this so easy for advanced economies made poor by physical destruction of their capital base but so hard for developing economies?

The most plausible reason I can think of is that the advanced economies already had in place the institutions that allowed them to exploit investment fully, and so once they were able to increase capital stock, they quickly became rich again. This argument is reinforced, I think, by the well-known fact that most cross-border capital flows (over 90%, I think) are to rich countries, not to poor ones. This wouldn’t make sense at all if rich countries didn’t have a greater ability to absorb new capital efficiently and profitably than poor countries. If what mattered on the other hand was distance from the capital frontier, the further a country was from that frontier, the more profitable it would be to invest there, and so more capital would flow to poor countries rather than to rich countries. The opposite is true.

So what kinds of institutions might matter? Economies with clear and enforceable legal systems, to take one factor, tend to have higher levels of social capital because it is much easier for entrepreneurs to take advantage of conditions and infrastructure to build profitable businesses. Without a clear legal framework, business opportunities tend to be monopolized by entities that have the political clout to take advantage of the legal system, and not only is it not obvious that more powerful entities are more economically efficient, but in fact the opposite may be true – these are what Acemoglu and Robinson call “extractive” elites.

Very powerful entities tend to support the status quo, to undermine disruptive new technologies and business organizations, and otherwise often to favor the less efficient (themselves) over the more efficient. As part of social capital, clear ownership rules for land and other assets matter. Here are Acemoglu and Robinson on the subject:

Key to our argument in Why Nations Fail is the idea that elites, when sufficiently political powerful, will often support economic institutions and policies inimical to sustained economic growth. Sometimes they will block new technologies; sometimes they will create a non-level playing field preventing the rest of society from realizing their economic potential; sometimes they will simply violate others’ rights destroying investment and innovation incentives.

I would also argue that the institutional framework around the writing down of overvalued assets, and the liquidation process itself, is an important part of how efficiently an economy is able to absorb the benefits of capital stock. A formalized bankruptcy process that takes assets away from inefficient users, writes them down to a fair market value, and reintroduces them into the economy, creates a much more efficient economic system than one in which bad loans are not recognized, effectively bankrupt companies are allowed to continue in value-destroying activity, and the use of assets is not systematically transferred from the less efficient to the more efficient user.

In fact an efficient and relatively rapid bankruptcy process is, I would argue, of fundamental importance to the ability of an economy to exploit capital stock efficiently. Even very advanced countries without a formal process to transfer resources quickly can have a hard time exploiting its capital and labor factors, especially after a period in which a great deal of labor and capital were directed into unproductive uses. I think Japan’s twenty years of nearly zero growth may be explained in part by the very slow process in Japan by which resources were transferred from “losers” to “winners” after the investment orgy of the 1980s.

In fact more generally the sophistication and flexibility of financial systems are an important component of social capital because these determine the capital allocation process. Financial system capable of taking risk and supporting new and disruptive technologies or organization structures tend to result in a greater ability by a society to absorb capital. In that light, and as an aside, I would suggest that the country that sees the most change in the list of its largest companies from decade to decade – because this list creates a simple way of determining how quickly companies can be created and destroyed as their level of efficiency changes – is probably better at absorbing capital than a country whose largest companies are the same decade after decade.

Crony capitalism

These are probably the most important components of social capital, but I would include a lot more in my definition than just the relative strength of extractive elites and well-functioning legal, ownership, financial and bankruptcy frameworks. The extent of corruption, nepotism, or the importance of what the Chinese call “guanxi”, erodes social capital because in a society in which corruption or guanxi is more important, the winners in business competition are, in the aggregate, not the most efficient but rather the most connected, and in fact they are often the least efficient for the reasons already noted (they profit not from improving efficiency but rather from improving their access to transfers of resources).

The extent of monopoly power or the extent of significant subsidies to favored sectors and companies also limits social capital for the same reasons. Monopolists and the subsidized tend to be more interested in protecting and extending their power to expropriate national resources than in accelerating efficiency – the rewards for the former far exceed the rewards for the latter which, in many cases, may even be negative.

There are many social and political reasons to be concerned about the various characteristics of what is often called crony capitalism – corruption, guanxi, nepotism, limiting access to credit to powerful insiders, protecting national champions from more efficient competitors, etc. – but the important point in our context is that because they limit the ability of economic agents to take advantage of the benefits of capital stock by heavily tilting rewards towards agents that can play the political game better rather than towards those that can play the economic game better, they undermine the economy’s ability to absorb high levels of investment. The purpose of investment, in countries with high levels of crony capitalism, is often not to maximize productivity but rather to reward political access, and so agents that can exploit capital stock more efficiently are undermined in their ability to do so.

This is not to say that crony capitalism cannot deliver growth. Clearly it can. But I would argue that it can deliver growth only when the interests of the elite are correctly lined up with growth. So, for example, I would argue that in the early stages of reform, especially in countries that have suffered many years of terrible economies and weak investment, crony capitalism can be consistent with high levels of growth because the kinds of programs that lead to growth – mostly massive investment programs in countries in which capital stock is excessively low – benefit the elites directly. Once there is a divergence in interests, however, crony capitalism can become inconsistent with rapid growth.

Beyond these measures, which are basically measures of the ability of elites to distort participation in the economy, I would argue that educational levels also matter. More educated societies and, perhaps even more so, societies in which there is limited ability by the elite to block participation by the non-elite, tend to be better at exploiting economic opportunities because they benefit from economies of scale in accessing talent and ideas.

Social trust matters too, as this can sharply reduce frictional costs. It is not an accident, I would argue, that many of the wealthy industrialists in Britain during the first industrial revolution were Quakers. Because their religion forced them to be honest at all times, even in business dealings, they were generally associated with trust and were eager targets for business relationships, which lowered their frictional costs substantially.

The relative lack of bureaucracy matters too, partly because more bureaucratic systems are more open to corruption and to interference by powerful players, and partly because more bureaucratic systems, by imposing higher costs on starting new businesses, tend to favor the richer and more powerful, who have the ability to pay these frictional costs, at the expense of the poorer and less powerful. Even cultural attitudes to business can matter. Recently I read the following about the how doing business in the US is different from elsewhere:

Having essentially run the same company from both countries, Mr Kelleher has found the most important difference to be the attitude. “From the moment I arrived, I knew it to be different. People are more open to hearing about your business idea; they won’t make themselves hard to reach, or dismiss proposals or ideas because they haven’t come through the right channels” he says.

I can go on but I think my point is relatively clear. The social capital model suggests that there is some amount of investment that is wealth enhancing for any economy, depending on its ability to absorb and exploit the benefits of that investment. Beyond this amount, however, it can be difficult for an economy that scores lower in social capital to take full advantage of investment, in which case the additional productivity generated by higher levels of investment are low, and are more likely to be exceeded by the cost of the investment.

Raising the amount of investment, in this case, is wealth enhancing up to some point, beyond which it can become wealth destroying. At that point it is far more efficient to improve the institutional ability to absorb investment than to increase investment itself (although, because this is intimately caught up in social and political power structures, it can be brutally difficult to do so).

The “Doing Business” report

One attempt at measuring social capital as I define it is the World Bank’s “Doing Business Report”, which tries to score countries according to the ease with which businesses can operate. In the latest report China ranks in the middle – number 91 out of the 185 countries ranked, just below Barbados, Uruguay and Jamaica and just above the Solomon Islands, Guatemala and Zambia. In the report China ranks differently according to various sub-rankings, some of which I think are more important (starting a business, protecting investors, resolving insolvency) and some less (paying taxes, trading across borders).

Social capital is a tough measure to score, and I do not want to suggest that the World Bank rankings are a good or even adequate measure. They are merely a rough proxy, and some analysts, for example those associated with labor unions, argue that because labor regulations have a negative impact on the World Bank ranking, these rankings are at least in some cases driven more by ideology than by objective requirements. China itself is opposed to these rankings and is apparently trying to get the World Bank to discontinue them. According to a recent Financial Times article:

China is leading an effort to water down the World Bank’s most popular research report in a test of the development institution’s new president, Jim Yong Kim. According to people close to the matter, China wants to eliminate the ranking of countries in the Doing Business report, which compares business regulations – such as the difficulty of starting a company – in 185 different nations.

…Pushed by China and other critics – including trade unions, international aid charities and some other developing countries – last year Mr Kim set up an independent review of the report chaired by Trevor Manuel, South Africa’s planning minister. But a number of people involved in the process complain that Mr Manuel has appointed two longstanding critics of the report as advisers to the panel, raising doubts about its impartiality.

I do not want to get into the debate about the usefulness of this particular set of rankings because it is not relevant to whether or not there is such a thing as a level of social capital that constrains the ability of a country to take advantage of investment. What is more, in large countries like China or the US, there may be significant variations in social capital even within a country. The key point is that this model presents a very different argument about what an appropriate level of investment is for any country.

I am not going to insist that one model is obviously better than the other at describing reality. This is clearly a subject of reasonable debate and there is nothing approaching unanimity on the subject. My main point here is just to suggest that there are implicitly two very different ways of looking at the world, and they have very different implications for continued investment in China. I of course believe the social capital model is the appropriate one, and I will try to explain why, but I don’t want to suggest that mine is the only reasonable and consistent point of view.

Where this disagreement about what is an optimal level of capital stock comes out most clearly is in the debate about China’s decision aggressively to pursue investment growth in the poorer inland provinces. The inland provinces in China are generally much poorer than the coastal provinces and much more backward economically (and in fact this has been true for centuries). If you believe in the capital frontier constraint, then the policy implications are obvious beyond much dispute: Beijing must encourage as much investment as possible in the poor inland provinces, even to the extent of diverting investment from the richer coastal areas.

If you believe in the social capital constraint, the implications are more complex. It makes sense, in this case, to encourage some investment into the inland regions, but only up to a point. Because these poorer inland regions are almost certainly much less able efficiently to absorb the benefits of investment and capital stock, we are also likely to reach the productive limits of investment much earlier. This means we are also likely to waste capital at much lower levels of capital stock per worker.

So which model does a better job of describing reality in China today? The capital frontier constraint implies that because all of mainland China operates more or less under a single legal and political system, every part of China is as likely to benefit from any given level of capital stock per worker as any other part. Very poor Guizhou, in other words, is just as able to exploit Shanghai levels of investment efficiently as comparatively rich and advanced Shanghai. The closer we can bring capital stock per worker in Guizhou to Shanghai levels, according to this way of thinking, the better off China is and the less income inequality there is likely to be.

The social capital constraint suggests that Guizhou should optimally have much less capital stock per worker than Shanghai because it is less able to take advantage for a variety of reasons having to do with local institutions, political and social conditions, and so on. It implies that investment in the poorer parts of China would have been lower absent a government strategy to raise investment levels in the poor regions.

Which way should investment go in China? If you believe in the capital frontier constraint, then clearly we are better off diverting resources from Shanghai to Guizhou. Not only will this reduce inequality within China, but it will increase China’s overall wealth because the total returns to China, including hard-to-record externalities, will be much higher for investment inGuizhou than for investments in Shanghai.

Of course if you believe in the social capital constraint, then you would not want to divert resources from Shanghai to Guizhou. You would in fact want to do the opposite. Diverting resources from Guizhou to Shanghai might increase income inequality but it will make China richer overall. To address the inequality, this model would suggest, either we should keep investing in Shanghai and simply transfer income from Shanghai to Guizhou, or we should work especially hard to reform the social, political, financial and economic institutions in Guizhou so that it can grow not so much by increasing investment but rather by increasing its ability to transform existing investment into more productive uses.

The IMF paper with which I started this newsletter, and other similar analyses, comes out implicitly quite strongly in favor of the social capital constraint. Here is what it says:

This paper reviews trends in investment at the provincial level in China and finds evidence that some types of investment is becoming excessive, especially in inland regions. In these regions, investment Granger-causes consumption on average. By contrast, in coastal provinces, private consumption has on average become more self-sustaining and less dependent on investment. Moreover, in relative terms, investment is more closely associated with higher household income in coastal provinces while in inland provinces it seems to influence corporate income more. This suggests that the share of investment contributing to the productive capital stock in coastal areas is larger than in inland provinces. If this trend is continued, valuable resources are likely to be wasted.

If investment in the inland regions is indeed less productive than investment in the coastal regions, it is hard to justify the capital frontier constraint model. Since Guizhou is much further from the frontier than is Shanghai, investment in Guizhou, according to the model, should in the aggregate be more productive than investment in Shanghai. The IMF says it isn’t. Of course the social capital constraint model would have no problem with the IMF’s findings.

I leave it to my readers to decide which model they think is a better description of reality. One way of thinking about this is to consider why historically some countries that have “gone west” and invested in poorer regions were successful (the US in the 19th Century, for example) and some were not (Brazil in the 1950-80 period and the USSR in the 1930-1960 period, for example). One possible explanation may be that in the successful cases, higher investment followed increases in social capital, and in the unsuccessful ones they preceded them.

But whichever model one finds more congenial, I would insist that whenever anyone discusses the appropriate level of investment in China, he is implicitly using one model or the other to value investment. He should however do so explicitly, since the implications are so radically different.

The capital frontier constraint model says we should continue to increase investment in China as quickly as we can and we should especially direct this increase to the poorest and most backward parts of China. The social capital constraint model says we should slow overall investment growth as much as possible, especially in the poorer inland regions, because they result in a huge cost to China’s economic wealth – although the resulting losses are as of yet unrecognized because capital stock is not being written down to its “correct” value and losses are simply buried in the debt which is continuously rolled forward.

The social capital model also suggests that the most powerful way of increasing Chinese wealth in the next few years is to implement the political, economic, financial and social reforms needed to allow China to increase its ability to absorb and exploit its already too-high level of capital stock. These are the kinds of reforms Beijing may in fact be discussing.

Can convergence be imposed?

Before discussing Beijing’s attitude, I want to digress a little. One sell-side analyst, traditionally a lot more bullish than I am about medium term growth prospects for China, and a lot less concerned about rising debt, recently made a proposal that plays up the very big differences between the two models. According to an article in People’s Daily, there is indeed scope for rapid catch up among the poorest provinces:

China’s regional disparity could bring vast potential for economic growth, a top economist from Standard Chartered Bank said Wednesday. “In the next five years, China’s economy will maintain a growth rate of 7 to 8 percent thanks to the growth opportunities offered by the regional disparity,” said Stephen Green, Standard Chartered’s chief economist for China. China’s economic growth ticked down to 7.7 percent in the first quarter, falling short of market expectations and suggesting a tepid rebound for the economy.

Green said those worried about China’s economic slowdown are overreacting, as the differences in economic development between China’s regions could provide a strong engine for economic growth. Green used data acquired through the bank’s research to categorize Chinese cities into three tiers according to their GDP per capita. Beijing, Shanghai and Tianjin are first-tier cities, with an annual GDP per capita of nearly 80,000 yuan (about 12,903 U.S. dollars), he said.

He described second- and third-tier cities as those with an annual GDP per capita of 50,000 yuan and less than 30,000 yuan, respectively. Green said the research indicates that if second-tier cities reach first-tier GDP levels, the economy will maintain an annual growth rate of at least 7 percent for the next five years.

Green’s points are that there is a large difference between the richer and poorer provinces, and that the same set of policies that drove up income levels in the richer provinces can, presumably, be applied to the poorer provinces in the same way and for the same effect as their income levels converge with those of the richer provinces. This convergence alone will guarantee that China will grow by 7-8% for many more years.

Green may be right, but I think it is worth pointing out under what conditions he would be right and under what conditions he would be wrong. If the difference in wealth between the richer and poorer provinces is indeed caused mainly by the difference in capital stock per worker, and if otherwise there are no significant institutional differences between the two that prevent the poorer regions from catching up, then it is probably true that the policies that worked in the coastal regions can be successfully applied to the inland regions with much the same economic impact. Beijing can turn all of China into Guangdong and Zhejiang.

But if the poorer regions are poorer not because they lack investment but rather because they are institutionally more “backward” and so lack the ability to absorb investment efficiently, then it is not so clear that their income levels can converge with those of the richer regions within China except under conditions of significant social and political change. As an aside I am struck by the fact that the disparity between richer and poorer regions in China has existed in very much the same way for many centuries, and wonder if this isn’t due at least in part to dramatic differences in what I am calling social capital.

If social capital is indeed much lower in the poor regions than in the rich, then it isn’t at clear to me that we can expect much further convergence except at a huge cost to China’s economy overall. Resources, in other words, can simply be transferred wholesale from the rich to the poor regions, so that convergence is achieved not by speeding up growth in the poor areas but rather by reducing it in the rich. At any rate, depending on which model is correct, we will see over the next five years if there is indeed significant convergence and at what cost.

What does Beijing believe?

It is pretty obvious if you consider China’s track record and the statement of government officials that for many years Beijing has implicitly believed in the capital frontier model (although the kinds of reforms pushed in the 1980s by Deng Xiaoping, who seemed to understand intuitively the importance of institutional constraints, were more in the form of institutional reforms than increases in investment). Since the early 1990s the solution to every social or economic problem or crisis has been to increase investment, and in recent years there has been an especially strong push to increase investment in the poorer regions. In my November 7, 2012, piece for Foreign Policy I put it this way:

China’s spectacular growth over the past 30 years, like that of the USSR and Brazil before it, was made possible mainly by the ability of policymakers to control credit and unleash waves of investment when needed. This allowed Beijing to keep growth rates high regardless of the circumstances and no matter how the leadership managed domestic problems.

It was able to avoid a surge in unemployment when it restructured the hugely inefficient state-owned industries in the 1990s by sharply increasing infrastructure investment. Investment spending helped it smooth over the social dislocations caused by its rigid and antiquated political structure. It eased political conflicts and factional fighting by directing billions of dollars into pet projects, much of which the politically connected have since siphoned off. China grew vigorously through the Asian crisis of 1997, the Chinese banking crisis a few years later, and, the collapse of the global economy in 2007-08. In each case, unrestricted access to savings allowed China to power growth by pouring cash into the projects of its choice.

The only way to justify this astonishing increase in investment in the medium term is to argue that even though Chinese investment levels are extraordinarily high (comparing them not to the US or Japan but rather to other developing countries like Brazil, whose per capita income and worker productivity levels are low but still higher than those of China), they are so far from the optimal level determined by the capital frontier that China is always made richer in the aggregate because of the increase in investment.

But attitudes in Beijing may be changing. Consider Premier Li’s statements last week, which some people are claiming (a little prematurely, perhaps) represents a major shift in policy. According to an article in last week’s Xinhua:

China will allow the market to play a bigger role in economic innovation, Premier Li Keqiang said on Monday at a State Council meeting on the reform of government. As more power is delegated to lower levels, the government should shift its focus to three areas — improving the policy environment for development, providing high-quality public service, and upholding social fairness and justice, he said.

There should be a better balance between the government and the market, and between the government and society, the premier said during a videophone conference to launch a new round in transforming the functions of the cabinet and its branch agencies. The reform of government functions is a major effort to help the nation maintain growth, control inflation, reduce risks, and enjoy healthy and sustainable economic development.

According to the premier, the reform will minimize government approval needed to authorize general investment projects and general qualification certificates. It will contribute to fair competition in the market, and to corporate-level efforts to upgrade management and technology. It will ultimately expand employment opportunities, through speeding up the registration of industrial and commercial enterprises, and give more latitude to small and medium-sized enterprises and to service industries. It will also inject greater vitality to development initiatives at local level.

Li stressed that more effective administration should be in place on matters of deep public concern, including food safety alarms, the environment and work safety. Justice should be meted out in a timely manner when the law has been broken in such cases. More should be done to cut redundant capacity in industries that suffer such problems, he said.

The South China Morning Post has him adding “If there in an over-reliance on government-led and policy driven measures to stimulate growth, not only is this unsustainable, it would even create new problems and risks.” Li, in other words, is not suggesting that China should increase investment. On the contrary he wants to slow investment growth. He is instead implicitly suggesting that China should take steps to change the way in which it absorbs investment.

And it is not just Premier Li. The South China Morning Post has an article claiming that President Xi is also very much on board with the need to change the underlying growth model:

Chinese President Xi Jinping has taken charge of drawing up ambitious reform plans to revitalise the economy, sources close to the government said, shunning policy stimulus for fear it could worsen local government debt and inflate property prices. A consensus had been reached among top leaders that reforms would be the only way to put the world’s second-largest economy on a more sustainable footing, said the sources, who are familiar with the plans and Xi’s involvement.

China’s economic growth is at its weakest in 13 years, although still the envy of any major economy. Xi will present the reforms at a key meeting of the ruling Communist Party later this year that will set the agenda for the next decade, signalling his seriousness to see breakthroughs, the sources told Reuters. Some of the sources cautioned that the reforms could face resistance from vested interests, especially state firms.

Broadly, the measures would liberalise interest rates and overhaul the fiscal system for local governments to ensure they had a steady stream of tax revenues rather than relying on volatile land sales to raise funds. The reforms would also free up China’s rigid residence registration, or hukou, system that precludes people from access to basic welfare services outside their official residence area, the sources said.

Notice the direction of these polices. Rather than resolve the problem of slowing growth simply by increasing investment – which is what was always done in the past, and which would “work” again if the capital frontier model is the valid one from which to consider the impact of higher investment – Beijing seems to be going out of its way to preclude this way of dealing with slowing growth. Instead it will try to change other factors, factors that I would argue affect social capital by determining China’s ability to absorb existing investment levels.

The market seems to agree with this new approach. According to an article in Xinhua:

Chinese shares jumped on Friday after the State Council announced fewer economic and investment activities would be subject to central authorities’ approval, extending the rally to three consecutive trading days.

A major change

I believe that in the past two to three years there has been a significant and welcome shift in Beijing’s attitude towards maintaining growth, and that this shift implicitly represents a shift from the capital frontier model of optimal investment levels to the social capital model. Keynes famously reminded us that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist,” and I would argue that in this sense models do matter. The economic model that we implicitly use to justify policy can result in hugely different policies with hugely different outcomes.

The surge in debt of the past few years has created tremendous concern, but I would argue that this concern would not be justified if investment levels in China were still too low. In that case any credit-fueled increase in investment would likely have resulted in a net improvement in China’s debt servicing capacity, in which case, with government debt at well below 25% of GDP, rising debt would not be a concern.

But if investment is being misallocated, if investment levels are higher than China’s ability to absorb and exploit capital stock, then it should not be surprising at all that debt capacity is becoming a problem. In fact, as I have argued for many years, this is simply an automatic consequence of additional investment in the investment-driven growth model. Debt, in this case, must be rising faster than debt servicing capacity, in which case Beijing’s true debt level is not the nominal debt level but rather the nominal debt level plus estimates of contingent liabilities likely to rise as a consequence of wasted investment.

Let me not overstate my case. The fact that China’s debt is rising much more quickly than China’s debt servicing capacity is consistent with my implicit model – which claims that the optimal amount of capital stock in China is a function of China’s relatively low level of social capital, and that Chinese investment has far exceeded its optimal level – but it doesn’t prove it. The fact that debt may be rising faster than debt servicing capacity is not necessarily inconsistent with the capital frontier model. After all, as the US amply proved in the 19th Century, even countries in which additional investment is economically justified can still run into debt problems and even crises.

Neither model has been proved. China may have too much capital stock, or it might not have enough, in which the current debt worries may simply reflect bubble conditions in the credit market. The policy implications of the two models, however, could not be more different.

If you believe that China can and should continue to increase investment until capital stock per capita approaches US or Japanese levels, then clearly China should continue to invest, and it should invest more in the poorer regions than in the richer ones. Everyone, even among the remaining China bulls, agrees now that Beijing must change some of its credit allocation conditions, but the old growth model will continue to be the right one according to the capital frontier model. There is no need to change the capital allocation process significantly and there is no need to liberalize interest rates.

What is more, according to this model, China’s very low consumption share of GDP mainly reflects the extraordinary growth in GDP. As high investment levels are maintained, it will simply be a question of time, and probably a short time at that, before the household income share of GDP, and with it the household consumption share, begins to surge. GDP growth can remain at 7-10% for at least another decade.

If you believe, however, that China’s very low level of social capital has long ago made its investment strategy obsolete, the consequences and implications are radically different. It suggests that China has overinvested beyond its capacity to utilize these investments economically, and so there are hidden losses on bank balance sheets created by the failure to write down physical capital to its true value. In this case Chinese growth cannot help but drop significantly as these losses are finally recognized and as investment levels are sharply curtailed.

What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently.

What to do?

The real challenges for China, if you believe in the social capital constraint, are not about maintaining high rates of growth in the short term but rather of raising the levels of social capital in China. This is much more difficult and much more likely to be virulently opposed by the elites whose ability to constrain economic efficiency is precisely at the heart of their wealth – which consists of appropriating resources rather than creating resources – and of their power. It is, however, the only real way to sustain growth over the medium and long terms.

In fact, the social capital model suggests that the famous “middle income trap” might just be a social capital trap. Countries can force up economic growth rates (actual the growth rate of economic activity) simply by mobilizing savings and forcing up investment rates, but ultimately their inability to absorb continuously the higher levels of capital mean that they cannot push real wealth per capita beyond some fairly hard constraint represented by their institutional inability to absorb investment.

This hard constraint, in other words, is the “middle income trap”. Reforming social, political, financial and economic institutions in ways that raise social capital quickly would be, in this view, the only sure way to avoid the dreaded middle-income trap. The two sets of policy implications, as I see them, are the following:

The implications of the capital frontier constraint:

  • Beijing should not abandon the investment-driven growth strategy, but it should adjust the credit allocation process to slow the growth in “bad” debt, which is a separate issue and not fundamental to the economy. The seemingly unsustainable rise in debt, in other words, is not a systemic problem reflecting a combination of the need to keep investment high with a systemic inability to invest productively. It is simply an accidental result of distorted incentive structures within the financial system and so can be administratively resolved.
  • China’s economic growth rate might slow a little, but this is simply the consequence of China’s having gotten much closer to the capital frontier, in which case a lower return on investment should be accepted. Chinese growth will stay in the 7-10% region for many years.

The implications of the social capital constraint:

  • China has invested far more than its ability to absorb the investment, which means that for many years GDP growth has been overstated and that this overstatement is hidden in the form of unrecognized bad debt. Rising bad debt is, in other words, a systemic problem and cannot be resolved within the current system. Beijing must constrain investment growth sharply, redirect a much lower level of investment into areas that improve social capital (SMEs, agriculture, services), and engage in significant social, political, economic and financial reforms to force up China’s ability to absorb additional investment.
  • Not only will China’s real GDP growth drop as China shifts towards a different growth engine, but it will drop even more as China is forced to recognize the hidden losses buried in its debt levels.

Before closing, I want to mention a seminal 2002 paper by Daron Acemoglu and James Robinson (“Economic Backwardness in Political Perspective”). The paper is important not just because of its explanation of development but also because of its attempt to understand the political implications of technological and institutional changes that promote development. The authors conclude:

In this paper, we constructed a simple model where political elites may block technological and institutional development, because of a “political replacement effect”. Innovations often erode political elites’ incumbency advantage, increasing the likelihood that they will be replaced. Fearing replacement, political elites are unwilling to initiate economic and institutional change. We show that elites are unlikely to block developments when there is a high degree of political competition, or when they are highly entrenched. It is only when political competition is limited and also the elites’ power is threatened that they will block development. We also show that such blocking is more likely to arise when political stakes are higher, and in the absence of external threats.



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The titillating and terrifying collapse of the dollar. Again.

Foreign perceptions about the Chinese economy are far more volatile than the economy itself, and are spread across a fantastic array of forecasts. On one extreme there are still many who hold the view that overwhelmingly dominated the consensus just four or five years ago, with a book by Martin Jacques, When China Rules the World, titillating or terrifying many with a subtitle that promised the end of the Western world and the birth of a new global order. Although few within this camp still believe in their earlier forecasts of 8-9 percent annual growth for another one or two decades, many among them still think China will manage to double its GDP in ten to twelve years.

On the other extreme are those who expect the economy to collapse well before the end of the decade. Although he himself does not expect an economic collapse but rather a political one, among the deeply pessimistic is George Washington University’s David Shambaugh, who published an article in the Wall Street Journal last year about “The Coming Chinese Crackup”. His article set off an intense debate among China watchers that still continues and indeed has been made more intense by a number of recent measures that seem aimed at limiting economic discussion and analysis.

Shambaugh warns that Beijing’s policies, aimed at staving off imminent political collapse, are instead “bringing it closer to a breaking point.” This seemed to mark a sharp change from his earlier views, all the more noteworthy given that his credentials as a knowledgeable and sympathetic observer of China had been reinforced just two months earlier when the prestigious China Foreign Affairs University, “the only institution of higher learning under the guidance of the Ministry of Foreign Affairs”, according to its website, named him the second-most influential China expert in the United States.

While political whispering and gossip about political instability have undoubtedly surged during the past year, I have no ability to judge China’s complex power struggle and its mysterious political maneuverings. No one I know, even the most plugged-in of my friends and former students, seems to have much sense of the political direction in which we are going, and the only thing with which everyone agrees is that they are all a lot less certain than they used to be.

In my opinion, however, there is no question that the days of rapid growth, which powered the inexorable economic rise on which Jacques relies for the future described in his book, are well and truly over. There is no way that growth won’t drop to below 2-3% well before the end of this decade, although if it manages the adjustment well and doesn’t put off too much longer an intelligent plant to resolve its debt burden, Beijing could keep the annual growth in household income from dropping much below 5% during this period.

This doesn’t mean that I think China is likely to experience an economic or financial crisis, let alone political collapse, however, although historical precedents make it very clear that as a country’s balance sheet becomes increasingly fragile, it takes a smaller and smaller adverse shock to set off a financial unraveling. There is nonetheless absolutely no question in my mind that its GDP growth rate will continue to drop sharply – either by 1-2 percentage points a year, or a lot more steeply after two or three years in which it maintains growth rates above 6 percent.

But titillation and terror continue in various forms. For many analysts who don’t understand why continued rapid slowdown is inevitable and why, therefore, it makes sense to tone down some of the rhetoric, recent statements made by Zhou Xiaochuan, Governor of the People’s Bank of China (PBoC), set off some very loud alarm bells. In his statement on April 16 to the IMF’s International Monetary and Financial Committee meeting in Washington, D.C., the head of China’s central bank closed with two sentences that caught the eyes of a number of analysts:

Starting from this April, China has released foreign exchange reserve data denominated in the SDR in addition to the USD. We will also explore issuing SDR-denominated bonds in the domestic market.

A concurrent release by the central bank on the PBoC website emphasized the first of these two statements: “starting from April 2016, the People’s Bank of China is releasing foreign exchange reserve data denominated in the SDR, in addition to the USD currently used.”

A little bit of context is in order here. Every month the PBoC announces the value of its foreign currency reserves in renminbi and in US dollars. Beginning in April, it plans also to announce the value of the PBoC’s reserves in Special Drawing Rights (SDRs).

The PBoC correctly points out that because the SDR is necessarily less volatile than any of the constituent currencies – US dollar, euro, the Japanese yen, pound sterling, and, in October of this year, the renminbi – using the SDR “would help reduce valuation changes caused by frequent and volatile fluctuations of major currencies.” We saw how this works Sunday, in an article in the South China Morning Post that opened with this:

China’s foreign exchange reserves rose, albeit marginally, for a second consecutive month in April, indicating easing in capital outflows, according to data released by the People’s Bank of China on Saturday. The US$7.1 billion rise beat the market forecast of a drop and took outstanding forex reserves to US$3.22 trillion at the end of last month. In March, the reserves rose US$10.2 billion, ending a five-month decline.

At the bottom of the article, the SCMP gave us the SDR figures released by the PBoC:

In terms of SDR, the country’s foreign exchange reserves were 2.27 trillion at the end of last month, down from 2.28 trillion at the end of March.

A $7.1 billion increase in reserves when quoted in US dollars turned into a SDR 0.1 decrease when quoted in SDRs. The dollar declined against most major currencies in April and this weakness showed up in the form of an increase in the dollar value of the PBoC’s non-dollar reserves. Because the US dollar share of PBoC reserves is around 1.5 times its share of SDR, this same weakness showed up in the form of a decline in the SDR value.

Aside from reducing volatility, the PBoC also claims that using the SDR to report foreign exchange reserve data will help “provide a more objective measurement of the overall value of the reserve”. Here the PBoC is mistaken; there is no additional information in the new number. Indeed anyone who preferred to keep track of the SDR value of PBoC reserves could have done so all along simply by converting each monthly US dollar value into SDRs – or euros, yen, sterling, or any other currency for that matter – at the then-prevailing exchange rate. There is no special trick here.

Undermining dollar hegemony

It was the last sentence in the PBoC release that raised eyebrows among many analysts, and this is where the titillation and terror come in. Reporting the value of foreign exchange reserves in SDRs, according to the PBoC release, “would also help enhance the role of the SDR as a unit of account.”

Why is the PBoC so concerned about enhancing the role of the SDR, an “international reserve asset” that until now has had little practical use and into which the renminbi has only recently entered? Shortly after the release, an article in the South China Morning Post provided one possible answer. It warned that the PBoC’s use of the SDR was aimed at achieving Beijing’s “longstanding strategic aim of dethroning the US dollar in the international monetary system.” According to the article “Beijing‘s renewed passion for the awkwardly phrased reserve asset is all part of its strategic goal – led by the central bank’s veteran governor Zhou Xiaochuan – to end the US dollar’s hegemony; the world’s second-largest economy wants to forge a new global financial order.”

In an article for MarketWatch, David Marsh, managing director of a London-based research company called Official Monetary and Financial Institutions Forum, explained in greater, slightly fawning, detail why this latest move is all part of a grander, carefully-thought-out strategy:

China’s utterances over the years on the International Monetary Fund’s special drawing rights confirm the Beijing authorities’ reputation for long-term thinking as well their ability to create riddles on what the goals actually are. The mystery is starting to look little less obscure. The world’s second-largest economy is embarking, pragmatically but steadily, toward enshrining a multicurrency reserve system at the heart of the world’s financial order.

Although it accepts that many years will elapse before the dollar can be dethroned from its No. 1 role, Beijing favors a “4 plus 1” system: the euro, sterling, yen, and yuan coexisting with the dollar. These are the five constituents of the SDR, which the yuan formally enters in October, following a U.S. Treasury-endorsed IMF decision in November. As part of this thinking, China for some years has been showing less interest in purchasing U.S. Treasurys — a trend that is likely to continue.

Beijing has upgraded the role of the IMF’s composite currency unit by starting to publish its foreign reserves total (the world’s biggest) in SDRs in addition to its long-standing practice of publishing them in dollars.

Marsh, like many other analysts who have repeated the popular but confused story about the rise of the renminbi and the decline of the US dollar, has probably misunderstood the way reserve currencies work within the global balance of payments. Whatever some people in Beijing might think about enshrining a multicurrency reserve system, in fact Beijing’s economic policies in the past two decades have done the opposite. They have systematically enhanced the reserve role of the US dollar. Had Beijing done otherwise, it would either have undermined China’s economic development or it would have created significantly higher domestic political pressures in the past two decades.

This is truer now than ever. Regardless of the stated intentions of certain political figures, Chine’s economic adjustment requires that Beijing continue supporting the dollar’s reserve-currency role. A reduced role for the US dollar would actually make China’s already difficult economic rebalancing costlier than ever.

As an aside there is of course no question that US dollars account for most central bank reserves, and have for seven decades, in spite of occasional periods in which many believed its role would be significantly reduced as another currency rose to take on a much greater presence – for example the D-mark was seen as a potential rival in the 1970s and 1980s, the yen in the 1980s and early 1990s, and the yen in fact widely expected to supplant the dollar altogether by the beginning of the last decade, and even the ruble in the 1950s. Nomura’s Stuart Oakley explained the current breakdown three years ago:

According to IMF data there is currently approximately $11 trillion of foreign exchange reserves sitting in the coffers of the world’s central banks. $6 trillion of this is referred to as “allocated reserves” where the currency composition is known. Most of the remaining $4-5 trillion “unallocated reserves” are owned by China who choose not to divulge the currency composition of their foreign loot. 

We know roughly 62 percent of “allocated reserves” are held in U.S. dollars, 23 percent in euros, 4 percent in yen, 4 percent in sterling with the Swiss franc, the Aussie and Canadian dollars making up the tiny remaining balance.

I will get back to this later, but I want to follow up on one of the other points Marsh made in his piece. He claimed that it was no coincidence that only a few days before his Washington statement, Zhou Xiaochuan had been in Paris: “The French capital is the traditional venue for plans (mainly fruitless) to unseat the dollar. These date back to the maneuverings of Jacques Rueff, the legendary pre-World War II French economist, and the ill-fated 1960s rebellion against the greenback’s exorbitant privilege.”

In fact the whole theory of the exorbitant privilege – first articulated by Valery Giscard D’Estaing, later France’s president, and referring to the tremendous economic benefits that the US supposedly receives because of the primacy of the US dollar among reserve currencies – came out of very special post-War circumstances. In the late 1940s, as the US ran trade surpluses with war-torn Europe, the Bretton Woods institutions were unable to recycle enough dollars to Europe to allow it to pay for consumption as well as fund the necessary rebuilding of infrastructure and manufacturing. The notorious “dollar shortage” was so severe that it threatened to derail any hope of European and Japanese economic recovery.

The large US dollar grants provided by the US under the Marshall Plan partially resolved the problem, but even this wasn’t enough. By the 1950s, as Cold War tensions rose, in order to rebuild European economies the US permitted protectionist policies in Europe without retaliating, so that its allies could reduce their current account deficits and eventually convert them into surpluses.[1] This would permit European employment to rise quickly enough that the concurrent increase in savings could fund faster increases in domestic investment.

No more dollar shortage

The exorbitant privilege, in other words, seemed only a privilege when the global dollar shortage meant that European investment was constrained by its inability to fund investment with a credible reserve currency. Although those days are long gone, they have not gone with an equivalent change in perception. Most Europeans are still opposed to allowing the benefits the US presumably obtains from its exorbitant privilege. What makes European intellectual obtuseness extraordinary is that while American politicians have vocally criticized predatory Chinese trade behavior for years, European policy has been far more predatory, and it is only the US “exorbitant privilege” that has permitted recent European policies, especially in Germany, to be among the most irresponsible in modern history.

The story by now is well-known. After first devastating peripheral Europe, German wage policies that caused a sharp contraction in domestic German demand have driven Europe’s current account from rough balance just a few years ago into the largest surplus ever recorded. The US has been remarkably polite about European policies, at least in public, and it wasn’t until last month that the US Treasury formally placed Germany, along with China and Japan, on a new currency watch-list. Putting Germany on this list was an action described as “provocative” by the Financial Times, and in contrast the US Treasury offered “what reads like cautious praise for Chinese authorities” – correctly so, in my opinion.

Conspiracy theorists are certain that there is some nefarious benefit that the US receives, along with the prestige, of controlling the world’s reserve currency, in spite of what should be obviously contrary evidence. While we all understand the reasons why countries engage in currency war, we are unable to understand that currency war is nothing more than the actions of a country determined to reduce its own share of “exorbitant privilege”, and force it onto the rest of the world, which in practice usually means the US. In the end the confusion over exorbitant privilege is simply part of the larger confusion that among other things drives continental machinations against the dollar and “Anglo-Saxon” financial hegemony.

For example French and other European right-wing opponents of the euro, like members of France’s Front National, fulminate against the US and oppose overt American support for the European Union and the euro as part of a long-term US strategy to emasculate Europe. Supporters of the euro, however, are no less insistent that its current failures are caused largely by covert Anglo-Saxon opposition, generated by the fear that a unified Europe will be a threat to US power, or that the success of the euro will undermine the dollar’s reserve currency role.

This confusion is so deep that participants at last year’s World Credit Rating Forum, a conference organized by Chinese rating agency Dagong Credit rating, were able to witness a remarkable speech by Dominique de Villepin, former Prime Minister of France who, in his opening address, proposed an alliance between France and China which together would form a partnership that would overturn US and British financial domination and the hegemony of the dollar. Rather than the stirring call to arms he might have planned, his speech came off as incredibly patronizing, at least to some of the younger Chinese attending. Later that week two of my students who had attended the conference, knowing that I am half-French and enjoying the very informal atmosphere I try to maintain in my seminar, teasingly related de Villepin’s speech to their classmates after which, turning to me, they expressed with grinning gratitude their appreciation that France was determined to lead poor China to great things.

But, that aside, is the reserve status of the US dollar part of US financial hegemony, and is it in China’s interest to replace it with the SDR, or even with the renminbi? Here is where the confusion lies deepest. The reserve status of the US dollar was and is necessary to China’s growth, and in fact Chinese actions in the past three decades have done more to enshrine it than anything the US has done. In fact, the US has tried, without success, to undermine its exorbitant privilege.

In fact the dollar presumably received a body blow eight years ago, delivered once again by Governor Zhou, but after which its share of total reserves actually seems to have climbed. After the first, American, leg of the global crisis in 2008 Zhou wrote a famous essay in March 2009 for the PBoC website in which he asked “what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth?”

His answer to the question he posed was careful enough to satisfy the requirements of both diplomacy and central bank obscurity, but it was widely interpreted, in spite of Zhou’s refusal to take the bait, as a fierce assault on US dollar hegemony, one that spelled the rapid demise of the American “exorbitant privilege”. The implications of Zhou’s question seemed obvious to many.

They believed that the US economy had been felled by a knockout financial crisis that was merely the first step in an inexorable US decline, one which would soon see the eclipse of old financial centers like New York and London by more vibrant stock exchanges in Shanghai, Sao Paolo, and Moscow. They also believed that the European economy was essentially sound and would sail through the crisis, with an ever more solid euro. As the indignant chairman of one of Spain’s largest banks bitterly proclaimed some time in late 2008, European banks had been conservative, prudent and level-headed, in spite of the derision heaped upon them by American and British banks, and that was why Spanish banks were in such great shape, and why the European financial system would remain largely unaffected by what was wholly an American crisis.

What can history teach us?

As part of this consensus very few analysts in China or abroad expected that Chinese GDP growth would drop below 9 percent, at least not until the end of the decade, and it was widely accepted that GDP growth could not drop below 8 percent because 8 percent was believed to be the minimum needed to stabilize unemployment. Beijing would never allow growth, these analysts said, to drop below that number. Among foreign analysts – albeit much less so among the Chinese – the capabilities of Chinese policymakers were held in such astonishingly high esteem that it seemed unnecessary to distinguish between what Beijing wanted to happen and what actually would happen.

The same optimism was applied to the stated desire of many in China that the renminbi take its place as one of the major global currencies. The data that showed the rapid increase in the share of global trade denominated in renminbi said to the optimists nothing about the very low base against which growth was measured, or about the obvious speculative interest in holding an appreciating currency, and everything about its inexorable rise, which pointed indirectly but powerfully, the consensus had it, to the equally inexorable decline of the US dollar to secondary status.

Not everyone agreed with the consensus, however, and in fact it seems that most economists with a background in economic and financial history in fact disagreed strongly. In my Peking University (PKU) classes I have always insisted on the importance of placing economic and financial events in historical context and of understanding the structure of balance sheets and financial sector incentives in analyzing the evolution of financial markets and economies. From 2008 to 2010 the extremely bright students who made up my central bank seminar used both to predict the inevitability of economic rebalancing.

Also around this time I published an article that argued that because global financial crises tended always to increase the liquidity premium and make more valuable the liquidity advantage global financial centers had over local stock markets, contrary to consensus I expected New York and London to take market share from local stock markets. A few months later in another article I argued that not only would the US dollar not fade away as a reserve currency, but that for similar reasons we should expect its use “actually to increase, not decline, as investors and exporters increasingly move out of less liquid currencies and into the most liquid.”[2]

In retrospect history seems to have been the better guide than the consensus. While it is too early to say for sure, the Shanghai, Sao Paolo and Moscow stock exchanges don’t seem to have taken market share from the old global financial centers and in fact seem likely to lose it as local markets have seized up and in some cases required significant government intervention. What’s more, rather than see its role diminish rapidly, as was widely expected in 2008-09, the dollar’s share of total currency reserves has grown, according to the IMF, by more than 3 percentage points since then, to over 64%.

My PKU seminar was also always extremely skeptical of claims that emerging markets had decoupled from the West and would become self-perpetuating engines for growth. In fact it seemed clear that the sub-prime crisis was simply the trigger for a disruptive global adjustment to years of misguided monetary policy and balance of payment distortions. Excess liquidity had been created by all of the major central banks, and this had supported the imbalances that led to what must inevitably be a global crisis.

The sub-prime crisis, in other words, was not the problem. It was simply the trigger for a global crisis caused by ferocious growth in central bank liquidity, which forced or accommodated significant distortions in the global balance of payments that could only be temporarily resolved by soaring debt.

That is why my students and I were convinced almost from the beginning that the global financial crisis would occur in three stages. The first stage was the American crisis, which would be brutal but from which the US would recover fairly quickly. The second stage would be the crisis in Europe based on the unsustainable institutional foundations of the euro, and it would probably run until sovereign debt was forgiven and the strictures created by the euro were resolved. The third stage would be the emerging market stage, set off by the collapse in commodity prices as China’s economy slowed. In early 2012 I wrote in one of my newsletters that industrial metal prices would drop by more than 50% within three years and iron, then trading above $190 a ton, would soon test $50 – as China was forced into rebalancing. This seems almost inevitable as part of the necessary Chinese adjustment.

Returning to Governor Zhou’s statement in April to the IMF, like his 2009 essay, will the new PBoC policy to report the SDR value, along with the US dollar value, of its foreign exchange reserves increase the visibility and viability of the SDR, and if so, will it in any way undermine the use of the US dollar as a dominant reserve currency as it is slowly replaced by the SDR or the renminbi? The answer is that while it may increase the visibility of the SDR, it will in no way increase its viability. More importantly, it will have not undermine the dollar as the global reserve currency nor will it support the rise of the renminbi.

The effects of reserve currency status

It turns out that improving the visibility of the SDR will not make it more widely used as a reserve currency. Central banks can only buy SDR if the IMF or an acceptable sovereign credit wishes to issue bonds denominated in SDR, and they will only want to do so in more than token amounts if they can hedge by buying the constituent currencies. This they will not be able to do.

Regardless of excited complaints about the “exorbitant privilege” the US government enjoys from the US dollar’s hegemonic status, in fact the US absorbs very little economic benefit and a huge economic cost when foreign central banks stockpile US dollar reserves, and no other country is willing to absorb this cost. That is why whatever happens to the SDR, the US dollar will continue to be the dominant reserve currency for the next several decades unless the US government itself decides to prevent or limit the ability of foreign central to accumulate reserves in US dollars (and sooner or later – and the sooner, the better economically for the US – Washington will do so because the economic cost to the US far exceeds the political benefits).

Whatever happens to the SDR, the renminbi will not become an important reserve currency at any time over the next few decades. While many in Beijing may not understand the costs to the issuing country associated with significant foreign purchases of its currency for central bank reserves, they nonetheless exist and are significant. In spite of explicit policies to increase renminbi holdings among foreign central banks – much ballyhooed but of limited value – Beijing’s overall economic policies implicitly make this impossible. If foreign central banks acquire significant amounts of renminbi denominated bonds, China’s economic rebalancing will become far more difficult because either Beijing’s debt burden will grow even faster than it currently is growing, or its unemployment will be higher.

This would happen anyway if the US were to decide to limit foreign central bank purchases of US bonds, perhaps by imposing cross-border taxes. If it were to do so the US economy will grow more quickly in the subsequent years, while the global economy, and especially countries that historically depend on trade surpluses to generate growth, will grow less quickly. In fact countries like China have put into place policies that require a hegemonic reserve role for the US dollar for many more years for them to be successful.

To see why these seemingly counter-intuitive statements are in fact logically necessary we only have to go through the balance of payments exercise. The SDR is a constructed currency, and no issuer will be willing to issue unlimited amounts of bonds denominated in SDRs unless it can hedge them by buying the constituent currencies. But if a central bank buys an SDR-denominated bond issued by the IMF, and the IMF hedges it by buying the requisite amount of bonds in dollars, euros, yen, sterling, and, soon enough, renminbi, this is no different than if the original central bank simply bought the requisite amount of bonds in dollars, euros, yen, sterling, and renminbi. Put differently, as I wrote in response to Governor Zhou’s 2009 essay, if the PBoC wants SDRs, it can easily get the equivalent by buying the constituent currencies according to the formula set out by the IMF.

But this isn’t the end of the story. Historically, neither Europe nor Japan, and certainly not China, have been willing to permit foreigners to purchase significant amounts of government bonds for reserve purposes. When the PBoC tried to accumulate yen three years ago, for example, rather than welcome the friendly Chinese gesture granting the Bank of Japan some of the exorbitant privilege enjoyed by the Fed, the Japanese government demanded that the PBoC stop buying. The reason is because PBoC buying would force up the value of the yen by just enough to reduce Japan’s current account surplus by an amount exactly equal to PBoC purchases. This, after all, is the way the balance of payments works: it must balance.

What is more, because the current account surplus is by definition equal to the excess of Japanese savings over Japanese investment, the gap would have to narrow by an amount exactly equal to PBoC purchases. Here is where the exorbitant privilege collapses. If Japan needs foreign capital because it has many productive investments at home that it cannot finance for lack of access to savings, it would welcome Chinese purchases. PBoC purchases of yen bonds would indirectly cause productive Japanese investment to rise by exactly the amount of the PBoC purchase, and because the current account surplus is equal to the excess of savings over investment, the reduction in Japan’s current account surplus would occur in the form of higher productive investment at home. Both China and Japan would be better off in that case.

But like other advanced economies Japan does not need foreign capital to fund productive domestic investment projects. These can easily be funded anyway. In that case PBoC purchases of yen bonds must cause Japanese savings to decline, so that its current account surplus can decline (if the gap between savings and investment must decline, and investment does not rise, then savings must decline). There are only two ways Japanese savings can decline: first, the Japanese debt burden can rise, which Tokyo clearly doesn’t want, and second, Japanese unemployment can rise, which Tokyo even more clearly doesn’t want.

There is no way, in short, that Japan can benefit from PBoC purchases of its yen bonds, which is why Japan has always opposed substantial purchases by foreign central banks. It is why European countries also strongly opposed the same thing before the euro was created, and it is why China restricts foreign inflows, except in the past year when it has been overwhelmed by capital outflows. The US and, to a lesser extent, the UK, are the only countries that permit unlimited purchases of their government bonds by foreign central banks, but the calculus is no different.

It turns out that foreign investment is only good for an economy if it brings needed technological or managerial innovation, or if the recipient country has productive investment needs that cannot otherwise be funded. If neither of these two conditions hold, foreign investment must always lead either to a higher debt burden or to higher unemployment. Put differently, foreign investment must result in some combination of only three things: higher productive investment, a higher debt burden, or higher unemployment, and if it does not cause a rise in productive investment, it must cause one of the other two.

The two conditions under which foreign investment is positive for the economy – i.e. it leads to higher productive investment – are conditions that characterize developing economies only, and not advanced countries like Japan and the US. These conditions also do not characterize developing countries that have forced up their domestic savings rates to levels that exceed domestic investment, like China.

The case of Australia

The confusion that arises from a failure to understand this affects a whole series of policies around the world. Recently, for example, Canberra blocked the acquisition by a Chinese buyer of the S. Kidman & Co estate, “the largest private land holding in Australia”. This land holding was “approximately 1.3 per cent of Australia’s total land area, and 2.5 per cent of Australia’s agricultural land”, and it was blocked on the grounds that it was not in the national interest, according to the April 29 statement to the media on the subject by Scott Morrison, the Australian Treasurer.

Morrison did not provide much greater detail on the reasons for blocking the acquisition, but he assured the press that Canberra welcomes foreign investment. “Foreign investment has underpinned the development of our nation,” he wrote, “and we must continue to attract the strong inflows of foreign capital that our economy requires. Without foreign capital and investment, Australia’s output, employment and standard of living would all be lower.”

I think it used to be true that foreign capital was necessary to increase Australian output, but it is much less true today. In fact I would argue that foreign investment is only likely to be positive for Australian growth under specific conditions, and these do not apply to the Kidman transaction.

Australians are clearly concerned about the political implications of a major acquisition of Australian assets by foreigners, and although this was not a formal part of the reason for blocking it, there is no question that the nationality of this particular foreign entity mattered. Some people argue that in evaluating large foreign purchases Canberra should not distinguish between a Chinese buyer and, say, an English buyer, and that to the extent it does this can only reflect hidden assumptions about racial or ethnic superiority.

This is nonsense, of course. Whether rightly or wrongly, Australians are more opposed to foreign government involvement in domestic politics than to involvement by foreign private individuals (and of course any major economic player is inevitably also a political player). Differences in their recent histories, political cultures, the primacy of rule of law, and so on, have convinced Australians, probably with reason, that the behavior of a private buyer from England is less likely to be driven by his government’s foreign policy objectives than the behavior of a Chinese buyer.

Having said that, however, it is also worth pointing out that a major acquisition of Australian land by a foreigner does not necessarily mean greater foreign leverage in domestic politics. It might mean greater Australian leverage on the foreigner. The buyer, after all, is held partly hostage to his property, and it is worth remembering that American, British and French businesses with significant commercial interests in Germany in the 1930s tended to be far more likely to support accommodation with Nazi policies than businesses that were not exposed commercially to Germany. The effect isn’t symmetrical, however, and I suspect that this is more likely to be true in countries in which the government is above the law – German businesses with significant commercial interests in the US, Britain and France, for example, were probably much less likely to support Berlin’s accommodation of American, British or French policies than vice versa.

While they may understand the politics, the economics of the transaction are probably not what most Australians assume. The Chinese purchase of the Kidman estate impacts the Australian economy primarily through its impact on the Australian balance of payments. The net amount of capital flowing from China to Australia will cause a reduction in the Australian current account surplus (or an increase in its deficit) with China in the period in which it occurs. This net amount is equal to the purchase price, less the amount financed within Australia, plus or minus other capital flows between the two countries set off by the purchase – for example it would increase if Chinese ownership of the Kidman estate causes other Chinese entities to increase their investments in China.

If there is a consequent net increase in productive Australian investment, there will be a boost to Australian GDP generated by either a reduction in Australian unemployment or an increase in Australian wages. If not, either Australian GDP growth will remain unchanged and its debt burden will rise, boosting consumption and so strengthening Australia’s non-tradable sector in line with a weaker tradable goods sector, or GDP growth will decline because of an increase in Australian unemployment. In the former case it would be because the Chinese purchase increased the amount of capital within Australia that had to be invested, and this capital caused real estate and equity prices to rise, thereby setting off a wealth effect.

The key is whether or not the Chinese purchase of the Kidman land results in an equivalent boost in productive Australian investment. It is not at all obvious that it will. If the Chinese investors bring with them novel management techniques and new technologies that are unfamiliar to Australians and that cause the Kidman estate to be far more productive than it otherwise would, and if these new management techniques and technology then spread through Australia, raising productivity everywhere, then the benefits the foreign investment would bring to Australia outweigh the costs.

It is hard to imagine that this will be the case, however. Whoever owns the Kidman estate is likely to maximize the land’s productive value no more than any Australian owner would, given current technologies. In that case for advanced countries like Australia, foreign investment is only useful to the extent that it provides the competitive fillip to keep Australian businesses at the forefront of innovation. In a global economy of weak demand, however, countries export capital to advanced economies not to make the recipient country more competitive but rather to generate foreign demand for its exports.

So how does Australia benefit from the Chinese purchase of the Kidman estate? If the Chinese buyer significantly overpays for the asset (which might be the case if Chinese capital outflows are being driven by political or financial uncertainty at home), the Australian seller of course benefits by getting more than the asset is worth.

If the Chinese buyer brings in new managerial or technological innovations that increase the productive use of the Kidman estate, Australia benefits by the amount of the additional productivity generated over future years. And finally if the Chinese investment funds productive investment within Australia that had been on hold because of an Australian inability to raise the necessary capital, which seems quite unlikely, Australia benefits by an increase in productive investment that otherwise would not have happened, and this increase would cause unemployment to drop (or wages to rise) as Australians are able to consume the resulting increase in national output.

Otherwise there is a cost to Australia which emerges from its the impact on the balance of payments. The net capital inflow must cause Australian investment to rise or savings to drop. If it does not cause investment to rise, it must cause savings to drop, and of course that means either the Australian debt burden must rise or else unemployment will.

The geopolitics of trade deficits

Doesn’t the same happen to the US? Yes, it does. Like all rich countries, the US has no problem funding productive domestic investments that it wishes to fund, and so foreign capital inflows cannot cause productive domestic investment to rise. Therefore as is the case with other countries with credible currencies, they must cause domestic savings to fall, and the only way this can happen is with a rise in the debt burden or a rise in unemployment. This is exactly what happened in the periods both before the 2008 crisis (debt rose) and after (unemployment rose).

I should add that while the US doesn’t benefit economically, it might benefit politically. During the Cold War, the US may have drawn tremendous foreign policy advantages from allowing US demand to stabilize foreign markets and reduce foreign unemployment.

It is not clear to me however that even this political benefit is any longer very substantial, but this is the only rational explanation for why the US has not, like other countries with credible currencies, discouraged foreign central banks from acquiring US dollar reserves. After Bretton Woods, it was considered vitally important that the global trade and capital regime be stabilized if the war-torn countries were to benefit from economic recovery, and because the US was the only country that could stabilize the global trade and capital regime, and because it felt that it had to do so to protect its allies from the kind of economic instability that might drive them away from the US and even into the arms of the USSR, the US took on that role.

Should the US continue playing this role? In my opinion if the economic costs do not already significantly exceed the political benefits, it is only a question of time that they begin to do so. This is the great irony of the global financial crisis. While China, Russia, and France lead the charge to strip the US of its exorbitant privilege, and the US and it’s allies resist, in fact each side should take the opposite position, especially if they wanted to benefit most from beggar-thy-neighbor policies. If the US were to take steps to prevent foreigners from accumulating US assets, the result would be a sharp contraction in international trade. The US current account deficit would fall as a direct function of the reduction in net capital inflows, and as it did so, US unemployment would fall and GDP growth rise.

At the same time the European and Chinese current account surpluses would fall exactly in line with their ability to export capital, and they would be forced to choose either to lend capital to capital-poor developing countries, forcing them into substantial current account deficits that would make repayment highly unlikely, or to suffer the consequences of a collapse in their surpluses, which almost certainly would cause both soaring debt and surging unemployment. If Europe and China were prevented from handing exorbitant privilege to the US, their economies would suffer terribly.

This is the great irony of the global financial crisis. China, Russia, and France want to lead the charge to strip the US of its exorbitant privilege, and the US resists. And yet if the US were to take steps to prevent foreigners from accumulating US assets, the result would be a sharp contraction in international trade. Surplus countries, like Europe and China, would be devastated, but the US current account deficit would fall with the reduction in net capital inflows. As it did, by definition the excess of US investment over US savings would have to contract. Because US investment wouldn’t fall, and in fact would most likely rise, US savings would automatically rise as lower US unemployment caused GDP to grow faster than the rise in consumption.

But what about the extremely low savings rates in the US. Don’t they prove, as Yale University’s Stephen Roach has often pointed out, that the US is savings-deficient and relies on Chinese and European savings to fund US investment, or at least the US fiscal deficit, because the US consumes beyond its means?

What the candidates won’t tell the American people is that the trade deficit and the pressures it places on hard-pressed middle-class workers stem from problems made at home. In fact, the real reason the US has such a massive multilateral trade deficit is that Americans don’t save.

This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry.

It must happen because, to repeat what I have said earlier, if foreign exports of capital to the US increase, by definition so must the excess of US investment over US savings. Because there are no productive investments in the US that investors want to make but cannot because of the unavailability of capital, increased net capital exports to the US do not cause investment to rise. In that case they must cause savings to fall, and they do so either because of the wealth effect or because of the increase in the current account deficit driven by the increase in the capital account surplus (often as capital inflows drive up the value of the currency).

During boom times the obvious mechanism by which they cause a fall in savings has been seen a number of times throughout modern history, including most famously in the US and peripheral Europe before the 2008-09 crisis, in the US and Germany before the 1929 crisis and before the 1873 crisis. As foreign savings pour into the economy, they flow into asset markets, driving up prices, especially in real estate and the stock markets. As household owners of these assets see their wealth rise, they experience a wealth effect that results in a subsequent increase in consumption – usually funded by rising debt as incomes do not rise, or rise more slowly than wealth. The increase in consumption creates new jobs that replace the jobs lost as workers producing tradable goods are displaced by the rise in the current account deficit.

During depressed periods, which usually follow the boom times described above, as excessive debt levels and declining asset prices eliminate the wealth-effect impact on consumption, the decline in consumption forces layoffs and unemployment rises. Rising unemployment, of course, reduces savings as worker income drops to zero but worker consumption declines by less.

The idea proposed by Roach and many others that the US needs foreign capital to balance its low savings rate, in other words, or that this low savings rate is itself the consequence of spendthrift habits of American households, flies in the face of logic and the balance of payments mechanisms. It is simply not true.

What of the benefits?

But what about all of the benefits to the US associated with exorbitant privilege that are so widely known and cited? It turns out that it isn’t easy to list these benefits because for all the conviction that they are substantial, few analysts can identify them except very vaguely. The main benefits seem to include:

  • It lowers US government borrowing costs. An otherwise excellent 2009 survey by McKinsey claims that “the United States can raise capital more cheaply due to large purchases of US Treasury securities by foreign governments and government agencies.” As Nomura’s Stuart Oakley put it in 2013, “Who wouldn’t want cheap access to world capital markets that reserve currency status brings? Not to mention cheaper transaction costs on international trade.” This seems reasonable at first: more demand for government bonds after all should drive prices up. But because foreign purchases also automatically increase the supply of US dollar debt, either directly or indirectly, when rising unemployment causes a larger US fiscal deficit. Were this not so we would have absurdly to conclude that driving up a country’s current account deficit, the obverse of its capital account surplus, would automatically lower its borrowing cost.
  • It allows Americans to consume beyond their means. This extraordinarily bumbling interpretation implies that American current account deficits force other countries unwillingly to run current account surpluses, and not the reverse. Any country with a credible currency will “consume beyond its means” whenever foreign central banks try to stockpile its currency. And yet most countries refuse the privilege, often indignantly, as unfairly forcing up its currency, and so forcing it to “consume beyond its means”.
  • Outstanding currency notes provide seignorage benefits. Currency notes are effectively interest-free loans to the issuing government. The value of his benefit, however, is tiny, almost negligible, and anyway has nothing to do with reserve status. Any credible currency can enjoy seignorage benefits, and with the creation of the Euro 500 note in 2002 we saw a significant shift in seignorage benefits from the USD 100 note, implying that these benefits come mainly from those who are trying to hide their wealth. This is why rather than celebrate, Brussels has just announced that it will eliminate this “benefit” by discontinuing issuance.
  •  The US sells economic insurance. As the US intermediates low-risk high-quality inflows into riskier outflows during times of stability, it effectively earns a risk premium for which it pays out during periods of instability. This creates real value both for the US and for countries that choose to buy this “insurance”. As Barry Eichengreen, author of Exorbitant Privilege explains, “the US has a built-in insurance policy. Whenever something goes wrong in the world – whether in the US or abroad – and incomes go down, the dollar goes up. So that insulates the US against the worst effects.” Eichengreen is right, but to the extent that he is, it does not depend on the reserve currency status of the US dollar. Any country whose economy is perceived as a safe haven in times of trouble, for example Japan, Germany and Switzerland, receives such inflows during market disruptions. But in recent year this has not been perceived as a benefit. Just over two years ago Japan’s Prime Minister Shinzo Abe was determined to protect Japan from this “benefit”, arguing that “If it goes on like this, the yen will inevitably strengthen. It’s vital to resist this” according toan article in the Wall Street Journal.

Japan’s determination not to allow other countries to force it into accepting exorbitant privilege was not fully appreciated by other countries, including China. Two months after the Wall Street Journal article was published, Bloomberg published the following:

China doesn’t approve of excessively loose monetary policies by other nations, according to a senior government adviser who wrote a book with Li Keqiang, the country’s incoming premier.

“We have already taken a position on this before and China doesn’t approve of some countries’ overly accommodative monetary policy,” Li Yining, 82, a Peking University professor and delegate to China’s top advisory body, said at a briefing in Beijing today when asked about Japan’s recent easing. “This is an act of transferring the crisis to others.”

The remarks may reflect official displeasure over the yen’s depreciation amid Japanese Prime Minister Shinzo Abe’s campaign for more monetary easing to fight deflation. China is “fully prepared” for a currency war should one happen, central bank Deputy Governor Yi Gang said March 1, according to the official Xinhua News Agency.

The US should lead a reconvening of the world’s economic policymakers in a global conference to restructure the global capital and trade regime, so that countries looking to kick-start or goose domestic growth cannot do so at the cost of US unemployment or rising US debt levels. Enshrining SDR is is a start. If central banks were allowed only to accumulate SDRs, the US would be forced to absorb just under 42 percent of these distortions, as opposed to the roughly two-thirds it currently must absorb. Europe would be forced to absorb almost 31 percent and China, Japan and the UK between 6 percent and 11 percent.

But even this is too much. It would be far better, as Keynes unsuccessfully proposed during the Bretton Woods conference, that countries that try to force domestic demand deficiencies caused by domestic policy distortions onto their trading partners, rather than resolve them domestically, were prevented from behaving irresponsibly. It is surprising that Washington has not yet taken the lead in attempting to restructure the international trade and capital regime so as to limit reserve accumulation in US dollars. The logic, however, is inexorable. It is only a matter of time before it does so. The only question is how much economic pain and domestic unemployment is it willing to accept before it decides to move.



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[1] In one of the flights I took last year I was able to watch a documentary about the Nixon tapes. In one conversation, one of his aides frets about protectionist European measures that are hurting US businesses, and discusses retaliating to pressure Europe into withdrawing the measures. Another aide interrupts and warns that retaliation would undermine European support for certain Cod War positions, after which Nixon immediately puts an end to all talk of pressuring Europe to remove its protectionist policies. This was a pretty constant refrain from the 1950s onwards, and continues to inform policy today – TPP for example.

[2] Both articles were South China Morning Post columns, the first “Financial capitals unlikely to lose their clout”, November 3, 2008, and the second “Reserve currencies rarely change,” May 25, 2009

The re-emergence of the Jacksonians

We’ve pelted Donald Trump with all the withering humor we can muster, and even though it is hard to imagine an easier target for elitist humor, with his blustering narcissism, his intellectual inconsistency, his questionable business record, and his truly stupid television show, above all of which rages his ferocious hair, it’s been so frustrating. Although we have shown again and again that he is dishonest, unfit for the presidency, and incapable of office, not only has he been able to survive, but he actually seems to thrive on the relentless series of what for any other candidate would have been knockout blows. Donald Trump’s supporters are indifferent to our wit and to our arguments, and we’ve convinced ourselves that this only proves what probably didn’t need much proving, that his supporters are racist nitwits and that they support Donald Trump for reasons that are too trivial to matter. This frightens us because collectively they seem to be bringing something new to American politics.

But we are wrong on all counts. Most of Trump’s supporters are not racist nitwits, and not only do they have legitimate reasons behind their support of Donald Trump, in fact they are very important ones. We are finally starting to see this. We are wrong, however, to see recent events as some kind of turning point in American history. The outrage which the American political establishment is being rejected certainly brings dangers and risks, but much fewer than we think because in fact we’ve been here many times before, and by remembering our history we can make some pretty good guesses as to how this all of will evolve.

Trump’s supporters belong to what we sometimes call the Jacksonian tradition in American history, and their history, which of course pre-dates the presidency of the man who gave them their name, combines the impressive with the shameful. Like Andrew Jackson himself they have been the strongest defenders of some of our most fundamental American values while undermining others. While their social peers in Europe have largely accepted their limited role in politics, except from time to time when they rise up in sans-culottes rage, the Jacksonians always demand to be heard when they feel their rights are threatened.

But while he may count on the support of the Jacksonians, Donald Trump is no Andrew Jackson and soon enough, like most of his predecessors, he will abandon his followers or be abandoned by them. Because Jacksonians lack sophistication, and tend to be largely uneducated, at times when the small victories they have worked for are threatened to the point of creating deep-seated anxiety it has always been easy for scoundrels to exploit them, but as one of the greatest of their heroes reminded us, you can’t fool all the people all of the time. The Jacksonians have been the defenders of American democracy even when their history has been marred by misjudgment, and although Donald Trump’s time will be limited, the effect of Trump’s supporters will be far-reaching, and probably positive for the US in the longer term even if it risks foolishness in the short.

I won’t pretend I’ve ever been a Jacksonian. In the early 1980s, when I was getting my Ivy League education, my brother and I lived in Manhattan’s notorious Alphabet City and ran a music space on Avenue C and 3rd Street. One of the friends we made in that heavily Dominican neighborhood was Dani, a bright, uncontrollable but ferociously charming 15-year-old, who at some point within a few months of our meeting him suddenly seemed to have constructed us into his family. As we got to know Dani, we quickly learned about a life very alien to ours but which he took for granted. Dani’s daily life combined what to us was the romance of New York street hustling and the sheer awfulness of life for a kid living in one of the worst neighborhoods of the city. It consisted mostly of petty crime and street hustle, avoiding trouble with local gangs and only picking fights you knew you could win.

He didn’t stay often with his Dominican mother but, until my brother and I managed to get him a tiny apartment in the basement of our building, Dani usually slept in Lower East Side squats, friend’s apartments, and even sometimes in a wooden box tucked away on a side street. He went to school occasionally, and until we put him on an allowance he depended mostly on hustling, shoplifting and small burglaries to earn spending money (in fact we met him when he tried to charm my brother and me into not noticing as a friend of his made off with a crate of beer from our bar). When he was 16 he got caught up in the crack epidemic sweeping New York and it took us more than a year, and a tough year at that, to get him to stop.

Dani never knew his father but had been told that his father was half African-American and half Dominican, although if Dani wanted to seem white he easily could. Over time we met his two younger sisters, who both eventually became prostitutes and junkies, and both eventually died of AIDS before Dani turned 25. His older brother, with the very inappropriate nickname of Hippie, was a fairly scary guy, heavily scarred and stocky, who had been in and out of jail several times. He too died early, in his mid 30s, halfway through a 12-year sentence. Hippie had been convicted of a series of armed robberies at local ATMs, and because he had forced Dani to join him as lookout – and Dani, like most of us, was far too frightened of Hippie not to do whatever he demanded – Dani was himself sentenced to four years in jail.

I was glad to see Hippie in jail because of the way he had dragged Dani into dangerous crime, but my brother, both tougher and less judgmental than I was, would send him care packages six or seven times a year. After Hippie died my brother’s girlfriend showed me some of the letters Hippie had sent my brother from jail: badly written, misspelled, with the most hackneyed expressions of emotion, which conveyed nonetheless an almost heartrending gratitude for packages that were the only evidence Hippie had during his final years that anyone on the outside cared or ever thought about him.

With that kind of background it was easy to assume away any useful future for Dani, but he had always been bright and ambitious. I think I may have been the first person ever to tell him how smart he was, some time when he was still 15, because when I did, and then had to insist that I wasn’t just making fun of him, his mouth fell open with surprise and he began beaming cockily when he realized that I was probably right. He certainly was bright, and while in jail, Dani decided he would complete his high school education. We spoke by telephone nearly every week so that he could brag about his progress, and about the facility for computers he discovered he had.

How to succeed

Over the next few difficult years after his release Dani made an amazing recovery. He got a job working in some computer capacity, and then another job driving a truck. After a lot of oats were sowed, mostly with the arty white girls who had begun moving into the neighborhood in the mid-1980s, he suddenly fell in love with a working class girl of Irish descent, and decided he had to marry her. He did, and they are still married nearly three decades later.

A few weeks after the events of 9/11, an event that shocked him terribly, I happened to meet Dani for beers when he told me, very casually and without the least sense of having done anything praiseworthy, that beginning two or three days after the Trade Center disaster, every morning he had joined the hundreds of volunteers working downtown to dig up bodies and clean up the rubble of the devastated Twin Towers. I didn’t know what to say when I heard that except that I felt very proud of him, which surprised him. After a moment of confusion, he suddenly figured out why his volunteer work was indeed sort of an impressive thing, and he beamed, realizing that he had just hustled some big points with me.

Around that time I left New York to live in Beijing, but from there I learned that Dani’s knack for computers paid off. A few years after 9/11 he wrote to me to say that he had started a small computer consulting business and had moved to the Midwest. He had three daughters, of whom he was inordinately proud, and joked about the dictatorship his wife exercised within the family. He was now a member of the middle class, and although he was much closer to the bottom of the middle class than to the top, he had achieved a social standing almost unimaginable for anyone in his family. He was very clear that his adored daughters were never going to be given the chance to return to the place from which he came.

Over the years during trips back to the US I saw him from time to time, although rarely, but I got emails and later was able regularly to check his Facebook page. His page consisted of the expected combination of family pictures, silly animal videos, and the corny jokes he had always been famous for, along with dutiful messages about the various volunteer work he and his wife (and the kids) were doing as community members and as a family. He had determined to become “normal”, as he saw it, but of course far from being normal what he had become was the result of extraordinary effort and determination.

Late last year I noticed for the first time on his Facebook page that he had taken an interest in politics, and this year I could see that the candidate of whom he seemed most to approve was Donald Trump. I sent him a joking Facebook message about his new-found interest in politics and asked him if he really was a Trump supporter. He wrote back, a little sheepishly, knowing that I was unlikely to be impressed, saying that yes, he was going to vote for Trump if he got around to voting.

After a few more kidding messages back and forth, as I expected, I could see that Dani didn’t know much about Trump’s policies and his background, even though many of his friends also supported Trump, and he didn’t mind that he knew so little. To the extent that he and his friends even noticed it they dismissed the controversy around Trump as noise, and probably to be expected by anyone who had decided to take on the establishment, which he believed Trump to be doing. He had never paid attention to politics before because he had never thought any of it mattered, but he had some idea that Trump was a successful businessman determined to toss out a political establishment for whom Dani had always seemed irrelevant.

Few people who follow the Trump saga will be surprised to learn that Dani never really was able to explain to me very clearly why he supported Trump, except to the extent that he felt a vote for Trump was a vote against everyone else, and that rather than be swayed by the howls of liberal or conservative anti-Trump rage, which he barely followed, he thought that every time some over-educated pundit attacked Trump it only reinforced his sense that Trump was probably taking on the Washington establishment. Democrat or Republican, Dani wasn’t able to distinguish among the Trump critics, and we shouldn’t be too quick to take that as evidence of how hopelessly naive Dani is when it comes to politics. As fas as he and his family were concerned there really was little to distinguish the two.

Dani’s success in life was tenuous enough that he was unwilling to admit that his middle-class life was threatened in any way by financial difficulties, but from the way he talked about how the government had mismanaged the economy, and his concern about illegal immigrants taking jobs, I suspect that things weren’t always easy financially, and the educational needs of his daughters would certainly be creating pressure for him. The things that worried him seemed to be the things that were weakening his grasp on the edges of the middle class.

Trump and the dummies

Dani clear doesn’t seem to most of us to be an obvious Trump supporter. Given his background he is clearly a tough guy who can handle himself in a fight, but I know him well enough to know that if he ever actually attended a Trump rally, which I doubt, there is no way he would be one of the trouble-makers that joined the mobs looking to beat up protesters. He probably wouldn’t have any sympathy for the protesters, but in Dani’s world you mind your own business.

So how does Dani fit in? Clearly he isn’t a racist, and just as clearly he isn’t one of those losers who flock to Trump campaign events to get reassurance that their failures are caused by someone else. He is a successful, middle-aged, middle-class family man, not terribly educated but smart, of black and Latino descent, who participates and volunteers in community events (grumbling just enough to be good-natured about it), and who cannot hide the sense of joy and even surprise whenever he looks at his daughters.

And yet he supports Donald Trump, a man who probably isn’t especially racist himself but is distressingly reluctant to reject racism, and who is so intensely narcissistic that the idea of his volunteering to help some abstract community, and for no reward, wouldn’t even register with most of us. It is almost impossible, for example, to imagine Donald Trump working shoulder to shoulder with Dani, digging through the fetid ruins of the World Trade Center to pull out bodies, simply because, as Dani tried to tell me that night over beers, he felt there was an obligation to show respect to the bodies of the people who had died there, especially the cops and firemen.

It is also hard to imagine that Dani could have much sympathy for someone who inherited a fortune. He came from a wholly dysfunctional family, and shortly after he turned 18 he was in jail for violent crime, had almost no education, and a history of crack addiction, and yet he was able to turn himself around through hard work and a total lack of self-pity. Even Donald Trump might agree – or perhaps he is narcissistic enough not to – that Dani’s pitiful success is heroic in a way that Trump’s magnificent success isn’t.

But in fact Dani’s support for Donald Trump isn’t any more surprising then the fact that Dani is almost completely ignorant of anything Trump has done or said. His support for Trump simply reflects a recurring and predictable feature of American history. There are so many historical precedents for anyone willing to read American history in light of the Trump campaign that it should have been obvious from the surge in recent years in immigration and, even more so, the surge in income inequality, that sooner or later someone like Trump was going to emerge and someone like Dani was going to support him.

In fact what is important about Dani’s support of Donald Trump is what it says about the bulk of Trump’s supporters and what it says about the ignorance of the opposition to Trump. The political establishment in the US, the press, and much of the huge anti-Trump constituency loves the excitement of the Trump campaign because Trump has given America and much of the world a wonderful gift whose value we are too embarrassed to acknowledge. He allows us to feel the thing that we most eagerly want to feel: unified and justified outrage.

Nothing seems to make us happier than when we are able to join hands to recoil together in outrage at some thing that is unambiguously detestable. We count with delight the racists who flock to Trump’s campaign speeches as fodder for our outrage, we quiver with an almost delicious anger as we note the redneck shit-kickers who show up hoping that some raghead will allow them to unleash their hatred of Muslims, we recoil when Trump measures his penis, we are enraged when Trump has the effrontery to contradict today what he said only yesterday, and then we damn the sheer stupidity of anyone who is unable to see the contradiction. We are certain that Trump’s supporters consist of the worst people in America, and there are enough of them to make him president.

But Trump’s supporters are not the worst people in America, and they will never make him president. Of course it is true that many of the worst people in America do support Trump. Why wouldn’t they? There is no doubt that if you think black people have slyly and unfairly, and no doubt at the connivance of the Jews, gained the upper hand in America and deserve to be knocked down a notch or two, or that the only important decision that must be made by the mob of which you are a part is whether to beat up the Mexican first or the Arab, or if you loathe foreigners but aren’t really sure where you stand on people from Oregon because you can’t remember whether or not Oregon is a foreign country, then of course you are going to attend a Trump rally – which gives you the comfort that a homogenous crowd grants itself – and roar with approval every time Trump says something outrageous.

But who cares about whether or not these people attend Trump rallies, except for those who are eager for the excitement and danger of showing up to protest? We must remember two things. First, these people, the dumb ones, are not the ones who are going to win Trump the presidency, or even the Republican nomination, because these people don’t vote. They aren’t smart enough to vote. They find voting to be too complicated and confusing.

Second, the dumb ones and the thrill seekers who attend the rallies only because they are cheap entertainment have locked Donald Trump into an unwinnable position. If he wants to keep them roaring their approval at ever-larger rallies, and his narcissism makes him want it desperately, Donald Trump must be outrageous every day. But our standards of the outrageous adapt so quickly that this only means that every day Trump must do or say something more outrageous than he did yesterday, or he risks losing his momentum. The whole penis incident only makes sense when you recognize the pressure under which Trump has placed himself to remain outrageous.

Strotspheric outrage

But if you have to be more outrageous every day than you were yesterday, and the election is months away, it is certain that at some point you will become stratospherically outrageous, and you will have gone way too far. This is when Trump’s real supporters will begin to get over their intoxication, as they eventually almost always do, and this is why it is probably only a matter of weeks before the whole Trump phenomenon begins to collapse. You cannot easily maintain a geometric progression when it comes to outrageousness.

Because while the dummies of America may indeed flock to Trump’s campaign speeches in order to enjoy the spectacle, it is unfair to dismiss Trump’s supporters as if they are all the same. Many people who support Donald Trump, and Dani is an obvious case, are good people, honest, hard-working, perhaps not especially well-educated, but they are often the backbones of their communities and their country.

And they are not as stupid as we want to believe. Does immigration hurt them? Yes it does, and while I believe that immigration has always been one of the greatest and most powerful sources of American success, and will continue to be for decades, if not centuries, I also fully understand that only someone who treats trade as a matter purely of ideology can deny that there are short-term costs. But Dani and millions of Americans do risk paying these costs, and it is unnecessary and even stupid to point out the irony of Dani’s own immigrant background as if this conclusively proved anything because it is wholly besides the point. When Dani worries about immigration it is because he is worried about his daughters’ education, and not because he has forgotten that his mother is Dominican. Trump’s supporters know that some of them may end up paying the short-term cost for what many of them even know is America’s long-term benefit, and they know that they do not have enough slack in their incomes and savings to afford it.

And what about their fury at what they believe to be unfair international trade? While there may well be global benefits to free trade, and almost certainly are, it isn’t so incredibly hard to recognize that the global trading environment is systematically gamed by many countries – and yes, sometimes by the US too – and that they do so because there are gains to be had at the expense of other countries. The global trade regime has undoubtedly benefitted certain constituencies in the US, but it has also created significant costs for the US and, more importantly, has resulted in a redistribution of income, and while the hard-working if uneducated millions who support Trump may not be able to explain the costs to them as glibly and as self-confidently as they are denied by bankers and other winners from free trade, they are right to complain. Trade is undoubtedly a complex issue, but there is a real case against the current system of free trade that must be addressed in a way that makes sense to Trump’s supporters.

And finally Trump’s supporters are enraged by the inexorable rise of income inequality. The only response they have been offered is that this rise in income inequality is natural, probably the result of technology, and cannot in any way be reversed, so we might as well get used to it. This response is so profoundly untrue that it can only be seriously proposed by someone for whom American history is a total mystery. We have had periods of rising income inequality before, and they have always been reversed once there was a political determination to do so. Dani, and the millions like him, have every right to be enraged by the past three decades of rising income inequality, and if they dismiss every anti-Trump witticism as completely irrelevant until it addresses income inequality, they are right to do so.

Trump’s followers may not articulate it very well, and they may too easily allow their anxiety about immigration and trade to spill over into nativism and hatred of foreigners, but they do have a strong case that makes them in fact part of a venerable history. Trump is almost certainly not going to resolve any of these issues for them – the historical precedents are pretty clear on that point – but it isn’t stupidity that drives them anyway to Trump. It is the recognition that because anyone that belongs within the political establishment has clearly proven himself unwilling or unable to resolve any of these issues, then gambling on someone “outrageous”, who they identify as outside the political establishment, is perfectly reasonable because it has no possible downside. Their logic is the logic of successful hedge funds: when there is no cost to being wrong, then you must gamble, no matter how small the chance of being right.

The Jacksonians ride again

The Jacksonian tendency in American politics has existed throughout American history. Their first flag bore the motto “Don’t tread on me”, and all of their subsequent flags have retained that message in one form or another ever since. Their often-admirable self-reliance, however, comes with other qualities.

They are often ferociously nativist, i.e. anti-immigrant, and while we think they are always foolishly unaware of the irony of their provenance, in fact they understand that irony to be irrelevant. They know that the filthy immigrants that thirty years ago threatened to corrupt the American ideal are today the nativists that are determined to protect American purity, but the fact remains that they often have too little slack in their daily lives, and those of their families, to afford any financial interruption. Perhaps that is why they seem so unimpressed with irony and it is probably only arrogance on our part that assures us that they are too stupid to see it. Dani and I have spoken about his family background many times, and he knows full well that his American genealogy is shallow, but he grew up in the streets of New York and he is convinced that he is as full-blooded an American as any one else, and of course he is.

Jacksonians can shift their views haphazardly. In modern times, for example, they usually support states’ rights, although during the 19th century, during Andrew Jackson’s campaign, they demanded a much stronger presidency. But there are also rock-hard consistencies. Jacksonians romanticize the common man, whether he happens to be at the time the frontier settler, the homesteading farmer, or an employee of the Ford Motor Company in the 1920s, in the same way that Dani spoke feelingly about the police and the firemen whose bodies he felt obliged to dig up after the tragedy of 9/11. They have always fulminated against anything resembling a hereditary aristocracy, and instead admired or even worshiped, sometimes with astonishing foolishness, the nouveau riche that displaced them because these men made their own way. Trump has convinced them, in spite of the truth, that he is one of these self-made men, and as long as they believe him they will forgive his clownishness and his self-importance.

This is because Trump has positioned himself well, if dishonestly, among people who have a long history of loathing monopolists and big city bankers. Jacksonians have always despised New York and Washington (and now Los Angeles too) as the homes and headquarters of all that is wrong with the Republic. They value fair play and a level playing field as the highest aims of government, and oppose on principle government actions that attempt to redress social wrongs by favoring any group – and while this hatred of government redress can very easily slide into racism, it is unfair to dismiss it as only racism, especially when many conservative and religious but often silenced African-American and Latino families scattered around in cities, small-towns and farms across the country share the same feeling. In fact if someone were ever able credibly to overcome their fear that nativism leads automatically to racism, many of these blacks and Latinos would quickly join the Jacksonians.

Jacksonians include the original tea-partiers and the Sons of Liberty, who despite their subsequent glorification included hooligans and sometimes-vicious mobs who were often revolutionaries less for love of liberty than for hatred of the rich. They included the Know-Nothings of the 1850s, nativists who rose up in anger to purify an America that was likely to be overrun by filthy Irish Catholics, along with the Locofocos of the 1830s, who rose up in anger to protect workers from the depredations of rich monopolists. William Jennings Bryan counted on them in his crusade against gold, and even more against the New York City bankers who backed the gold standard. His followers were known as the progressives, and their racism and nativism was largely romanticized out of history, but they were no less Jacksonian than those who say they support Trump today, something Harvard historian Niall Ferguson has already pointed out.

The Jacksonian fury with the changes brought about by rapid industrialization and the monstrous Second Bank of the United States, around which the new country suddenly saw individuals of once-unimaginable wealth emerge, put Andrew Jackson in the presidency, and it is unfortunate that the real concerns many Americans had in the 1830s have been subsumed by the racism of Andrew Jackson and his followers – both against black slaves and against native Americans – but we do no favor to our understanding of American history if we allow racism to be the whole story of Jackson’s presidency, any more than if we forget that people like Dani, who is not a racist, comprise a larger share of Trump’s supporters than the racist fools we love to mock.

Dirty rotten scoundrels

The strength of the Jacksonian tendency has waxed and waned depending on American conditions. It is during periods of especially heavy immigration, and during periods in which income inequality is especially deep, that they have come out in force, so much so sometimes that they rock the political establishment to its very bones, and usually none too soon. But with very few exceptions the Jacksonians have almost always chosen as their leaders the worst and most hypocritical of scoundrels, scoundrels who nearly always betray them once they’ve pocketed the millions they’ve obtained from thrashing the old elite.

When we tremble at the idea of Trump as president, we should remember their weak track record in putting presidents into office (even William Jennings Bryan for all his oratorical brilliance got trounced). Perhaps their only triumph was Andrew Jackson himself, but his success in no way suggests that Trump can do the same. Andrew Jackson, for all his barbaric treachery towards native Americans, was no hypocrite and no opportunist, and his accomplishments, especially as a soldier, put in him in a category that is wholly out of Trump’s reach, so much so that to compare the two is meaningless.

But while they have nearly always been unlucky or foolish in who they end up choosing as their leaders, the Jacksonians have still managed to disrupt the political establishment in ways that proved pretty permanent, and they are doing so again. As absurd as Trump may be, he channels their sans-culottes hatred of the elite in ways that might actually strengthen democratic institutions. Trump’s supporters might be why the US has never developed a European-style permanent aristocracy or its institutionalization of power. And perhaps it is not just coincidence that any period in which there has been a significant downward redistribution of wealth seems to have been preceded by a period in which the Jacksonians have done well. For better or for worse, Trump is not exceptional in American history and the good news is that even though he will never win the presidency, he has made it clear that future presidential candidates have no choice but to address income inequality and the anxieties of the Jacksonians if they want to keep the likes of Trump out of office.

Even if Trump does get the Republican nomination, the only effect might be to destroy Abraham Lincoln’s party forever, and the Democratic candidate, almost whoever it is, will win by an historic landslide. And for those who need the bogeyman of a possible Trump presidency in order to maintain that delicious feeling of justified outrage, so what if Trump becomes president? That is not the end of the world, or even close to it. The first thing every American president learns is how little he is able to do, and President Trump will be in office for four years, with a Congress in which both parties despise him, and he will accomplish nothing, after which he will exit office with among the lowest popularity ratings ever recorded.

And about that wall, how many times have we heard our liberal friends threaten that if Trump becomes president they will give up their US citizenship and move to Canada? What idiots. In the incredibly unlikely circumstance that Trump becomes president, the very first decision he will make, because he has no choice but to make it, and probably the last he will ever implement, is to build the wall between Mexico and the United States that he has promised. But anyone whose has followed Trump’s business career knows damn well what will happen. He will indeed build the wall, but inevitably he’ll build it on the wrong side of the country – perhaps out of incompetency or perhaps because there is a lot more money to be made with a longer wall. Those liberal idiots can talk all they want about going to Canada, but they won’t be able to get there. There’ll be Trump’s wall in the way.


P.S. I don’t really write about political events on my blog, but after a discussion about Trump with an English friend during one of my business trips, I wrote this on the flight home with some vague idea of perhaps submitting it to some publication. However I didn’t want to spend too much time on this as I am swamped with other commitments and so have decided to publish it here. By the way I wrote this just before the horrible events Tuesday in Belgium, which reminded me that while I dismiss the chances of Trump ever making president, or even of lasting much longer as a candidate, there is a fly in the ointment that will give him a few more weeks purchase. Terrorist organizations seem to know that we are in a period of elections in the US and Europe, and that to the extent that they can affect the election process in the West – and clearly they can – they must do what they can to ensure that the extreme parties of the right perform well. The two are in a self-reinforcing loop. The awful events in Brussels will not only strengthen Donald Trump, Marine Le Pen, Vladimir Putin and a host of others, but their increased strength will raise the number of domestic recruits for terrorist organizations. It is a maddening process.

Will China’s new “supply-side” reforms help China?

It wasn’t enough that we started 2016 with one of the worst weeks in the recent history of Chinese and global markets, but the panic continued into the following weeks and wreaked a great deal of damage to confidence. A lot of the reflexive China bulls are cautioning against misinterpreting the implications of the stock market collapse, and of course they are right, but the fact that the plunging Chinese markets can easily be misinterpreted should not in any way suggest that things are fine. Two weeks ago in the FT Alphaville blog (which is the best place to read regularly about China’s vulnerabilities, in my opinion, especially in their relentless focus on the changes in the various components of the balance of payments) Peter Doyle discussed one of the standard set of responses that we’ve seen repeated regularly since 2011 and 2012. The bull refrain has been, in his words: “things really aren’t that bad or surprising, and there’s considerable willpower and ammunition left in Beijing should it be necessary.”

“This makes good copy,” Doyle suggests, and adds, more diplomatically than I might have, “but is not persuasive”. It certainly isn’t, and he discusses some of the reasons why. On the same day George Magnus published an OpEd in the Financial Times that makes a point that too many people, as he points out, are still overlooking.

China’s chief vulnerability, and the main factor driving the tendency towards the increasingly fragile balance sheets that underlie the series of interrelated financial-market disruptions that began seriously in June 2013, is the inexorable rise in debt, and any analyst that fails to come to grips with the problem of excess credit is simply wasting his time. In the article Magnus writes:

Important economic reforms to the real economy and state monopolies have stalled, or succumbed to inertia and pushback. Policies designed to develop new sectors have not been matched by those needed to tackle problems in larger ones, such as poor productivity, chronic overcapacity and now a fourth consecutive year of producer price deflation. Tellingly, China’s most serious problem — the relentless accumulation of debt — received passive attention at most.

I will return to his point about stalled reforms, but Magnus is right about the debt. China’s most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt. In fact it doesn’t really matter if China is able to report growth rates for another year or two of 7%, or 6%, or even 8%. If the only way it can do so is by allowing debt to grow two or three times as fast, there will have been no improvement at all, the economy will not have adjusted, and China’s longer-term outlook will be worse than ever.

It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted. The astonishing ability of the China bulls, both foreign and Chinese, to celebrate every unexpected decline in growth and every new surge in debt as if they somehow justified nearly a decade’s worth of denials of the urgency of China’s rebalancing has done so much damage to China that the sooner Beijing’s leaders finally turn against the bulls, as I believe they might finally have done, the better for the Chinese people and the Chinese economy.

Beggaring thy neighbors

Before I explain why I think Beijing has decided that it has been misled in recent years, I should point out that what worried me most about the events of the past weeks was not the stock markets themselves, nor even the change in how investors and businesses inside and outside China perceive Beijing’s ability to manage the economy and the markets (I have already said many times that just as most people systematically over-rated the quality of Chinese policymaking in the past, they are likely now to be overly harsh in accusing Beijing of mismanagement). I am far more worried about how other countries might misinterpret the rapid decline in the RMB, accompanied by what seems like another surge in capital outflows.

Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth. Certainly if the PBoC ever were to stop intervening, and to let the RMB depreciate to some imagined fundamental “equilibrium”, we would quickly see that there is no such equilibrium level. In a speculative market, the market does not tend towards some stable value, with self-dissipating movement in any one direction reducing pressure for further movement in that direction. Price movements instead are self-reinforcing, and can quickly overshoot fundamentals.

Beijing is more likely to believe that the economic slowdown was caused by been weakness in domestic real estate and infrastructure construction, and not because exports are weak, and the latest trade data confirms the relatively strong export performance. Although manufacturing overcapacity is certainly a problem, much of it is in areas in which global demand has simply collapsed, and isn’t coming back, and so a cheaper currency would have little impact beyond temporarily reducing excess inventory, which is not enough of a benefit to justify the many costs of a weaker currency. Production facilities would still have to be closed down.

I think the real reason for the recent RMB weakness lies elsewhere. Beijing is trying to boost domestic liquidity in the hopes that this will generate stronger domestic demand, but expanding liquidity fuels capital outflows, and these put downward pressure on the currency, while increasing PBoC concerns about the monetary impact of money leaving the economy which, as an article in last week’s FT argues, might be worse than we think. Last week’s People’s Daily reports that prominent Tsinghua professor and former member of China’s Monetary Policy Committee, Li Daokui, claimed at Davos “that at least $3 trillion foreign exchange reserves in China is required to prevent foreign debt default risk”, for reasons that elude me, but if this reflects official views, after dropping $513 billion in 2015, current PBoC reserves of $3.33 trillion might suggest that two or three more months of continued strong outflows might prompt further steps by the PBoC to limit outflows.

The biggest risk created by the weaker RMB, as I see it however, is not a Chinese risk but rather a global one. The rest of the world may view recent Chinese RMB weakness as a signal for a new round of competitive devaluations. I have already said that I expect 2016 to be another bad year for trade, and I am worried that it seems as if every major economy in the world has implicitly decided to use US demand to bail out its own faltering economy. This will very likely derail the US recovery in 2016 or 2017 unless the US, too, decides to step in and intervene in trade. If that happened, of course, the impact on Europe and China would be terrible, but it seems to me a matter purely of logic that if the hard commodity and energy exporters are nearing the limits of their absorption capacity, either the major surplus nations or the US are going to have to absorb a bigger share of the demand deficiency created in Europe, China, and Japan.

The nine-point summary

But all this is preamble. Rather than add to the mass of coverage that the recent market events in China have generated, or to continue expressing my concern about the intractable arithmetic of global demand imbalances, I plan to discuss the process of Chinese reform and adjustment in this issue of my blog. While these may at first seem unrelated, in fact financial market disruptions are tightly tied into the self-reinforcing processes of rising debt, capital flight and slowing growth that recent reforms were supposed to untangle and address – and for which they have clearly failed.

I will argue that most economists have an incoherent understanding of China’s rebalancing needs, and for this reason many if not most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant. This is going to be a long post, so for those who want the 9-point summary:

  1. China’s economic growth is not decelerating as a natural consequence of the aging of China’s growth model. It is decelerating for three reasons. The first reason is the reversal of the growth process by which China’s imbalances have reached their systemic limits.[1]
  1. The second reason is that during the phase of rapid growth, China’s balance sheets, as occurred in every similar case, evolved to become highly inverted, and just as this automatically caused growth to be higher than expected during the expansion phase, it must cause lower-than-expected growth during the contraction phase.
  1. Finally, the economy must shift, one way or another, from one of rising leverage to one of declining leverage, and with rising debt the only thing propping up growth levels, deleveraging cannot help but cause growth to drop.
  1. This means that regardless of trends in underlying productivity, growth must slow sharply, and it will, either smoothly and continuously, or in the form of higher growth early in the adjustment period and a collapse in growth later.
  1. The growth deceleration can be temporarily countered by rapid increases in debt, but ultimately this will only increase future deceleration, with a rising chance that the shift will be disruptive. Every growth miracle in history has been followed by an unexpectedly difficult adjustment, and it is unreasonable to have expected that China would be any different.
  1. The only way to minimize the costs of the adjustment is to take steps to speed up the rebalancing of demand and the repayment of debt. This must be the direction of reforms if Beijing is going to reduce the costs of adjustment and the risk of a disruption.
  1. Repaying debt simply means allocating debt-servicing costs, either directly or indirectly, to specific sectors within the economy. This will either occur in ways targeted by policymakers, or if postponed for too long, it will occur in unpredictable ways determined by circumstances. For example default allocates the costs to creditors, inflation allocates the costs to household savers, economic collapse and high unemployment allocates the costs to workers, etc.
  1. By far the most efficient ways for Beijing to minimize the adjustment costs for the economy and reduce the risk of a debt-related disruption is to allocate debt-servicing costs to local governments by forcing them to liquidate assets directly or indirectly to pay down debt, and to increase household wealth by transferring wealth directly or indirectly from local governments to the household sector. Successful reforms must be consistent with these two goals.
  1. Beijing has already tried to address its growth problems by implementing the productivity-enhancing reforms beloved of orthodox economists, but while these might be a good idea in normal times, they will have almost no effect on reducing the cost of China’s economic adjustment.

Evaluating Beijing’s policies

It might seem exceptionally contrarian to say that most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant, but I think that senior policymakers in Beijing are beginning to agree. I say this because with the end of the Central Economic Work Conference last December, Beijing has announced with some fanfare that it plans to design and implement a new reform program consisting of what are being called “supply-side” policies.

A new reform program would seem only to be necessary if the old one has failed or is failing. It does seem to have failed. Chinese businesses and investors are very obviously increasingly concerned about both Chinese and global prospects, and so it is fitting that stock markets have been so accident prone this year. Like everyone else I have often cautioned against reading too much about China’s economic fundamentals into stock market performance. To the extent that there is informational content in the price behavior of stocks, however, we are more likely to see it expressed in the volatility of the markets than in its actual price level.

While opinion is still very split about the outlook for the Chinese economy, there is clearly a growing sense of unease about progress to date on the successful management of China’s economic adjustment, and this unease is at least part of the reason for market volatility. That is why the important news for me has been the announcement of the new reforms and the form of the announcement. Analysts are still very uncertain about what this new package of supply-side reforms that we’ve been hearing about since at least November may entail, but they way in which the reform package was announced suggests, at least too me, that the leadership is no longer satisfied that the policies Beijing has been pursuing during the past three years are having the intended effect.

I will discuss why later, and in spite of the limited information available, I also plan in this blog entry to try to place the package of reforms in some sort of useful context and to evaluate whether or not in principle these reforms are likely to be consistent with the rebalancing process. This might not be as difficult a task as it may at first seem, because rather than try to guess what Beijing will or won’t do, I will instead try to specify the conditions, albeit very abstractly, under which various policies will, individually or in the aggregate, be consistent with the rebalancing process.

It helps of course that China’s development model is not unique, and that its experiences are “different” only in the sense that with its powerful and rigid institutions (most importantly the extensive government involvement in the economy and its control of the banks) it has pushed the typical imbalances associated with its growth model often to levels that are unprecedented. There have otherwise been dozens of other countries that have experienced investment-led “miracle” growth in the past century, and their histories have been remarkably consistent.

Based on these histories we should be able to make fairly reasonable predictions about some of the problems that China faces today. Indeed we should have been able to do so a decade ago, but because very few economists seem to be familiar with the history, no matter how predictable they were each new reversal or systemic shift always seemed to come as a surprise. This is an important point to stress, especially if we want to understand what kinds of policies are likely to prove useful over the next several years. China’s extremely successful growth model was always likely to generate sustainable and rapid if unbalanced growth under certain easily-specified conditions.[2] It was also always likely to cause the financial sector and the various government and business balance sheets to evolve in a specific direction and imbed certain risks.

This is why nearly a decade ago – even if none of the economists or analysts writing about the Chinese economy understood why, with the exception of a handful, mostly Chinese academics – it was clear that the Chinese growth model would have to be reformed, and that these reforms were generally fairly easy to specify. Imbalances can persist for many years if the institutional constraints preventing adjustment are very strong, but all unbalanced systems tend towards rebalancing, and eventually the institutional sources of the imbalances are reversed, and they do.

Must everything cause a crisis?

Not everyone sees things this way. In the standard economic framework the economy is always at or close to equilibrium, and when exogenous shocks or policy distortions push it away from equilibrium it is only temporary.[3] For that reason most economists seem to assume that the longer what looks like an imbalance persists, the less likely it is really to be an imbalance that must ultimately reverse itself, when in fact the opposite is true. Imbalances can persist and get deeper year after year, but that only means that the reversal is more certain and likely to be more disruptive.

For the same reason most economists also seem to assume that if anyone thought that the Chinese economy was deeply imbalanced, and that debt was growing at an unsustainable pace, he was necessarily predicting an imminent crisis. This belief is so powerfully embedded in the standard equilibrium models most economists use that, strangely enough, even those of us who described the imbalances in one paragraph and in the very next paragraph insisted that a crisis was unlikely – in China’s case because of the government’s very high credibility and its role as financial guarantor – were automatically assumed to be predicting an imminent crisis.

Earlier this year, for example, a strategist at a Chicago-based fund by the name of Brian Singer said:

“Everyone is aware of China’s horrid debt levels and [Chinese financial markets analyst] Michael Pettis has done some great work, but he is China’s ‘Chicken Little’,” Singer said, referring to his panic-style predictions. “He discovered through his research that China has built up a lot of debt and he is right. China’s debt to gross domestic product (GDP), however, is pretty close to the United States’ and Germany’s.

“If we’re all so terribly concerned about China’s debt to GDP levels, why aren’t we equally as concerned about the US?…Even if [China’s] growth is slowed from double digits down to 4 or 5 per cent, they would still be absorbing that debt a lot faster the US could.”

I have already explained many times why comparing US and Chinese debt is nonsensical, and should be very obviously so, but to the extent that Singer, who seems an intelligent person, finds it impossible to accept that countries whose already-high debt levels are rising unsustainably (which simply means that debt is rising faster than debt-servicing capacity) do not necessarily default or collapse soon afterwards, it can only be because the economic model he implicitly uses is incoherent and that he is unfamiliar with financial history. Not only can an unsustainable rise in debt persist for many years, in some cases even decades, as Japan may one day prove, but in fact most unsustainable debt burdens are not resolved by crisis or collapse.

They are always resolved by mechanisms in which debt-servicing costs are explicitly or implicitly allocated to some sector of the economy, usually unwillingly, and while default or some form of financial crisis is one of the usually-explicit ways (the losses are assigned to creditors, obviously enough), it can often take many years before it happens, and it does not even happen in the majority of cases, as I will explain later in this entry when I discuss some of the ways in these debt costs have been allocated.

So while I have never predicted a crisis, panic-style or otherwise, I certainly have pointed out very early on that Chinese growth had become dependent on an unsustainable relationship with debt. While it was always possible that after many more years this could lead to a crisis, I always noted that a crisis was unlikely and most certainly not imminent. So why would Singer (and, to be fair, most other economists who use conventional equilibrium models) have found it impossible to see the sentences in which I said crisis was unlikely, once they read sentences in which I said imbalances were deep? It is because the two statements are incompatible in their models, which exclude ordinary balance sheet dynamics. The systemic creation and reversal of imbalances are not formally captured in these models.

My point is not simply to correct any misperceptions about what I did or didn’t say – in fact I have to confess that it hasn’t been all bad: in the past year because of similar mistaken models I have received a huge amount of credit from very generous people for correctly predicting market crises that in fact I did not predict. My point is rather about the incoherence of conventional thinking about unbalanced economies. The wide-spread inability intuitively to understand disequilibrium explains at least in part the misplaced confidence so many people have in the role Chinese reforms of the past few years would have in resolving China’s economic vulnerabilities (and those of peripheral Europe, for many of the same reasons) because it made improving productivity, rather than the rebalancing process itself, the main objective of the reforms. Refocusing on the rebalancing process will allow us to see not just why many of the old reforms simply didn’t matter, but also which of the new supply-side reforms might in principle work and which cannot.

Debt isn’t irrelevant

China’s unsustainable rise in debt is part of a self-reinforcing dynamic involving the consumption imbalance, and the important point is that because imbalances necessarily must reverse themselves eventually, any useful reform must be consistent with China’s economic rebalancing. In fact it should have been obvious years ago that Chinese policymakers only ever had two choices. They could proactively implement the reforms aimed at reversing the imbalances, however costly these reforms might be (and the longer they were postponed, the more costly they would become), or they could try to postpone the necessary reforms indefinitely – as many if not most countries in similar circumstances had done unsuccessfully in their attempts to sidestep the costs of rebalancing.

In the latter case, however, they would have almost certainly discovered, as their predecessors always discovered, that as the debt burden increased, the increasing impact of the distortions caused by the imbalances – and it is important to remember that the two are self-reinforcing – would eventually break through the institutional constraints that had prevented adjustment earlier. Rising balance sheet fragility makes an economy more sensitive to imbalances and to disruptive shocks, by which I mean that and balance sheets become increasingly fragile, their disruptive unraveling can be caused by progressively weaker random shocks – i.e. “triggers” – so that in very extreme cases it takes deceptively minor shocks to trigger major disruptions.[4] The risk in that case is that the imbalances would reverse themselves disruptively and force an unwanted resolution of the excessively high debt burden – of which the most obvious, but not only or even most likely, way would be in the form of a financial crisis of some sort.

I will give concrete examples later of how this has happened in previous cases, but put in starker terms, when for structural reasons economic growth in any country depends on an unsustainable increase in the debt burden, then simply as a matter of logic policymakers have two choices. They must either move aggressively to bring debt under control before the economy reaches its debt capacity limits, in which case they will cause growth to slow sharply over a difficult adjustment period during which balance sheets are rearranged. Or if they wait too long – usually because they mistakenly believe there is a set of efficiency-improving reforms that can cause productivity to rise faster than debt – at some point, as the debt burden continues to rise, either creditors will refuse to lend, in what economists call a “sudden stop”, or debt capacity limits will otherwise be reached, after which, in either case, growth will collapse. China must prevent its debt burden from reaching these levels.

Although it would have been much better for China if policymakers had recognized the urgent need to rebalance and implemented the necessary changes a decade earlier during the administration of Hu Jintao, it seems that Xi Jinping’s administration acknowledges the risk of continued credit expansion and wants to implement the necessary reforms before the economy is forced into a disruptive rebalancing. This, in effect, was what had been recognized during the October, 2013, Third Plenum. What is less clear to me, however, is how much time policymakers believe they have in which to force through the necessary reforms, and whether their assessment is realistic.

Right and wrong reforms

However much time they have – and in my opinion they are unlikely to have much more than 2-3 years in which to get credit growth under control, but there is no science to this so I cannot know for sure – as Beijing moves forward in its struggle to rebalance the Chinese economy, we should keep three things in mind:

  1. The rebalancing process is in fact fairly straightforward and easy to understand or describe, albeit only conceptually and at a very abstract level. Both the logic of China’s existing growth model and the almost uniform experiences of the many historical precedents reveal clearly the vulnerabilities China faces, what it must do to address them, and why the necessary reforms will be difficult.
  1. But while we should know what must happen, the specifics of the rebalancing process can be extremely complex, and depend very much on institutional conditions, at both the national level and the local level, and which include very powerful vested interests created by the development model. This is why even if it is clear in principle what must be done, choosing and implementing the actual reforms will be neither easy nor straightforward, and will involve significant experimentation and political maneuvering. However if we understand the rebalancing process in principle, we can at the very least distinguish between reform policies that are consistent with the necessary rebalancing process and policies that are not.
  1. But there is a conceptual problem. The historical precedents suggest – with ample support from Chinese experience of the past 3-4 years – that like very small whales with very large blowholes the economists advising policymakers, with the agreement of outside analysts, will offer a profusion of reform proposals which confuse two very different sets of reform programs, largely because of the mistaken model used by most economists and to which I referred earlier on the section on Singer. One set consists of what I call “asset-side” policies that are designed to improve China’s economic efficiency, and these are the only reforms that are meaningful according to most consensus economic models. The other set consists of what I might call “liability-side” policies – although these involve more than the liability side – that address the rebalancing process directly, and while finance specialists, or economists who have been influenced by the balance sheet approach of people like Hyman Minsky, easily recognize these kinds of reforms, in general they are not well understood. I have discussed before, including most recently in the September 1 entry of this blog, the difference between the two kinds of policies.

This third point is important and probably explains a feature of history about which economists seem unfamiliar. There have been dozens of cases in the past couple of centuries in which sovereign debt levels were seen as being excessive. In some of these cases the debt was subsequently repudiated, but in most cases policymakers at first sought to reassure their creditors that the country was facing a short-term liquidity shortage, and promised to design and implement a package of policies that would improve the country’s economic efficiency, increase growth, and restore confidence. In some cases these promises were perhaps never credible, but in many cases they were, and the markets were prepared to give policymakers enough time for the measures to work and for the country to begin growing its way out of its debt burden.

Efficiency versus rebalancing

But of these dozens of cases, few, if any, sovereign borrowers were in fact able actually to grow their ways out of their debt burdens until, either explicitly or implicitly, the debt was substantially written down and assigned to an unwilling sector.[5] Until policymakers take on the debt burden directly, the historical precedents seem to tell us very firmly, sovereign borrowers have never been able to implement reforms that improve efficiency enough to allow them to grow out of their debt burdens.

I have explained elsewhere some of the reasons that determine whether a country’s debt is “excessively high”, and I hope formally to list these reasons more fully in my next book, but the key is the gap that is created between projected debt-servicing costs and the projected revenues earmarked to service the debt when an economic entity suffers an unexpected surge in debt or an unexpected decline in growth. When this happens and as debt levels rise relative to debt servicing capacity, at some point the major stakeholders — including businesses, creditors, household savers, workers and so on — became uncertain enough about how this gap will be allocated that they take steps to protect themselves from this uncertainty.

As this happens investors, recognizing that stakeholder actions are likely to undermine the economy further and worsen balance sheet fragility, express their worry about the risk of default in the form of high required yields. They also make it difficult for the sovereign borrower to issue new forms of debt. Finance specialists will recognize this condition as very similar to, but more general than, the trigger that sets of financial distress costs.

For most economists this seems implicitly to be a surprising statement: excessive debt is a balance sheet problem, and not an efficiency or productivity problem (although of course inefficient or unproductive economic activity is usually, along with badly-designed balance sheets, the main cause of excessive debt). That is why, because policymakers will rely on advice from economic advisors who are unlikely to understand balance sheet dynamics and who are almost completely unfamiliar with historical precedents, it was almost inevitable that at first Beijing would prioritize the wrong set of reforms aimed at raising the equilibrium growth rate of the economy, even sometimes at the expense of further balance sheet deterioration.

And they have. This process is the typical end of the expansion phase of every investment-driven growth “miracle” in history. In each case after many years of investment misallocation, both unexpectedly high debt and unexpectedly low growth create the gap between debt servicing costs and expected revenues, with each driven by and exacerbating the other (as has clearly been the case in China today).

As the gap widens, it creates rising uncertainty about how excess debt servicing costs will ultimately be allocated, and at the point at which this uncertainty is high enough to alter materially the behavior of economic agents, and so lower the net asset value of the economic entity, the borrowing country has “excessive” debt. Once it does, the process of deleveraging, like rebalancing, is inevitable, and it too can occur in many different ways, all of which involve forms of “debt forgiveness”, usually involuntary.

Some forms of debt forgiveness are explicit. The devastating LDC debt crisis of the 1980s, which began in August 1982 when the Mexican government announced that it was unable to service its obligations to foreign banks, ended only in 1990, when these loans were exchanged for a nominal amount of Brady bonds equal to only 65% of the original notional amount of outstanding loans. In the subsequent years, one after another of the indebted LDCs obtained notional debt forgiveness of 30-50% in the subsequent Brady-bond restructurings.

Partial debt forgiveness has been a formal part of nearly every sovereign default or debt restructuring in modern history, although usually not until there has been a long and painful period of angry posturing and one or more partial restructurings. During this time we often also see informal kinds of partial debt forgiveness, for example when sovereign borrowers have repurchased their obligations in the secondary market at steep discounts, often secretly, or exchanged their obligations for other assets at a discount, for example the famous debt/equity swaps in several Latin American countries in the 1980s (see footnote 3).

The ways of debt forgiveness

Most forms of “debt forgiveness”, however, are implicit, and nearly always involuntary. German’s excessive debt burden after the Great War, for example, was “forgiven”, unwillingly, mainly by middle- and upper-middle-class households and civil servants, whose fixed income portfolios withered to nothing in the hyperinflation that began in mid 1921 and ended in early 1924. China’s huge portfolio of NPLs at the end of the 1990s (perhaps as much as 40% of total loans) was resolved by a decade of severe financial repression, so that lending rates of around 7% – in an economy in which GDP grew nominally by 18-20% and the GDP deflator usually exceed 8% – implied substantial debt forgiveness.[6]

Because these loans were funded by even cheaper deposits, debt was forgiven at the expense again of household depositors in the banking system, and of course it is no coincidence that during this period the household income and household consumption shares of GDP, which began the decade at already very low levels, plunged to levels that are historically unprecedented. There are many other ways of allocating a significant portion of the debt-servicing cost to unwilling agents in the economic equivalent of debt forgiveness: to creditors when debt is repudiated, to workers when wages are suppressed in order to increase net revenues for debt servicing, to small business owners when assets are expropriated to pay down debt, and so on.

In the current global environment this problem, by the way, is not one just limited to China. For example the same thing is happening in many European countries which – for all the urgency some, like Spain under President Rajoy, have implemented efficiency-enhancing reforms – have been unable to grow their economies faster than the growth in their outstanding debt. I would argue that so far the policy advice Beijing has been receiving has also mistakenly assumed that China’s slowdown was caused mainly by various regulatory and institutional inefficiencies and rigidities, and that as these are removed by regulatory reforms, or countered by the appropriate fiscal and monetary policy, the Chinese economy will naturally move towards a stable equilibrium with much higher productivity levels. This they think will ensure sufficiently rapid growth and will give Beijing additional time in which to resolve its debt problems.

But this is not how the adjustments have ever worked and until now it does not seem to be working in China. A rapid slowdown in growth is imbedded in the adjustment process, and will inevitably occur with or without the proper reforms. For now the only way to keep growth from dropping sharply is to allow debt to rise as rapidly as is needed to meet growth targets, currently at least two to three times as fast as the growth in China’s debt-servicing capacity, but as debt rises growth will continue to decelerate more quickly than predicted.

How never to be wrong

In fact growth in China has already slowed sharply, and by far more than was permitted in most of the standard models, but bizarrely enough the rapid deceleration in growth has not caused economists to reject their models. Instead, with great nimbleness and intellectual flexibility, and often without ever missing a beat, they have simply applied the same framework to explaining lower growth. Like Kevin Keegan famously, they always know what’s around the corner but they never know where the corner is.

A typical case might be Stephen Grenville, a former Australian central banker, whose growth forecasts are regularly and quickly undermined by reported growth data with no appreciable effect on his analysis. It may be unfair to single him out, but I have become familiar with his work mainly because several of my investment and academic friends in Australia seem to delight in sending me his articles and making witty comments about how economists can take data that confounds their forecasts and use it to confirm their analysis. He has long been an optimist on Chinese growth and a little over two years ago he assured Australian investors that Chinese government debt was quite low, and that keeping it low was easily achievable. Now he accepts that it is high and poses risks, but it was apparently never likely to be otherwise.

He even cheekily wondered at the time about economists predicting a slowdown “How wrong do you have to be before you lose your expert status?”, he asked. The question is going to prove purely hypothetical, the investor from Sydney who sent me the article assured me, given that there is no amount of slowdown and no strain in credit that will do the trick for Grenville, but he was nonetheless fairly annoyed that a former Australian government official who claimed to understand what was happening in China would have done the unforgiveable and never warned that iron prices were about to drop from over $190 to test $50, even though that turned out to be a fairly easy prediction.

Perhaps he forgot. As an aside, one of my PhD students, Hao Yang, helpfully explained to me early last year that if I ever needed to write these kinds of academic papers he could do it for me because that is precisely what PhD programs train students to do. I suspected he was being a little cynical, but certainly it has been widely noted within the investment industry that while there have been profound disagreements during the past decade about the Chinese economy, and its performance seems to have thoroughly confounded the expectations and forecasts of majority opinion, so far it is hard to find economists who haven’t been proven right, and not just among Australians. Something so extraordinary almost certainly could not happen without a great deal of highly specialized training, so perhaps Hao Yang was not being cynical at all.

The most common argument used by analysts like Grenville to justify the recurrence of “unexpectedly” low growth while maintaining the validity of the conventional equilibrium models is usually that slower growth is a natural consequence of China’s rising capital intensity. As the level of investment increases, and so becomes less scarce, the return on capital naturally must drop, and it is this drop in the marginal return on capital that explains the deceleration in growth.

This explanation however verges on the nonsensical, and it is useful to consider why:

  1. While it is true that the return on capital should decline as capital intensity rises, and that the capital intensive component of growth in China should be declining precisely because Chinese investment has surged, in fact surging investment is a three-decade-old story, whereas growth only began to decelerate rapidly over the past 3-4 years, just as China began to rebalance. This cannot just be coincidence.
  1. The deceleration in Chinese growth moreover has been far too rapid to be explained by any normal decline in marginal returns on capital as investment rises, even if capital intensity were uniform throughout China, and in fact it isn’t. Capital intensity varies tremendously from province to province, so while investment saturation might conceivably explain growth deceleration in the most advanced provinces in China, it cannot do so to anywhere near the same extent in most provinces because of the tremendous variation in capital intensity across China’s 31 provinces and provincial-level entities. In fact a mathematician looking at a map of China listing provincial per capita investment rates would immediately see that such rapid deceleration, compressed over so short a time period, would require extraordinary mathematical convolutions to support an argument based on investment saturation.
  1. Most damning of all, if growth deceleration were caused only, or mainly, by declining returns on capital as capital intensity rises, the most rapid deceleration would occur in the most advanced provinces, whereas there should be no slowdown in the least advanced. In fact across provinces the opposite is true.

Andrew Batson recently posted an interesting and related entry on his blog that is worth reading in full. Aside from investment saturation and unexplained invoking of the “middle-income trap”, I am not aware of any other plausible explanation for the sharp decline in reported GDP growth (and I ignore the very active debate about whether the real decline in economic growth is fully described by the reported decline in the GDP data) that might serve as an alternative to the model which posits sharp slowdown as the inevitable consequence of the rebalancing process.

The two important points if I am right, then, are, first, that during the adjustment a sharp slowdown in growth is inevitable, and is embedded within the rebalancing process, and second, that until the debt is specifically addressed, efficiency-improving reforms will never be enough to resolve the rebalancing process. Growth in other words will continue to decline substantially no matter what Beijing does.

By how much? I have argued since 2009 that the upper limit of average growth during the rebalancing period, which was always likely to be with the advent of the new leader, during the 2013-23 period, is likely to be 3-4% and that the longer Beijing succeeds in postponing the decline the greater the risk of disruptive “catching up” of the necessary deceleration in growth. It is not clear how quickly China has been growing in recent years because of the huge discrepancies between the reported growth data, which even Premier Li has questioned as being “for reference only”, and nearly every attempt by investment banks and independent economists to calculate growth independently. While it is hard to know what numbers to trust, most independent estimates already range from 1% to under 5%, but any higher growth rate over a longer rebalancing period is extremely unlikely and can only happen if implicit transfers from the state sector to the household sector very implausibly average more than 2-3% of GDP annually.

Do we care about the amount of economic activity?

Unfortunately the locus of the debate among those who recognize that the growth slowdown is not incidental and part of a “normal” deceleration of growth has shifted primarily to the accuracy of the published data. The Economist has typically been among those publications least convinced that China was facing a very difficult adjustment – in fact the FT’s Alphaville and the Economist have tended to bracket either side of the debate during the past few years – but in an article last week they worriedly note just how uncertain things have become:

Increases in indebtedness of that magnitude have been a forerunner of financial woes in other countries. Cracks are beginning to appear in China: capital outflows have surged, bankruptcies are occurring more frequently and bad loans in the banking sector are rising. It is all but certain that more pain lies ahead, though quite how much and how it will play out are matters for debate. 

I think the cracks may have appeared a while ago, but in the same article they make reference to the debate about how accurate are the GDP growth data:

Judging by the eerie stability of key indicators recently, China’s statisticians appear to have been doing just that. In year-on-year terms, growth over the past six quarters has been 7.2%, 7.2%, 7%, 7%, 6.9% and 6.8%. Such a tight clustering is improbable. 

I am not sure this is always as fruitful a debate as many seem to think it is. Of course it matters to anyone who wants to understand the economic cost of the adjustment, but arguments about whether the reported data are overstated, and by how much, have become part of the bull vs bear debate about whether Chinese growth is merely slowing temporarily, and not as part of a major economic reversal of the growth model. If you agree you are meant to accept the accuracy of the reported data. Otherwise you would question the data and assert that real GDP growth is substantially lower.

I don’t think this part of the discussion is especially useful. I have long argued that as long as China – or indeed any other country – has the debt capacity, it can get pretty much generate any amount of economic activity it wants. What is important is not how much growth there has been in economic activity, which is what the GDP numbers measure, but rather how much growth there has been in economic wealth, or in debt-servicing capacity, which is much the same thing, and how that compares with the growth in debt. In fact there probably hasn’t been much growth in the former, whatever the reported GDP data tell us, and there has been a lot in the latter.

Only two things matter

So what kinds of reforms are consistent with China’s rebalancing? Improvements in efficiency matter in the long term because as long as the economy does not suffer a major disruption they will tend to close the gap between the growth in economic activity and the growth in debt-servicing capacity, but they will have little effect on rebalancing. If the new set of reforms are to be truly effective, in other words, they must be designed directly to eliminate the balance sheet constraints on the economy. They must, in other words, accomplish the following:

  1. One of the two goals must be to rebalance demand. The distribution of resources must be rebalanced in a way that it can generate debt-free demand for the economy. In principle one way to do so is to reform the financial sector so that it is able to identify productive investment opportunities and channel credit in that direction. This has been one of the most regularly proposed “solutions” available to Beijing.

In practice this almost certainly cannot happen. As I have discussed elsewhere, if we understand the political and institutional constraints that drive the evolution of a country’s banking system we would see why the necessary reforms are likely to be impossible to implement, and for those who are interested, my former Columbia University colleague, Charles Calomiris has written excellently on the subject. “A country does not choose its banking system,” he and his co-author Stephen Haber point out, “rather it gets a banking system consistent with the institutions that govern its distribution of political power.”

The historical lesson here is fairly unambiguous, although as always it is disappointing that economists who do propose such a solution for China evince so little curiosity about the historical precedents. It should be no surprise that many countries in the late stages of their own investment-growth “miracles” have tried this kind of transformation, but none has ever managed so radical a change within its financial sector quickly enough, at least in part because the capital allocation decision is at the heart of distributional politics. Because China begins the process with the highest investment level in history, the extent of the transformation must exceed that of any other case, and it must occur at a time when weak Chinese demand is compounded by weak global demand, thereby reducing productive investment opportunities for the private sector.

Another source of additional debt-free demand is, in principle, the external sector. China, however, is already challenging Europe as running the highest current account surplus in history, and in a world in which demand is likely to remain weak for many years, the external sector is unlikely to provide sufficient additional demand. Of course China can generate more demand by exporting more capital to the developing world, as it proposes to do with OBOR and the New Silk Road projects. It can also exploit its technology lead in high-speed rail, as a recent People’s Daily article on potential contracts for the high-speed Moscow-Kazan, Las Vegas-Los Angeles, Malaysia-Singapore, and Tanzania-Zambia lines. The total amount of development finance or rail exports it can provide, however, is tiny compared to domestic demand requirements, and if the recipients find themselves unable to repay the debt, as history suggests could easily be the case, this becomes a worse alternative to misallocating investment at home.[7]

The only certain and politically feasible source of debt-free demand is domestic household consumption, but Chinese households suffer from the same problem Marriner Eccles identified in the US in the 1930s: those who want to spend do not have the resources, and those who have the resources do not want to spend – or in this case are not able to spend productively. The solution is as obvious as it is politically challenging: China must redistribute resources from the latter, i.e. the state sector, to the former, i.e. Chinese households.

  1. The other of the two goals must be to repair the balance sheet. Growth will not revive until the debt burden is sharply reduced. Debt can be reduced by partial debt forgiveness as part of a restructuring process following a default. It can be reduced as part of a pre-emptive restructuring. It can be reduced in the form of implicit debt forgiveness through monetization or financial repression. Or it can be paid down with funds generated from implicit or explicit taxes or from asset sales, including privatization. There are no other realistic ways to reduce debt.

Because most of China’s debt is internal debt, and directly or indirectly owed to the banks, debt restructuring with partial forgiveness is not an option at the macroeconomic level because ultimately it is a contingent liability of the government either way. But Beijing must resolve its debt burden at the national level or it risks repeating the mistakes of Japan –and Japan’s experience merely confirms what we already know: growth will not revive until the debt burden is sharply reduced.

China is also constrained from reducing the debt burden though monetization, financial repression, or taxes on households because in each case the cost is indirectly allocated to the household sector, which simply exacerbates the original imbalance. This leaves only two alternatives. First, Beijing can expropriate the wealth of small and medium enterprises directly or indirectly (in the latter case by raising taxes), although this means undermining the most productive part of the Chinese economy. Second, Beijing can liquidate government assets and use the proceeds to pay down debt. There are no other plausible options.

Multiple paths to the same outcome

One way or another China will adjust, and both of these objectives will be met. This will happen if for no other reason than because if something cannot go on forever, as Nixon’s CEA chairman Herbert Stein helpfully reminded us, it will stop.

The logic of rebalancing is overwhelmingly corroborated, if it needed to be, by historical precedents. Every relevant country that has experienced Chinese-style growth has suffered in a similar way, and in every country the resolution has turned out to be the same, whether the resolution occurred automatically as a consequence of a financial crisis or occurred because of specific policies. But just because we can predict with total confidence that China will eventually rebalance and deleverage, it doesn’t mean that we can just as easily predict how this will occur.

There are several paths a country can follow once systemic distortions and imbalances have become deep enough. The path that China actually takes depends, of course, on the policies implemented by the government, the behavior and confidence of Chinese households, investors and businesses, and external conditions. For this reason the whole point of the reform process should be, first, to identify the distortions and imbalances that have become, or threaten to become, wealth destroying; second, to list the various plausible paths by which these distortions and imbalances will be reversed; third, to select the optimal path consistent with the country’s political, social and economic institutions; and finally, to design and implement the policies that move the economy along the least painful of the many paths.

I list what I think are only six plausible paths China can follow in Chapter 5 of my 2013 book, Avoiding the Fall, along with the associated conditions for each of these paths. Each of the various paths will take the economic system back into some kind of balance from which policymakers can expect further sustainable growth, but these various paths have very different impacts on wealth and stability.

Take rebalancing. I have already listed above some of the many ways deleveraging can take place, from default to buy backs to financial repression to the sale of assets to pay down debt, and likewise there are several ways the rebalancing of demand can take place.

Both the US in the late 1920s and Japan in the late 1980s had deeply unbalanced economies and excessively high savings rates, the consequence of which were huge current account surpluses, along with what may have been the highest and the third highest hoard of foreign currency reserves, respectively, in history (China today probably ranks second), and highly inflated domestic asset markets. The causes of their imbalances were, at least in part, high levels of income inequality and relatively low household income shares of GDP.

Both countries rebalanced in the subsequent decade, as they inevitably had to, and in both cases the savings share of GDP declined (or the consumption share increased, which is the same thing), but it declined for very different reasons. In the US, the rebalancing occurred mainly in the form of a collapse in GDP relative to household income, with the former dropping by around 35% between 1930 and 1933 and the latter dropping by “only” half that rate. This was accompanied by substantial income redistribution, much of it occurring partly because of redistributive policies under Roosevelt and mostly because of a wave of sovereign and domestic bond defaults whose losses were borne mainly by the high-saving wealthy. Japan’s rebalancing, on the other hand, occurred in the form of two decades in which GDP growth barely exceeded 0%, while the growth in household income and consumption averaged more than 1%.

The state must pay

It is worth noting, as we think about China’s options, that historically a sharp, economically disruptive rebalancing with negative consumption growth and even more negative GDP growth, as experienced by the US, and a long period of stagnation with low consumption growth and even lower GDP growth, as happened in Japan, represent the two main ways that significant savings imbalances have tended in the past to adjust. In principle you can also have moderate GDP growth and high consumption growth, but this has never happened in history, probably for obvious reasons, and the extraordinary faith many analysts have that this is the most likely outcome unless Beijing seriously mismanages the process is almost certainly wholly misplaced.

There seem to be four main mechanisms responsible for major incidences of income redistribution. The first is a politically-driven redistribution of wealth from rich to poor (sometimes disruptively, in politically unstable states, and sometimes not). The second is very high inflation or financial repression that erodes bond and bank-deposit values. The third is a wave of sovereign and domestic bond defaults. The fourth is war, although perhaps this occurs mainly because war is often inflationary.

However they occur, the many historical precedents, reinforced by logic, suggest very strongly that no reform program will be viable in China unless it is consistent with a rebalancing of demand from investment to consumption and with a reining in of credit expansion and eventual reduction in the country’s debt burden. Because the only plausible way of rebalancing demand requires that Beijing directly or indirectly redistributes resources from the state sector to the household sector, while the most efficient way to reduce the debt burden involves liquidating state assets and using the proceeds to pay down debt, it turns out that by far the most efficient and sustainable program of reform requires the wholesale liquidation of state assets to fund transfers of wealth.

And there’s the rub. While a reform program that liquidates state assets to pay down debt and to rebalance the household income share is economically the least disruptive kind of reform program, and is the one most likely to leave the economy in a position to resume rapid growth over the long term, it is unfortunately likely to be fiercely resisted by the many powerful vested interest who benefit from state ownership and control of assets. This is the big challenge faced by the Xi administration, and it has been the challenge faced by nearly every country that has undergone a similar type of growth “miracle”.

Why do we need a new program?

I have taken a very long digression before actually beginning my discussion of successful and unsuccessful reforms, among both the previous set of reform proposals and the newly proposed “supply side” reforms, because once we understand what has worked in the past, and what has never worked, it becomes much easier to evaluate the specific reforms that might work for China and those reforms that are clearly irrelevant. In fact they become almost obvious.

There are two main criteria by which to judge the usefulness of specific reforms. First, because the consumption share of GDP will rise no matter which of the rebalancing paths China takes, policies that maintain or even increase the growth rate in household consumption, mainly by maintaining or increasing the growth rate of household income, will push China along a “better” adjustment path of more rapid growth.

Second, because China will deleverage one way or the other, and because financial distress costs create a powerful inverted relationship between the size of the debt burden and the pace of economic growth, policies that reduce financial distress costs, by far the most important being those that pay down debt, will push China along a “better” adjustment path of more rapid growth. These should be the two main considerations when evaluating reform proposals, and while policies that accomplish neither may in fact benefit China’s economic efficiency in the long run, they will not protect China from a brutal and potentially disruptive adjustment.

Beijing formally promised to begin rebalancing the economy in a famous speech by Wen Jiaobao in March, 2007, although it was only in 2012 that the consumption share of GDP stopped declining and began to rise. Since then, the consumption share of GDP has expanded by perhaps one-fifth of the amount by which its GDP share would eventually have had to expand, and debt continues to rise at least twice as quickly as debt-servicing capacity, perhaps much more. Clearly Beijing plans to design and put into place what are being called “supply-side” policies mainly in response to the difficulties it has encountered so far.

I think it is safe to say that implicit in the new set of policies is the recognition that in recent years Beijing has failed to rebalance the economy by nearly as much as it should have, and that it has not made enough progress in implementing the Third Plenum reform proposals. These reforms, if implemented robustly, would have restructured the country’s economic institutions so as to consolidate the progress of the past three decades and make long-term growth sustainable, but this has turned out to be extremely difficult, largely, I suspect, because of what to many was an unexpectedly strong political opposition. And yet this opposition was very much one of the characteristic outcomes of the rebalancing process.

There are only three choices

I have explained many times before why every fiscal, monetary, or regulatory policy decision Beijing takes ultimately forces it to choose among three outcomes, and to understand the supply-side reforms, we must keep these three outcomes in mind. China faces a tradeoff in which Beijing must continually choose among these three:

  • Higher unemployment, the limit of which is largely a political issue involving social instability, with the added wrinkle that certain types of unemployment are likely to be perceived as more politically costly than others – e.g. because returning to the family farms acts as a kind of safety valve, even with a significant fall in living standards, unemployment among migrant workers is likely to be less costly politically, or because university graduates are presumably more communicative and have higher expectations, their unemployment might be more costly.
  • Higher debt, by which I really mean a higher debt burden, or an increase in debt relative to debt-servicing capacity, and this can rise until credit growth can no longer be forced up to the point where it can be used to roll over existing debt with enough margin to fund as much new economic activity that Beijing targets.
  • Higher wealth transfers, in which governments – and because the Xi administration is seeking to centralize power this is most likely to involve local governments rather than central government entities – must liquidate assets and use the proceeds directly or indirectly either to increase household wealth or to pay down debt. The main constraint on Beijing’s ability to direct this process is likely to be the tremendous political opposition of the so-called “vested interests”, for whom government control of these assets is an important source of power, patronage, and wealth.

Beijing’s range of policies, in other words, is quite limited and in every case either economically painful (higher unemployment or higher debt) or politically difficult (higher wealth transfers). This new program of “supply-side” reforms is probably expected to provide Beijing with an alternative path from which perhaps it can sidestep this difficult trio of outcomes, but it will also be limited by the fact that these are Beijing’s only options, so that the best Beijing can expect might be simply that the supply-side reforms will give it more time.

Announcing the supply side policies

A widely-read primer published last month by Xinhua, the country’s official news agency, explained what Beijing might mean by supply-side reforms. What I found to be especially interesting was its explanation of why Beijing had shifted from what it called demand-side reforms to supply-side reforms:

The Chinese economy is no longer galloping ahead on the back of investment, exports and consumption. Adjusting banking regulations and interest rates has not been very successful in boosting investment or consumption.

With growth falling below 7 percent, China’s economy is in dire need of a makeover. Instead of working on the demand side, attention has turned to stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity resulting from the previous stimulus. Such measures are intended to increase the supply of goods and services, consequently lowering prices and boosting consumption.

I think it is especially noteworthy that Xinhua says that the adjusting of banking regulations and interest rates liberalization, among the most important parts of the existing reform program, have not been successful, and that China is “in dire need of a makeover”. This fact alone, if true, should be a very powerful indicator of just how misguided the economic models are that implicitly underlie the optimistic consensus about the management of China’s adjustment process during the past few years. Because I have long argued that these reforms would at best reverse the process by which the imbalances were created (especially the elimination of the financial distress “tax”) if the balance sheet approach to rebalancing were the appropriate model, and are implicit in the trade-off among three outcomes I list above, they are at least consistent with what I believe is the correct analysis.

The day after the Xinhua piece, an article in the People’s Daily made the same point:

China used to rely on stimulating the demand side, including investment, consumption and exports, to support growth. However, the effectiveness of such a strategy has lessened.

The economy experienced acute volatility in the mainland equity market, disappointing economic indicators and a currency devaluation this year. The government appeared to have done everything it could, including five interest rate cuts and massive investment in infrastructure, but that was not enough to spur the slowing economy. (“That’s because it [the demand-side support policy] is no longer the remedy for the disease,” said Li Zuojun, a researcher with the State Council Development Research Center (DRC), a government think tank.

The sense that “supply-side” reforms are a response to failures in the current reform program permeates reports in the official and non-official Chinese press, to the point where it should resolve the long running argument between bulls and bears. Economists at various Chinese think-tanks have made the same point, many affiliated with government ministries, including at the independent Winbro Economic Research Institute and at China Academy of New Supply-side Economics, the latter set up by former government official, according to an article published two weeks ago in the South China Morning Post. Their goal is to explore new ways to create a better framework for reforms.

The same SCMP article provides a fairly good summary of the new thinking, and suggests more specifically the perceived failings of current policies:

Economist Teng Tai, founder of Winbro Economic Research Institute, a private think tank in Beijing, is one of the most vocal proponents of supply-side reform. The country’s previous strategies for boosting economic growth were quickly losing effectiveness.

“The effects of demand-side measures in driving economic growth are getting weaker and weaker,” said Teng, who in 2012 sparked debate with the publication of his Declaration on New Supply-side Economics. “Take fixed-asset investment for instance. The government can increase infrastructure investment for sure, but the effects can be easily offset by sluggish capital spending by property developers and manufacturers,” Teng said.

However, through “supply-side” measures, such as reducing government red-tape, cutting taxes, and freeing up the labour, land and capital markets, China could prevent economic growth from slowing even more, while creating new sources of growth, said Teng, who attended a recent advisory meeting chaired by Premier Li Keqiang.

Keeping growth high

It goes on to list similar doubts by another proponent of the supply-side measures:

“A breakthrough in economic theories is needed since the approaches found in old textbooks can no longer solve today’s problems,” said Jia Kang, a government researcher and a member of the Chinese People’s Political Consultative Conference. After retiring from his research position at the Ministry of Finance, Jia founded the China Academy of New Supply-side Economics in 2013, pulling together a group of economists from both public and private sectors to study the approach.

“The leadership’s emphasis on supply-side reform is a new approach for connecting theory with reality.”But China’s supply-side economics would be different from its Western version to reflect China’s reality. In essence, Jia said, it was a systematic summary of what the country needed to do to restart its economic engine.

The official press has also suggested that the new reform program is in response to the ineffectiveness of the existing reform program, although they appear careful not to suggest too bluntly that the policies of the past 3-4 years were not the right policies at the time. “While the effectiveness of traditional demand-side policy support lessens,” the People’s Daily tells us, “the country is now turning to the other side for new growth vitality.” Or as Li Yiping, People University professor and one of the sharper economists in China, writes in China Daily:

Since the 2008 subprime crisis in the US, China has taken a series of demand-management measures to stabilize growth, including a 4 trillion yuan ($616.8 billion) stimulus package in 2008. These measures were taken on the assumption that the government could solve microcosmic problems through macro policies.

But the government intervention distorted factor prices and created further overproduction pressure. In other words, the structural adjustment didn’t work. The marginal utility of the stimulus package declined sharply the 4-trillion-yuan investment was not enough to maintain 7 percent growth today.

While from what I can understand there are very realistic appraisals of some of the problems China faces, unfortunately rather than acknowledge that it will be impossible to maintain current growth rates for more than a few years, and that the longer they are maintained the greater the risk that China is forced into a disruptive adjustment, at least some of the policy advisors have drawn a different conclusion. China can maintain high growth rates if it switches to a new basket of “supply-side” reforms.

What are Beijing’s “supply-side” policies?

What are these reforms? Here is how the People’s Daily describes them, in an article that calls them the “top priority” of this month’s annual Central Economic Work Conference:

The supply-side reform will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system. Public service is set to be improved and new demand created to spur growth.

The country’s top leaders are likely to introduce all-round “supply-side reform” at the annual Central Economic Work Conference, which began on Friday in Beijing. “All signs are pointing in the same direction, that supply-side reform will command center stage next year,” according to a policy review of the conference by China Minsheng Bank, one of the largest non-State banks.

The article goes on to give a little more detail further along, of which perhaps the most important and encouraging comment, at least in my opinion, is the suggestion that the GDP growth target will be de-emphasized:

A Web commentary by People’s Daily called the supply-side reform “a profound change”. It will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system, it said.

In the most immediate move, the commentary said, the government will have to reduce housing inventories, and one way is to subsidize rural migrant workers so they can settle down in the cities where they work. It should also shed excessive industrial capacity, especially in industries with low technology and poor market prospects, it said.

A third thing to do is to deepen reform of the financial system, so as to build a nationwide system of financial service, taxation and multiple layers of insurance, the commentary added. Wang Yiming, vice-president of the State Council Development Research Center, said reform will definitely be the priority at the meeting.

GDP growth will be assigned secondary importance, economists said. Some suggested that next year’s GDP growth target should be lowered from “around 7 percent” this year to between 6.5 and 6.8 percent. GDP growth in the first three quarters reached 6.9 percent year-on-year, down from the 7.3 percent last year. The growth target won’t be published until the National People’s Congress in March.

In its December 22 primer, Xinhua explained what Beijing might mean by supply-side reforms:

Supply-side economics holds that the best way to stimulate economic growth is to lower barriers to production, particularly through tax cuts. The wealth-owners, rather than spending on direct “demand” purchases, will then be more enticed to invest in things that increase supply, such as new businesses, innovative goods and services.

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. …Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

The return of Say’s Law

My understanding of the proposed reforms is that they are only partially described by use of the phrase “supply-side”, whose overuse is already causing some off us the same confusion felt by Inigo Montoya, the vengeful swordsman from The Princess Bride: “You keep using that word. I do not think it means what you think it means.”

The phrase itself was first used in 1976 by Herbert Stein, of the University of Virginia, to discuss a body of policies that had evolved in opposition to demand-side policies, often mistakenly attributed to Keynes, that could not explain or address the stagflation of the 1970s. These policies later became more widely known as “Reagonomics”, the heart of which is usually assumed to be tax cuts as part of a strategy to reduce government involvement in the economy on the grounds that government involvement creates incentives that systematically distort economic behavior and reduce productivity.

The heart of supply-side economics is Say’s Law, sometimes summarized as “supply creates its own demand”, based on the work of Jean-Baptiste Say, a French economist who lived from 1767 to 1832 and whose main work is A Treatise on Political Economy. In that book Say claimed that “a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” Because the full value of any commodity produced is dispersed into the economy in the form of production costs, wages, and profits, insufficient demand for goods can never be a fundamental condition of any free market because the payments involved in creating the supply of goods and services also create purchasing power which will either be used for consumption or will be saved and directed to investment, creating demand that is equal to the value of those goods.

This doesn’t mean that Say and his followers deny that there can be supply and demand mismatches, of course, but that they happen only for two reasons. First, as long as perfect information is impossible, the economy will be subject to bad information, poor judgment or exogenous shocks that can cause these mismatches. These tend to be fairly small in effect and are always temporary. Second, and far more powerfully, institutional distortions can force agents into systematic misalignments of supply and demand (mainly by changing incentives for political reasons) that can get very deep and can persist for very long periods. The main source of these distortions, according to supply-siders, is the government. In that case the best way to increase productivity permanently is to remove the source of these distortions.

According to Say and his followers, policymakers should never worry about inadequate demand as the source of depressions. They should only worry about policy distortions that cause the market to create the wrong mix of goods and services. In what is perhaps the most quoted of all of Say’s passages, he says:

The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

But we have to be careful about how we interpret that last clause. At first glance Say and the supply-siders seem to suggest that the whole rebalancing thesis is wrong for China, and that there is no reason to worry about the low consumption share of GDP. If this were true, however we would immediately have to dismiss supply-siders because it only takes a little arithmetic to show that China’s soaring debt burden is a direct consequence of its demand imbalance, and to dismiss the consequences implies both that the country’s debt capacity must be infinite and that there will never be uncertainty about the allocation of debt-servicing costs, neither of which can possibly be true.

A more sophisticated reading, however, would recognize that China’s demand imbalance could never have existed except for very powerful political incentives that created in the past two decades deep institutional distortions. In that case the point of supply side reforms would be to eliminate these distortions so that the imbalances can reverse, and it seems to me that the only possible disagreement among supply-siders must be whether the purpose of reforms is to eliminate institutional distortions as quickly as possible or whether Beijing should take active steps to speed up wealth transfers to the household sector. Which side you support depends, clearly, on how urgent you believe it is to begin to deleverage the Chinese economy and how quickly rebalancing can occur as you eliminate distortions.

The main tenets of China’s supply-side reforms

It is pretty easy to see why this economic theory might appeal to Beijing. China produces far more than it is able to consume or demand domestically, but even with one of the highest current account surpluses in history and with explosive credit expansion to generate demand, inventories are rising and growth rates dropping sharply. Reforms during the past three years have done too little to resolve the problem, and whether China can rely on these reforms depends on how much longer Beijing can afford to allow excessive credit expansion before China runs into debt capacity limits, and on whether Beijing is strong enough to overcome domestic political opposition and speed up the pace of the rebalancing.

Is this new set of supply-side reforms the solution? At least some of the policies that are being bandied about are actually contradictory or mutually exclusive, and clearly there is not nearly enough certainty about what exactly the reforms entail nor, just as importantly, whether they can be implemented, but already analysts have been wrestling with the implications, trying to clarify the reform proposals, and providing their initial evaluations. According to last month’s Economist:

Those who first pushed supply-side reform onto China’s political agenda want a clean break with the credit-driven past. Jia Kang, an outspoken researcher in the finance ministry who co-founded the new supply-side academy, defines the term in opposition to the short-term demand management that has often characterised China’s economic policy—the boosting of consumption and investment with the help of cheap money and dollops of government spending.

Whatever the supply-side reforms imply about earlier reform proposals, I do not think we can easily declare yet either that the new policies will be successful as predicted or that they won’t – with one exception: I am very confident in saying that unless implicit wealth transfers to the household sector rise to 2-3% of GDP annually, which I recognize will be politically very difficult to manage, there is almost no chance that growth over the rest of this decade can remain at 7% or even at 6% or 5%.

Because we are still in the very early stages of this new set of policies, it is hard to discuss them except in very abstract terms, and already so much ink has been spilled describing them that contradictions and confusions have emerged. An article in China Daily seems to set the stage at least as well as any other:

China used to rely on three major forces to drive economic growth – investment, exports and consumption, which are classified as the demand side. As the effectiveness of boosting growth in the demand side wanes, the government has started to reform the supply side, or the supply and effective use of production factors, including funds, resources, skilled workers, equipment and technologies. The reform aims to accelerate economic growth by freeing up productivity and raising supply-side competitiveness. Measures will include cutting excess industrial capacity, reducing housing inventories and cutting production costs with policy support.

The focus on freeing up productivity and raising competitiveness is of course no different than the promises made by the earlier set of reforms, but supply-side doctrine proposes that rather than raising productivity by improving the distribution of demand and letting producers respond, Beijing will take steps to boost production efficiencies, confident that more efficient and profitable producers will trickle down into stronger consumption. Credit Suisse, in its December 21 report, specifies more concretely how Beijing plans to raise productivity:

The central committee of China’s communist party held the annual Economic Working Conference between 18 and 21 December. The conference listed five major tasks for 2016: (1) Reduce over-capacity. (2) De-stocking. (3) De-leveraging. (4) Lower corporate costs. (5) Improve weak links in the economy.

The meeting pointed out that supply-side policy should be given more attention in order to stabilize growth. The conference highlighted that promoting the supply-side structural reform is an innovation to help China to adapt to, as well as to lead, the new norm of the economy. In the coming years starting from 2016, China will promote the supply-side structural reforms on top of appropriate expansion of aggregate demand. China will maintain macro policy stability in order to create a stable macro environment for structural reform. China will enhance the strength of active fiscal policy through tax cuts and the periodic increase of the budget deficit. Steady monetary policy should be adapted with flexibility. China will maintain adequate liquidity and appropriate growth of total social financing. China will increase the degree of direct financing, lower funding costs and further develop the exchange rate mechanism.

An article in Xinhua proposes, similarly, the following policies that are consistent with Credit Suisse’s understanding:

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

Finally, another article, this time in the South China Morning Post, describes the intentions of President Xi for the proposed supply-side policies in the following way and in nearly identical terms:

Xi has listed the four big battles of the coming year as addressing overcapacity, cutting financing costs, reducing property inventory and preventing financial risks, China Business News reported.

The key objectives

As far as I understand these reforms, then, I would list the main objectives very broadly as consisting of the following:

  1. Reducing over-capacity. This will include encouraging mergers and acquisitions, as well as preventing bankruptcy. Because of very strong incentives that favor gross production over productivity, including pressure, mainly from local governments, not to fire workers, Chinese companies have been very reluctant to close down capacity even as demand has plunged globally. Because companies that maintain capacity at the behest of local officials can have them pressure banks to finance rising inventories, the obvious consequence is rising debt collateralized by permanently rising inventory, and with no formal mechanism to write down either, wealth will be overstated. It is not clear to me exactly what policies will be implemented to address over-capacity, but policymakers at the Economic Working Conference stressed that the balance between social stability and structural reform should be dealt with carefully. Overcapacity must be reduced, in other words, but not by firing workers to the extent that the resulting unemployment is destabilizing. It will not be easy to do one however without risking the other.
  1. Reducing real estate inventory. Xu Lin, director of the Department of Development Planning at the country’s top economic planner, the Central Leading Group for Financial and Economic Affairs, explains in an interview with Caixin in November that “the key step [in reducing the inventory of property] is to help migrant workers in cities to settle down through household registration reforms, thus creating more demand for housing and reducing excess inventory of property. The mega cities of Beijing, Shanghai and Guangzhou are suffering from population pressure, so they have strengthened controls on population growth. But there are many other big and medium-sized cities with little population pressure that should enhance efforts on household registration reforms. But those efforts have been inadequate.” We have already seen tentative “experimental” policies aimed at liberalizing the hukou regime, which determines the residency status of all Chinese, but the biggest problem, as is well recognized, is that the supply of hukous is for lower-tier cities whereas most demand is for the top tier cities.
  1. De-leveraging and otherwise strengthening balance sheets. Much of the focus here seems to be on making debt-servicing costs more manageable for heavily indebted entities, especially provincial and municipal borrowers, many of which are struggling. According to an article last week in the People’s Daily, Zheng Gongcheng, a member of the National People’s Congress Standing Committee, said there are a great many zombie companies among State-owned enterprises. “Their existence can only increase financial loss and the pressure to repay debt.” What makes this especially difficult is the highly politicized nature of lending, which the supply side reforms will try to address. As Caixin explained in another article: “Banks were sometimes strong-armed by local government officials to extend loans to these [zombie] companies because they feared letting them go under would cause social instability, a risk-management executive at one bank said. ‘But these companies are doomed,’ he said, adding that forcing banks to lend to them ‘amounts to dragging down the quality of the loans to non-performing.'”
  1. Fiscal expansion, including tax cuts. Fiscal expansion is usually seen as a demand side policy, but in this case tax cuts will be designed and implemented as much to improve business efficiency as to boost demand.
  1. Lowering corporate costs directly and by reducing government bureaucracy. Again, according to Xu Lin, “I think the core idea is to reduce transaction costs created by institutional arrangements. Businesses are paying quite high costs in transactions, taxation, financing and social security. High transaction costs in China are mainly created by institutional hurdles. Reforming the supply side will reduce costs and make it easier for enterprises to do business. It will encourage business innovation, boost quality and efficiency of the supply system, and improve the supply structure. Eventually, supply side reform will lead to higher productivity of the economy and improve enterprises’ competitiveness.” There has been a great deal of complaining in the past about the cost of bureaucracy and most of the reformers seem to stress the need for streamlining bureaucracy.

The goals, then, seem to be to take advantage of the urgency generated by recent events to force through a series of difficult reforms that will improve China’s economic efficiency over the longer term, but that must at the same time address the vulnerabilities that China faces in the shorter term that can easily overwhelm any larger reform program. These reforms clearly will not be easy and just as clearly face significant political constraints.

How will the reforms proceed?

I won’t pretend that I can lay out with any subtlety the specific reforms that Beijing must implement in order to improve the long term functioning of its economy, and can only wish the reformers the best of luck in what promises to be an immense task, but I do want to address, perhaps a little abstractly, the kinds of policies that will directly move China towards or away from the optimal adjustment path. Again, I want to make the distinction between the two types of reforms to which I earlier referred:

  1. China, like every other economy, has institutional constraints that prevent it from achieving the sort of frictionless system in which incentives, including the design and implementation of economic laws, reward economic behavior that increases social wealth, and in which land, labor and capital resources are exploited as productively as possible. These reforms, which I sometimes refer to as “asset-side” reforms, are not always clear-cut among economists and are no less subject to fashion than men’s hair-styles, but it is pretty normal that at any point in time there is a widely accepted consensus about what constitutes an appropriate set of reforms. The goal of these reforms is to identify institutional or investment constraints that reduce efficiency and eliminate them, with the goal of increasing productivity.
  1. In highly unbalanced and heavily leveraged economies in the late stages of a particular growth model, another set of reforms are designed specifically to speed up the rebalancing process and to reduce leverage.

I have already pointed out that historical precedents had always made it easy to predict the sequence of events:

  • During the later stages of the period of rapid expansion in economic activity, and in spite of ample evidence that included an overwhelmingly consistent collection of historical precedents, the economic advisors to the Beijing government, along with most of the research analysts covering China, would fail to recognize the relationship between growing imbalances, capital misallocation, and deteriorating balance sheets. Nor would they recognize the symmetrical role of balance sheet inversion, in which what had caused them to confuse speculative profits in a period of expansion with higher-than-expected productivity would necessarily cause the contractionary phase to slow even further because the symmetry of speculation meant that losses would be magnified just as profits were. Just as inverted balance sheets made growth unexpectedly high in the expansion phase, in other words, they would necessarily make growth unexpectedly low during the contraction.
  • At some point, however, debt levels would become so high that these same economic advisors would recognize the need for economic rebalancing, and for reforms that would accommodate the rebalancing in a way that lessened the chance of disruption.
  • However because of a continued failure to understand the balance sheet component, the proposed reforms were always likely to be the asset-side reforms described above. For that reason it was also fairly easy to predict that the reforms would have very little impact in improving the underlying imbalances in the Chinese economy or in reducing the country’s reliance on surging debt to stabilize growth rates. It was inevitable that barring some major positive shock, debt would rise far more quickly than the economic policy advisors had predicted, and China’s vulnerability would rise to dangerous levels.

So to repeat myself

So far China has followed the same unfortunate path as all its predecessors. The recent announcement of supply-side reforms is no more than an explicit recognition that this is exactly what has happened. Beijing clearly now faces two options. One option is to recognize that productivity growth will not pull China out of its rising debt burden and to focus on liquidating assets to pay down debt and to fund wealth transfers to the household sector.

The second option is to embrace “supply-side” reforms which design improvements in economic efficiency in the elimination of institutional constraints that are dramatic enough to lead to a surge in productivity powerful enough to allow China to grow its way out of its debt burden. China, in this case, will not have to allocate losses directly or indirectly to households, businesses or governments, nor will the PBoC have to monetize the debt, which of course is simply another way of allocating the losses to the household sector. At the same time the household share of GDP will rise so rapidly that investment can quickly decline with no impact on growth or unemployment.

No country in history as ever managed to pull off this second option. This doesn’t make it impossible for China to do so, but it is all the more worrying that no country has suffered from economic imbalances or from debt burdens as deep as those of China today. Frankly I find it difficult to work out arithmetically any such outcome with numbers that are consistent systemically except under assumptions of near frictionless transitions and many years of implausibly high levels of wealth transfer from the state to ordinary households, on the order of at least 3-4% of GDP.

If I am right, the best way for China to avoid a very painful and possibly disruptive adjustment is for the supply-side reforms to be designed and implemented to accommodate rebalancing. Each important reform must be designed either to accommodate or boost a rapid increase in household income or wealth or it must be structured to pay down debt. As I will show it is important to understand that wealth transfers are fully compatible with supply-side reforms, depending on how the reforms are formulated.

How the evaluate the reforms

To return to the main objectives of the supply-side reform plan I listed above:

  1. Reducing over-capacity. The purpose of reducing over-capacity must be to reduce the growing gap between the rise in debt that is required by companies to maintain unnecessary production facilities and the declining economic value to Chinese households of what is produced. Inevitably there will be lots of other considerations invoked by the relevant stakeholders and regulators involved in the problem of over-capacity, but they are barely relevant. If the reformers understand that the measures they take should be valued primarily in terms of their impact on reducing China’s debt burden, these reforms will be consistent with a smoother and ultimately less costly economic adjustment.

The difficulty in closing capacity of course is that it also usually means increasing unemployment. This is simply yet additional confirmation that all policy choices for Beijing boil down to choosing among higher debt, higher unemployment, and higher wealth transfers. But closing down unnecessary capacity can pay for itself, even if unemployed workers are temporarily put on the government payroll (causing debt to rise, but usually by less than it had before), but only temporarily as Beijing takes other measures to boost household income through wealth transfers from the state and so to boost consumption, a form of demand which is likely to be more labor intensive than the demand created in the process of over-capacity.

There seems to be a very clear consensus about at lleast some of the targets of the over-capacity drive. On Friday People’s Daily reported a statement released a day earlier by Premier Li Keqiang: “Steel and coal sectors should take the lead in cutting overcapacity, digest unreasonable inventories, reduce costs and improve efficiency.”

Steel and coal have been so universally recognized as problem sectors that it is pretty clear that they will not be able to escape significant cuts, but after a decade or two of extremely cheap credit (often negative in real terms), widespread moral hazard, and corporate governance incentives that prioritized production and employment above all other measures, it would be astonishing if over-capacity and bloated inventories were not a blight on most industrial sectors dominated by the state or by large companies with access to state patronage. Because these are likely to be the key causes of misallocated credit, and because measures that cut back on overcapacity are likely to be painful, and so politically resisted, if the measures do not extend well beyond steel and coal their impacts are not likely to be sufficient.

  1. Reducing real estate inventory. Conceptually there is no easier reform to explain than this one, and while I recognize that there may be innumerable legal and political implications, in fact the economics are brutally simple and incontrovertible.

The economic value of an empty apartment to the Chinese economy is exactly zero, minus running costs and depreciation, which are only partially mitigated by the positive economic impact of their role as a secure form of savings. The moment an empty apartment is occupied by a Chinese family, Chinese wealth and income are immediately increased by the value that family attaches to the change in its living standards. China is notorious for the sheer quantity of its empty apartments, and these empty apartments represent an enormous expenditure of labor and resources by the Chinese people of which a large amount of wealth is destroyed every day that the apartments remain empty.

To get a sense of the magnitude of the cost to China of residential vacancies, we would need to begin with an estimate of the number of vacant apartments. I have seen estimates of the number of empty apartments in urban China range from 64 million to as much as 89 million. I have read elsewhere that roughly between one in four and one in five urban apartments in China is empty. I assume these two sets of numbers are consistent. For comparison sake I understand that urban vacancies in China are roughly ten times the global norm – i.e. in the rest of the world one in forty to one in fifty urban apartments are typically empty.

If we assume that there are in fact 60-70 million empty apartments in China, and further assume that the average size of these apartments is 50-60 square meters and the average square meter costs roughly $1,500, then the market value of empty apartments in China is between $4.5 trillion and $6.3 trillion. The real economic value of an apartment is not necessarily the same as its market price, especially if a speculative real estate bubble has artificially boosted prices, so let us assume that the fundamental value of these apartments to Chinese households is actually between one-third and one-half of the market value. If these apartments were actually occupied, in other words, Chinese households would feel wealthier by between $1.5 to $3 trillion dollars, or roughly 12-25% of GDP.

If somehow vacancies in China were immediately to adjust to global norms, these back-of-the-envelope calculations suggest that the annual impact on household wealth would be the equivalent of an annual increase in household income of 2-3 percentage points – which increases the income of households by 4-6%, assuming that the income of ordinary Chinese households is roughly 50% of GDP.

This is not a negligible number. If the supply-side reforms Beijing is contemplating include measures that reverse the institutional distortions responsible for the very high vacancy rate in China, household income would be the equivalent of a 4-6% higher every year, and the household income share of GDP would be raised by 2-3 percentage points, which isn’t much less than has been accomplished over four very difficult years.

Reforms that fill up empty apartments, in other words, are clearly consistent with rebalancing, and are the kinds of reforms that will lower the adjustment costs for China. What kind of reforms can fill empty apartments? That I leave to smarter people than me, but if the carrying cost of an apartment, which is currently very low, were to increase significantly, most obviously by instituting an annual property tax, apartment owners would have very strong incentives either to sell or to rent out their apartments to generate enough income to cover the cost of holding apartments. The risk of course is that by forcing some owners to sell, this could cause the market to drop sharply, and while I would argue that lower housing prices represent, paradoxically, an increase in Chinese wealth, along with a redistribution of wealth from the richer to the poorer (and, not incidentally, might help President Xi flush out additional corruption), it might have a destabilizing impact on the banking system which would have to be addressed.

The point is that by placing real-estate-related reforms in the context of rebalancing, we can quickly tell which reforms are helpful and which are not. We can also see that houkou reforms aimed at diverting population flows to empty apartments in secondary cities, and away from the highly prized Beijing-Shanghai tier of cities, avoids addressing a big chunk of potential rebalancing value – empty apartments in those cities – and so these must be addressed by other policies. Finally building new low cost apartments for the poor represents an increase in debt, unless it is funded by the sale of state assets, and an increase in economic activity, but an increase in debt would only be justified by labor shortages in the relevant lower-tier cities – shortages that constrained the productivity of existing investment facilities, which is unlikely to be the case.

  1. De-leveraging and otherwise strengthening balance sheets. The purpose of this set of reforms and its consistency with the appropriate goals of rebalancing is pretty self-explanatory. There is one important point, however, that is often missed.

Debt exchanges that lower debt-servicing costs for provinces, provincial borrowing vehicles, or large corporate borrowers do not advance the rebalancing process or lower China’s adjustment costs in the least, contrary to expectations. All they do is reduce unbearably high debt-servicing costs for insolvent or nearly-insolvent borrowers by transferring part of the debt-servicing costs elsewhere. If a provincial borrower is able to swap out of an expensive loan into a bond with a much lower coupon, its debt-servicing costs will of course have plummeted, and it might finally have additional breathing space which it can put to good reforming use (although it can just as easily abuse the benefit), but every RMB it saves represents an equivalent reduction in the profitability of the bank or of some other lender, and so also a reduction in its retained earnings, and it will increase the contingent liabilities of the central government by the same amount.

The provincial debt swaps, in other words, do not reduce debt and do not reduce debt-servicing costs. They simply transfer debt from China’s provincial balance sheet to Beijing’s central balance sheet. Some economists are sophisticated enough to argue that because of the convexity of financial distress costs, this debt transfer will lower slightly overall financial distress costs for China, but this is only true if the resulting increase in central government debt – in the form of contingent liabilities, in this case – has no impact at all on the perception of central government creditworthiness. It would be extraordinary, however, if it had no impact.

  1. Fiscal expansion, including tax cuts. The optimal role of fiscal policy in lowering China’s adjustment costs is another case of reforms whose purpose should be fairly straightforward. If fiscal policy is designed to reduce income inequality, or to raise household wealth and fund this increase in wealth by the liquidation of state assets (and not by increasing debt), it will advance the rebalancing process, lower adjustment costs, and reduce the risk of disruption. Because there are a near-infinite number of ways fiscal policies can accomplish or not accomplish these objectives, it isn’t meaningful to try to list them, but the optimal set of policies involving changes in fiscal expenditures and perhaps a reallocation of tax collection, in which revenues of RMB 11.1 trillion were accumulated in 2015, according to People’s Daily, is quite clear: faster growth in after-tax, disposable household income, in which the lower the income, the faster the growth, and a reduction of outstanding debt.
  1. Lowering corporate costs directly and by reducing government bureaucracy. These may seem like the most obviously useful set of reforms, but this is only because economists mis-conceptualize the value of improvements in asset-side efficiency. These kinds of reforms, if done correctly, will benefit China in the long-term by raising productivity growth, but as in the case of the reforms implemented by Mariano Rajoy in Spain, they do not address the rebalancing process, and their net impact on reducing the country’s debt burden takes far too long to matter to China’s adjustment process. The historical precedents indicate that however effectively the reforms are designed and implemented, if China’s economic adjustment is excessively costly or economically or socially disruptive, they won’t even matter in the long term.

A new beginning, or more of the same?

My description of the kinds of supply-side reforms that Beijing may be contemplating may seem overly abstract, but the purpose of my very long essay is not to propose specific reforms that will help resolve China’s rebalancing. It is to warn against falling into the trap of economic orthodoxy. China’s problem is not that a spate of recent exogenous shocks has perturbed the economy from its path of high growth, and so it does not require efficiency-enhancing improvements to the way it manages the asset side of the economy in order to return to that high growth equilibrium.

China’s problem is a systems problem, and it is the same problem every country that has experienced a similar investment-led growth miracle has experienced. China must switch from the current growth model to a completely different growth model as smoothly as possible, and the more debt it has, and the more distorted the structure of that debt, the more difficult it will be to manage this switch smoothly. This new growth model requires that household income comprises a much greater share of GDP than it currently does, and one way or another this new model will be imposed upon the Chinese economy. The first of the only two important questions is whether the higher household income share of GDP is a consequence of a rise in household income or a drop in GDP.

Because the quality and structure of Chinese debt severely limits the options available to Beijing and significantly increases the risk of a shock causing a disruption or a crisis, one way or another debt will eventually become a lower share of China’s GDP. The second of the only two important questions is about the manner and speed with which debt is reduced. Put differently, the only way to reduce debt is to allocate the cost to some sector of the economy, and broadly speaking these sectors are the household sector, the private sector, the state sector, and the various more specialized subsectors within these three – for example households can consist of rich households versus the rest, the state sector can be divided among the central government and the provincial governments, the private sector can consist of SMEs, large corporations, labor-intensive industries, capital-intensive industries, the export sector, etc.

China can choose to avoid reducing debt for as long as possible, as Japan has done, but the cost is a near permanent state of economic stagnation and the risk is that a poor, volatile economy like that of China is unable to last as long as Japan, in which case it’s debt burden will be reduced in the form of a debt crisis or in the form of monetization by the PBoC, which is simply another way of saying that the cost of the debt will be implicitly allocated to household savers, as was the case in the Chinese debt crisis of the late 1990s.

But this would make rapid growth in consumption impossible. Without the ability to boost GDP with explosive growth in investment, as China did following the debt crisis of the late 1990s, this also means that GDP growth must collapse, and could even become negative.

Alternatively China can choose to reduce debt explicitly by allocating the costs to some sector of the economy. As I have discussed many times, including in my 2013 book, Avoiding the Fall, arithmetically and logically the only appropriate sector is the government sector, and given the need for President Xi to further centralize power if Beijing is to implement reforms successfully, it is obvious that debt costs must be allocated to provincial governments.

Of course this is politically easier said than done, but nonetheless these are the options open to China. It must rebalance and it will. It must reduce its debt burden and it will. It can do what many other countries have done in similar circumstances and waste time and resources by implementing the kinds of reforms beloved of academic economists that do not directly address the rebalancing or the debt directly, and so significantly raise its ultimate adjustment cost while running an increasing risk of crisis. Or it can take steps aggressively to direct the rebalancing and reduce the debt.

China has done the former during the past several years but Beijing’s recent announcements about supply-side reforms suggest that its leaders are frustrated by the ineffectiveness of the proposed reforms and are determined to set out on a very different path. Whether or not this very different path ends up being more of the same we will learn only over the next two or three years.

But whatever happens, this year will clearly be an important one for China, apropos of which, happy Year of the Monkey, which begins in two weeks. They say if you’re very smart you’re likely to do well this year, otherwise it’ll be a very tough year.



[1] The Chinese growth model is simply a variation on what I call a “Gershenkron” growth model, which has three main characteristics:

  1. Rapid economic growth is driven by rapid growth in investment. To achieve this rapid growth in investment, the financial system is structured so as to maximize credit expansion, and credit is directed primarily into infrastructure investment and investment in manufacturing capacity.
  2. In order to force up the savings rate so that savings can easily be directed into investment, direct and indirect taxes are used to constrain the growth in consumption by constraining the growth in the household income share of GDP. As households retain a smaller and smaller share of GDP, their consumption also becomes a smaller and smaller share of GDP. Because household consumption comprises most consumption in any economy, total consumption also declines as a share of GDP, and its obverse, savings, rises. Ideally the result is such rapid growth in GDP that even as the household share contracts, household income overall grows rapidly.
  3. The institutional settings that maximize credit growth and that constrain the growth in household income are further linked because the direct and indirect taxes on the household sector that constrain growth in household income also subsidize investment. In China’s case these taxes have mostly been indirect and include low wage growth relative to productivity growth, an undervalued currency, environmental degradation, the rights of eminent domain, moral hazard and, most importantly, financial repression.

Many countries have employed variations on the Gershenkron model and have achieves spectacular growth. All of them, however, have ended up with very difficult adjustments and significant debt problems. The sequence is usually the following:

  1. At first it is easy to identify productive investments and the system pours credit into these areas, achieving very and unbalanced rapid growth that is both wealth-creating and sustainable.
  2. At some point however the economy begins to reach investment saturation, and this is especially a problem in poor countries because most poor countries are poor because they do not have the institutional ability to absorb and exploit resources productively. When they reach this point continued rapid credit expansion results in credit growth that exceeds the growth in debt-servicing capacity, and the country’s debt burden begins to grow unsustainably.
  3. At this point the economy must switch to a new growth model that focuses not on continued expansion in investment but rather on implementing the institutional reforms that will allow businesses and citizens to exploit resource more efficiently. These reforms are usually described as a kind of “opening up” or “liberalization”, and require substantial changes in the educational, financial, and legal systems as well as an elimination of the direct and indirect taxes that had constrained the growth in household income and the subsidizing of investment.
  4. Because these reforms are always strongly opposed by the elite that grew up around and had benefitted from the Gershenkron model, the reforms are strongly resisted and in every case in history the result has been a dangerously excessive build-up of debt.
  5. Ultimately either the reforms are implemented against strong political opposition or, if they are not, the economy suffers from a crisis, usually a debt crisis, in which it rebalances disruptively. Whether or not the rebalancing occurs disruptively, the longer the debt burden is allowed to grow the more painful the adjustment.

[2] And as Albert Hirschman reminded us, all rapid growth is necessarily unbalanced.

[3] The orthodox world seems to be one that approaches that described by Adam Smith, in which we can assume a near-infinite number of economic entities, none large enough to have an impact on input or output prices, and in which there do not seem to be significant institutional constraints. In fact the only variables that operate as institutional constraints, and so the only variables that can prevent rapid adjustment towards equilibrium, are wage stickiness, along perhaps with certain kinds of price stickiness.

I suspect that in many orthodox models household savings preferences are also implicitly a kind of constraint that can occasionally change independently for reasons that are not specified (i.e. if there is a change in the household savings rate that cannot be modeled by demographics, income levels, unemployment, or various kinds of economic uncertainty, we simply assume that households have decided to become more or less thrifty). Efficiency in this world is usually maximized when the economy achieves some idealized equilibrium. Exogenous shocks can move the economy away from this equilibrium, and wage and price stickiness, along perhaps with rigidities in savings preferences, will slow the adjustment process by which the economy returns to equilibrium, but in the long run if left to its own devices the orthodox world always returns to equilibrium, rendering economic policy-making largely useless.

In the short run however the orthodox world accepts that fiscal and monetary policies can speed up the adjustment towards equilibrium, largely it seems by countering these constraints, or by setting interest rates in order to manage investment and consumption. There is a great deal of disagreement between those who seem to think that monetary policy is largely ineffective and those, known as monetarists, who followed Keynes in attaching importance to changes in the demand for money while berating him for not stressing the inflationary impact of money creation. Whether the disagreement between the two is a trivial one or is of major theoretical and practical significance seems mainly to depend on how seriously you take the neo-classical synthesis, but I think both the orthodox and the unorthodox would agree that it isn’t a good idea to confuse anything Keynes might have actually said or believed with any of the various “Keynesian” schools.

I try to describe this “orthodox” world because even though I suspect most mainstream economists would agree that the Chinese economy in no way resembles one that is comprised of a very large number of agents too small to affect output or input prices, in which there no major institutional constraints, in which unsustainable credit expansion cannot persist except over a very brief period, and imbalances return automatically and fairly quickly towards efficient equilibrium. As I have discussed many times, however, this world is very rigidly embedded into most of their models and analyses.

For those who are interested, Hyman Minsky lists the conditions implicit in the world of orthodox economists, with tremendous sensitivity, in the 5th chapter of his book, Stabilizing an Unstable Economy. In my September 1 blog entry I argued that economists typically focus on managing the asset side of the balance sheet, and almost never on the liability side, because they implicitly understand both the extent and the nature of economic growth to be almost wholly a function of the ways in which assets are managed. If you want to increase the growth rate of an economic entity, in other words, you must do so by improving the efficiency with which its assets are managed.

But this is only true under certain specific circumstances. In any economic entity in which either debt levels are high enough to introduce uncertainty into the debt-servicing process or the balance sheet is sufficiently distorted or inverted to transform the incentive structure or exacerbate or otherwise affect the impact of exogenous changes, the relationship between the value of assets and the value of liabilities can in itself increase growth, reduce it, or cause it to collapse.

[4] This very important but surprisingly poorly understood feature of balance sheet fragility was something that Irving Fisher often discussed when he insisted on the distinction between the events that trigger a crisis and the underlying “cause” of the crisis. In the early stages of the GFC, for example, optimists often pointed out that the total outstanding amount of US sub-prime mortgages was too small to matter much to the US economy, but the fact that something so “small” triggered so large a disruption simply means that balance sheets were extremely fragile and increasingly susceptible to smaller and smaller shocks. That is why while it is true that the Chinese stock market is too small to matter in any “fundamental” sense, that doesn’t mean we can completely rule out in the future its impact on a larger disruptive process.

[5] The only clear historical exception I can find in the past 200 years is the case of Romania in the 1980s. Nicolae Ceausescu, worried by political instability in Poland after it had been forced to restructure its debt (Poland was one of the 32 sovereign creditors participating in the “LDC Debt Crisis” of the 1980s), and concerned perhaps about the implications of a debt restructuring for his domestic reputation as a policymaker, chose to repay in full the $13 billion the country owed, which it did ahead of schedule in 1989 by imposing brutal austerity. Few think it is a coincidence that shortly thereafter, when he and his wife were captured quickly executed, there was general jubilation among Romanians.

Colombia and the USSR were technically not among the restructuring countries, although they traded as such (their loans were “voluntarily” rolled over by banks unwilling to add to the pool of formally restructured sovereign debt) and engaged in direct and indirect discounted buybacks. Chile was among the restructuring “LDCs” and was one of the only major restructuring countries, I believe, that did not request or receive a Brady restructuring with a formal discount. It was however among the most active participants in direct and indirect discounted buybacks, especially through its famous “Chapter 18” and “Chapter 19” debt-equity swaps.

A well-known economists suggested to me that the only exception he could think of was England after the Napoleonic wars, and although I am not sure whether it indeed is an exception, it is noteworthy that except for the case of Romania, which is not really an exception because it did not grow its way out of the debt but rather imposed brutal austerity, we would have to go back 200 years to find an exception. It is surprising that this very consistent and remarkable history has not at least been acknowledged by economists who have recommended with great confidence programs aimed at allowing overly-indebted sovereign entities to grow their ways out of their debt burdens.

[6] There is a great deal of confusion about this. In a January 13 panel discussion organized in Moscow at the Gaidar Institute Conference at which both Peking University colleague Lin Yifu and I participated, Dr. Lin proposed China’s experience during the past decade as precisely one case in which a country with an excessive debt burden was able to grow its way out of the debt with no partial forgiveness and no allocating to some other sector a substantial portion of debt servicing costs.

But it turns out that China was not an exception. China during this time had nominal GDP growth ranging typically from 16% to 20% and its GDP deflator was typically 8-10%. Interest rates however were extraordinarily low by any standard. The lending rate was around 7% and the deposit rate around 3.5%. While the standard explanation is that bad loans were resolved by transferring them to the AMCs and liquidating them efficiently, in fact the AMCs purchased most of the loans in two tranches, one at full face value and one at 50% of face value. I believe that they were able to liquidate only a portion of this portfolio, and at less than 25% of face value.

The AMCs received the full funding for these purchases from the banks that sold them the bad debt in the form of 10-year bonds, many or most of which were subsequently rolled over for a second ten-year period. Clearly this did not involve any transfer of value.

However under the nominal GDP growth and GDP deflator conditions described, a lending rate of 7% was clearly concessionary by any standard, and by at least 5-7 percentage points. In that case it is easy to calculate that the amount of debt forgiveness for just the first 10-year period ranges from 28% to 36% on all loans. The costs were borne, of course, by household depositors, who bore an additional cost to recapitalize banks equal to approximately 9% of their savings, in the form of a spread between the lending rate and the deposit rate that was roughly double the standard spread.

China did not simply grow its way out of its loan problem of the late 1990s, in other words. It implicitly passed onto households between an amount equal to between a third and a half of the value of the loans in order to recapitalize the banks and grant debt forgiveness to insolvent borrowers. It was no coincidence, of course, that during this time the household income and consumption shares of GDP plummeted, from already low levels. The impact of lagging consumption growth on GDP growth was countered, obviously, by soaring investment.

While this was a very successful way of repairing the damage caused by bad lending in the 1990s, China of course cannot use the same mechanism again. Rebalancing requires that consumption growth exceed GDP growth, and Beijing fully understands that it cannot use a surge in investment to counter the impact of such a huge transfer of wealth from the household sector.

[7] A recent editorial in Caixin makes the point a little bluntly: “Some officials have recently placed their hopes of avoiding painful reforms on the “belt and road” initiatives, arguing that they will export their way out of excess. But new markets opened by these programs will not be big enough to absorb all of China’s excess capacity. We have already witnessed backlashes in some developing countries against China’s steel exports. Such resistance will become stouter.”


China’s rebalancing timetable

We often read in the press rather alarming stories about the rise of an ugly and belligerent nationalism in China, but while these stories are certainly very real, after the November 13 bombings in Paris I was struck by a very different kind of Chinese behavior. A lot of young people that I know in Beijing – high school and college students, young professionals, musicians, etc. – were horrified by the violence that occurred in Paris and very eager to express a real sympathy for Parisians, which they did in the ways that young people express themselves today, via smart phones, social media, and all the other things that wouldn’t have occurred to me. I saw an awful lot of these expressions of sympathy and while these are no more than small gestures, of course, they are personal, not official. As someone who loves Paris I was very happy to see lines of solidarity immediately stretch out to include so many young Beijingers, most of whom have never even been to France.

To turn to more mundane topics, last week I received an email from Jorge Guajardo, the former Mexican ambassador to China, with whom I regularly exchange emails in which we discuss the political and economic challenges associated with China’s economic adjustment, along with any insights that his knowledge of Mexican history might provide. While the differences between China and Mexico are obvious, too few of the analysts trying to understand the political economy of China’s adjustment seem to know much about Mexico, or indeed about other developing countries that have undergone similar experiences and whose histories can provide a useful framework with which to understand China.

It is far more common for example to look at the US and Japan for external references and comparisons, even though these two countries have social and political institutions that are far less like those of China than many, if not most, other developing countries. The differences in wealth alone are quantitatively so great that they also become qualitative hurdles. The US, after all, has 7.2 times the per capita GDP of China, according to the IMF, and American households earn around 11 times the per capita income of Chinese households. Japan has 4.8 times the per capita GDP of China and Japanese households nearly 6 times the per capita income. Mexico, on the other hand, has only 1.4 times China’s per capital GDP and less than 2 times the per capita household income.

By the way one of the ways of expressing Chinese rebalancing is to think of it as a closing of the gap between the difference in per capita GDP and per capita household income. In his email Guajardo asked me for details on Chinese consumption levels in order to understand China’s progress on rebalancing demand within its economy, and in my response I referred to this release in October from China’s National Bureau of Statistics:

Based on the integrated household survey, in the first three quarters of 2015, the national per capita disposable income was 16,367 yuan, a nominal growth of 9.2 percent year-on-year or a real increase of 7.7 percent after deducting price factors, which was 0.1 percentage point higher than that in the first half of the year.

I am not sure how comparable the two numbers are, but with real GDP growing at 6.9% and nominal GDP at 6.2%, it seems that disposable household income is growing 0.8 percentage points faster in real terms and 3.0 percentage points faster nominally (I am assuming population growth is more or less flat as the household income numbers are per capita). I don’t know how to reconcile these two numbers, but the gap between the growth in household income and growth in GDP, which is at the heart of rebalancing, is clearly reversing. After decades in which GDP growth sharply outpaced the growth in household income – and, with it, consumption growth – we must see this reversal, so that the growth in household income exceeds GDP growth by enough that the consumption share of GDP can return to healthy levels.

But the gap is not narrowing quickly enough to rebalance the economy by the end of President Xi’s term in 2023. There are different ways to measure the household income share of GDP and I have no strong arguments in favor of one way or another, but, according to the Economist Intelligence Unit, “Chinese Disposable Personal Income as a Percent of GDP” bottomed out in 2011 at 41.5% and is now rising, reaching 44.0% in 2014. According to the World Bank the “Share of household disposable income and labor (wages) in GDP” bottomed out in 2011 at 60% but in their June 2015 China Economic Update their data only runs to 2012. I am not sure why these numbers are so different.

If we assume that disposable household income is currently half of GDP, eight years of real GDP growth of 6.9% and real disposable household income growth of 7.7% will only raise the household income share of GDP to 53.1% in 2023, a little more than 3 percentage points higher and still below its 21st Century average and leaving China as dependent as ever on investment and the current account surplus. At this rate it would take 25 years for disposable household income to raise by 10 percentage points of GDP, which I would argue is the absolute minimum consistent with real rebalancing.

Even if the gap were to narrow twice as quickly as it is currently narrowing (i.e. if the growth in household income exceed the growth in GDP by 1.6 percentage points) it could easily take 10-15 years for China to adjust sufficiently that its economy can return to sustainable growth. Unless there are far more radical policies implemented to speed up the growth in the household income and consumption shares of GDP, in other words, (and this basically means stepping up the transfer of wealth from the state sector to the household sector), at the current rate we are not going to see sufficient rebalancing for at least 10-15 years.

But does China have 10-15 years? The maximum adjustment period, as I’ve long argued, is largely a function of the country’s debt dynamics. Beijing can keep growth high enough that unemployment is held to acceptable levels only as long as debt can grow fast enough both to

  1. Roll over the large and growing amount of debt whose principal and interest cannot be serviced from earnings generated by whatever project the debt funded, and
  2. Fund the required amount of additional investment or consumption to generate enough economic activity to keep unemployment from rising.

In order to answer the question of how much time China has I thought it would be useful to work out a simple model for the growth in debt to see how plausible it is to assume that China has another 10-15 years in which to manage the adjustment without implementing far more dramatic transfers of resources, either to pay down debt or to raise household wealth. The model shows pretty clearly that China does not have that much time unless we make extremely implausible assumptions about the country’s debt capacity and, just as importantly, about market perceptions about this debt capacity.

The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.

But if financial sector reforms fail to result in a sharp improvement in the efficiency of lending, and if Beijing does not permit the economy to slow rapidly, it will be almost impossible to keep debt from rising significantly. Even assuming that higher debt levels do not generate financial distress costs that depress economic growth further (an assumption with which I strongly disagree), there is a real question about whether China can continue another five years without sharply adjusting its growth model during this time.

Making debt sustainable

The model must start with current debt levels, and then project both the growth in debt and the growth in GDP. Although there is a lot of concern about the quality of the data, we do have enough information at least to establish the minimum debt levels. As of the third quarter of 2015, total social financing (TSF), often used as the best proxy for total direct or indirect obligations of the Chinese government and banking system (although it excludes a number of relevant debt categories), had grown by around 12% year on year to RMB 135 trillion, which is equal to about 208% of China’s GDP.

Because of the provincial bond swaps completed this year, in which TSF debt was converted into non-TSF debt, debt actually grew by at least one percentage point faster than the growth in TSF, so with nominal GDP during that same period growing by 6.2%, to say that debt is growing twice as fast as nominal GDP is probably conservative. If we make the heroic assumption that debt-servicing capacity is growing in line with nominal GDP, we can assume, very conservatively, that debt is growing a little more than twice as fast as debt-servicing capacity.

Of course debt growing faster than debt-servicing capacity is unsustainable, so we will set as our first financial sector target the point at which the two grow in line with each other. Once China can reach this point, we will assume that it has resolved its adjustment and that any further increase in debt is sustainable and no longer causes uncertainty about the allocation of debt-servicing costs, and with it financial distress costs, to rise.

This is also a fairly heroic assumption. All the historical evidence – even more so for developing countries – suggests when an economy is perceived as being excessively leveraged, there is significant downward pressure on growth and increasing financial fragility until the economy begins systematically to deleverage. Deleveraging usually occurs either because the government has implemented policies that explicitly assign losses to sectors of the economy that are able to absorb these losses without creating financial distress conditions, or because creditors are forced into explicit or implicit debt forgiveness (for example through debt restructuring). We will assume however that deleveraging isn’t necessary, and that it is enough merely to keep the debt-to-GDP ratio stable.

For our model we are going to propose an average growth rate for a ten-year period, and we will assume that during this period, nominal GDP growth drops by a constant amount every year to reach this average growth rate. Nominal GDP growth will decline in a straight line from 6.2%, in other words. We will also assume that at first debt will grow just over twice as fast as GDP, as it is doing today, but this ratio will decline in a straight line until, at the end of ten years, debt is growing at the same speed as nominal GDP, so that the debt-to-GDP ratio is stable.

That is all it takes. If the total amount of debt today is equal to 208% of GDP, the total amount of debt as a share of GDP in ten years in our model will be wholly a function of the GDP growth rate. Here are the numbers:

Nominal GDP growth Debt as a share of GDP
6% 274%
5% 267%
4% 259%
3% 251%

If Beijing tries to maintain high growth rates of around 6%, unless there is a dramatic and disruptive change in the financial system it is unlikely to be able to do so without seeing debt grow at the end of ten years to 274% of GDP, something that no country under relevant circumstances has accomplished. Even if Beijing sharply reduces growth, to 3% on average (if household income grows at 5%, as China rebalances, household income will rise from 50% to 61% of GDP), debt must still reach nearly 251% of GDP without disrupting the economy.

One great advantage of this model over most others is that it makes very explicit the relationship between credit growth and GDP growth, so that it is impossible accidentally to posit scenarios in which debt is implicitly assumed to decline inconsistently with GDP growth acceleration. Debt levels in this model are specifically associated with different GDP growth levels, so that this model allows us to acknowledge that a country can safely service and refinance higher debt levels if it is believed to have greater growth potential.

It is clear from the model, however, that without a major change or disruption in policymaking, current debt dynamics will be hard to sustain, even with assumptions underlying the logic that are very conservative. What the model tells us is that if GDP growth declines in an orderly way – which assumes that there will be no unexpected shocks or disruptions – and if Beijing is able to reform the financial system and improve the relationship between credit growth and nominal GDP growth so that the two are sustainable at the end of ten years, there is almost no scenario under which debt does not rise sharply, in many cases perhaps out of control.

Many analysts argue that total debt in China in fact exceeds TSF, and believe that the true debt level is closer to 250% of GDP, and perhaps even more if we include the substantial number of corporate receivables that have surged in recent years. If this were true, and for those who want to make the appropriate adjustments, increasing the initial amount of debt by 42 percentage points, to 250% of GDP, would cause an increase in the final debt numbers ranging from 51 percentage points of GDP for growth rates of 3% to 54 percentage points for growth rates of 6%.

Tweaking the model

A more serious criticism is that Beijing has been trying to reduce the credit intensivity of growth at least since Wen Jiabao’s famous “Four Uns” speech of March, 2007, but has failed to do so. Credit is growing more slowly than it has in the past but not because the financial system has become more efficient but simply because debt levels have become too high, causing regulators to force down the growth in credit without seriously improving the efficiency of the financial sector. The result is that lower credit growth simply means lower GDP growth.

It is difficult to model the many ways credit intensivity of growth can change, but if we simply assume that there is no improvement except as growth slows, so that the ratio between credit growth and GDP growth stays constant, the table below shows debt levels at the end of ten years at different GDP growth rates:

Nominal GDP growth Debt as a share of GDP
6% 380%
5% 346%
4% 314%
3% 284%

On the other hand if we make assumptions that are far more favorable, if less plausible, and propose that nominal GDP will grow at 3-6% on average for the next ten years, but that the relationship between the growth in credit and GDP growth will improve much more dramatically than in our first set of scenarios, it is still hard to work out a good scenario. Let us propose that at the end of ten years, instead of debt growing at the same pace as GDP, as in our first set of scenarios, the efficiency of the financial sector will have improved to such an extent that it can generate up to 6% GDP growth without any increase in debt at all. We will also assume that to get there does not require a financial crisis or any debt forgiveness, and that the financial sector gets there smoothly.

This would be a remarkable achievement, and probably unprecedented in history, and it would be just barely enough to solve China’s debt problem. Here is the table that lists the debt-to-GDP ratio as a function of GDP growth:

Nominal GDP growth Debt as a share of GDP
6% 201%
5% 209%
4% 216%
3% 225%

It is in my opinion almost impossible that China would be able to improve its financial efficiency so dramatically without a significant slowdown in growth, but at least mechanically it is clear that if China were able to do so while maintaining nominal growth rates on average of 5-6%, by the end of ten years China’s debt to GDP ratio would be largely unchanged, although this would only happen after having risen to 235% during the first five years.

This set of scenarios probably represents the absolute upper limit of optimism for anyone who hopes that China can adjust smoothly and non-disruptively over a ten-year period without a dramatic change in policy, most importantly a process of wealth transfer in which as much as 2-4% of GDP is transferred from the state sector to ordinary households every year for many years. Under these scenarios debt stabilizes at a sustainable level at the end of the ten-year period, and growth rates remain reasonably high, but it is important to specify the assumptions to make clear just how difficult and unlikely this set of scenarios is likely to be:

  1. We are assuming that TSF captures the total relevant amount of debt.
  2. We are assuming that the growth in debt-servicing capacity is on average equal to the growth in nominal GDP.
  3. We are assuming that the financial system will adjust smoothly and without friction.
  4. We are assuming that there are no financial distress costs, so that as debt rises, it does not put downward pressure on GDP growth.
  5. Finally, and this is a fairly complex assumption, we are assuming that if there is unrecognized bad debt in the banking system that is being rolled over regularly, the interest cost is effectively zero. If the amount of bad debt in the system is low, we can safely ignore this assumption, but if say 20% of the loans consist of unrecognized bad debt, this will increase the growth rate of debt by perhaps 1-2 percentage points annually.

Obviously this set of scenarios – in which GDP grows on average at rates between 3% and 6% for ten years while credit efficiency is improved so dramatically that in 5-6 years China begins to deleverage and by the end of the period these growth rates can be maintained with no growth in credit – is theoretically possible, but just as obviously it is highly implausible, and I cannot think of any country in history that has achieved such a turnaround in its financial sector without having first experienced a brutal financial crisis. No matter how I work the numbers it just seems to me very obvious that unless it sharply speeds up the process of transferring wealth to the household sector so that consumption can grow much more quickly, China simply does not have ten years in which to manage a non-disruptive adjustment unless we are willing to make assumptions so heroic that even El Cid would blanche.

Varying the adjustment period

If we do the same exercise using the same assumptions we used in our very fist set of scenarios, but allow for a longer adjustment period, say fifteen years, we get the following results:

Nominal GDP growth Debt as a share of GDP
6% 307%
5% 297%
4% 286%
3% 276%

These numbers are clearly too high and show that there is no point in trying to develop scenarios in which China adjusts more slowly over a longer period of time. The argument that the more carefully and slowly Beijing manages the adjustment process, most especially the reform of the financial sector, the less likely it is to be disruptive, can only be true if we assume that there is no limit to Beijing’s ability to raise debt credibly.

If instead we go in the other direction and assume that Beijing adjusts more aggressively, and if we do the same exercise using the same assumptions but this time posit a seven-year adjustment period, we get the following three sets of results. The first set assumes that at the end of the 7-year period debt is growing at the same rate as nominal GDP:

Nominal GDP growth Debt as a share of GDP
6% 250%
5% 245%
4% 241%
3% 236%

The second set assumes that at the end of the 7-year period the nominal growth in debt is zero:

Nominal GDP growth Debt as a share of GDP
6% 200%
5% 205%
4% 211%
3% 217%

In this scenario debt rises to roughly 225% of GDP during the first four years before declining. And finally the third set of scenarios assumes that there is no improvement in the credit intensity of growth:

Nominal GDP growth Debt as a share of GDP
6% 317%
5% 297%
4% 277%
3% 259%

For the sake of completion, I will make the same set of assumptions and assume that Beijing moves even more aggressively, and in the first set of scenarios gets the growth in credit to keep pace with the growth in nominal GDP within five years, and in the second set of scenarios gets credit the growth in credit to drop to zero within five years. Here is the relationship between credit growth and GDP growth:

Nominal GDP growth Debt as a share of GDP
6% 235%
5% 232%
4% 229%
3% 226%
Nominal GDP growth Debt as a share of GDP
6% 199%
5% 203%
4% 207%
3% 212%
Nominal GDP growth Debt as a share of GDP
6% 281%
5% 268%
4% 256%
3% 243%

Once again in the second set of scenarios, in which the improvement in the financial sector is so dramatic that within a few years China begins to deleverage and in five years GDP is able to grow with no growth at all in credit, debt rises to 27-19% of GDP in the first three years before declining.

I can keep going but the conclusions are pretty clear.

  1. Credit growth in China is too high as are current debt levels, and the sooner Beijing gets credit growth under control, the better. This latter statement in itself is not controversial of course, but my simple debt model shows just how urgent it is for Beijing to get credit growth under control. It clearly does not have ten years or even seven years. It might have five years, but only if the markets – Chinese investors, businesses, and savers, both wealthy and middle class – are convinced that it is moving in the right direction.
  1. There is no obvious level at which debt levels for any country are too high, but China is already at the very high end among developing countries, and of course the more debt rises relative to GDP, the greater the risk of some kind of debt-related disruption.
  1. If you ask most economists why “too much debt” is bad, they will tell you that it is because the higher the level of debt, the greater the risk of a debt crisis. Unfortunately this very unsophisticated answer turns the discussion about debt into a discussion about why China will or will not have a debt crisis at current or future projected debt levels.

It also means, unfortunately, that for those who believe (and I include myself in this group) that the structure of Chinese financial markets and Beijing’s high credibility give it protection from the risk of debt crisis – so that a debt crisis is unlikely except at very much higher debt levels – there is little to worry about. In fact the real cost of excessive debt levels is what finance specialists call “financial distress” costs, and I have explained elsewhere how debt can become excessive. China is already experiencing financial distress costs and as debt rises, these costs will make it harder and harder for China to achieve target growth rates except at the expense of even more debt, so that rising debt automatically means lower growth than otherwise.

There is so much evidence supporting the view that high debt levels in an economy reduce that economy’s growth that it is surprising how few economists understand the urgency of getting credit growth under control. In the past whenever growth has slowed sharply in an overly indebted economy, economists blame the inadequacy of reforms and the cowardice of policymakers, but if slower growth has happened in every single case of excessive debt, it is absurd to blame the pusillanimity of policymakers. We are already seeing how rising debt levels have caused Chinese growth to drop below projections year after year, and already economists are shifting the blame from their ineffective models to the incompetence of Beijing’s economic stewardship. And as debt continues to grow, the economy will continue to slow, and economists will continue to blame Beijing’s incompetence.

  1. The great difficulty of reducing credit growth is that it will lead to higher unemployment as manufacturing capacity is closed down and less infrastructure built. The only way to prevent rising unemployment is by opening up or increasing other sources of demand that do not require even faster growth in credit.

Some of these other sources of demand, like a greater current account surplus or enough of a realignment of the financial sector towards productive investment, are too impractical or uncertain to rely on, and in the end the only certain alternative source of demand is domestic consumption. Domestic consumption, however, is constrained by the low household income share of GDP, as I explained in the opening section of this essay, and so Beijing must speed up the process as much as it can. Ultimately the only way it can do so is by transferring wealth from the state sector to the household sector, something it is trying to do and which is recognized in the Third Plenum reforms, but this is politically very tough.

I would argue that if China can engineer a process by which at least 2% of GDP is transferred directly or indirectly to the household sector every year (or is used to pay down debt), it can easily avoid a debt problem or many years of economic stagnation. If it doesn’t, however, it is hard to see how China can adjust quickly enough to avoid at the very least a “lost decade” or two of low growth.

  1. In every one of its economic policymaking choices, Beijing must ultimately choose between higher debt, higher unemployment, or higher transfers of wealth from the state sector to the household sector. Every single policy results in some combination of the three. The time frame within which this must be resolved is set by deb capacity limits, and as my model shows, Beijing probably has no more than five years, perhaps much less, within which to resolve the rebalancing if it wants to avoid a disruptive rebalancing.

What I like about the model I have described above is that it doesn’t allow analysts to hide their implicit assumptions about credit growth, GDP growth, and the relationship between the two. With this model an analyst can make any assumption he likes about the economy and about economic reforms, and from there make explicit assumptions about the consequent growth in debt and the growth in GDP, and see if these are at all consistent. It also makes clear that the real difference in opinion about sustainability will only show up in terms of medium- and long-term growth forecasts. It doesn’t tell us anything that China grows by 7% next year, for example. As long as China has sufficient debt capacity, the economy can grow at any rate Beijing chooses.

What matters is the associated growth in credit. If growth next year of 7% were achieved with 18% growth in credit, things would actually be getting worse, not better. On the other hand if China grew next year by 5%, with credit growing at “only” 8%, this would represent a significant improvement in China’s medium- and long-term growth prospects. This is something that a lot of economists seem to have real trouble in understanding. There is no “good” level of economic growth independent of the associated growth in credit.

Ultimately, and to repeat Conclusion 5 above, Beijing must continuously choose between a rising debt burden, rising unemployment, or rising transfers of wealth from the state sector. All of its policy options boil down to one or more of these three. So far it has mostly chosen the first, but this can only go on until the country reaches debt capacity limits.



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Thin Air’s money isn’t created out of thin air

A recurring conversation I have with clients concerns the ability of banks to create credit, and of governments to monetize debt, and whether this ability is the solution to or the cause of financial instability and economic crisis. Monetarists and structuralists (to use Michael Hudson’s names for the two sides, whose centuries-long debate pretty, exemplified by Thomas Malthus and David Ricardo during the Bullionist Controversy, dominates the history of economic thinking) have very different answers to that question, but I will suggest that each side disagrees because it implicitly assumes an idealized version of an economy.

We are normally taught that banks allocate credit by lending the money that savers have deposited in the banking system, but in fact banks create deposits in the banking system by creating credit, so it seems to many as if they can create demand out of nothing. Similarly, if governments are able to create money, and if they can borrow in their own currency, they can easily monetize debt, seemingly at no cost, by “printing” the money they need to repay the debt (actually by crediting bank accounts, which amounts to the same thing). This means that when they borrow, rather than repay by raising taxes in the future, all they have to do is monetize the debt by printing the money needed to repay the debt. It seems that governments too can create demand out of nothing, simply by deficit spending.

There is a rising consensus – correct, I think – that the misuse of these two processes – which together are, I think, what we mean by “endogenous money” – were at the heart of the debt surge that was mischaracterized as “the great Moderation”. For example in a book published earlier this month, Between Debt and the Devil, in which he provides a description of the rise of debt financing in the four decades before the 2008-09 crisis, along with the economic risks that this has created, Adair Turner specifies these two as fundamental to the rising role of finance in the global economy. He writes:

…in modern economics we have essentially two ways to produce permanent increases in nominal demand: either government fiat money creation or private credit money creation.

I am less than half-way through this very interesting book, so I am not sure how he addresses the main characteristics of debt, nor whether he is able to explain how much debt is excessive, or identify the main ways in which the liability side of the macroeconomic balance sheet intermediates behavior on the asset side to determine the growth and volatility of an economy. He invokes the work of Hyman Minsky often enough, however, to suggest that unlike traditional economists he fully recognizes the importance of debt.

And it is because of this importance that the tremendous confusion about what it means to create demand out of nothing is dangerous. When banks or governments create demand “out of this air”, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other equally easily specified cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand “out of thin air”, as many analysts seem to think, and doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.

I had originally intended this blog entry to be a response to questions in some of the comments following my last blog post, but because my response turned out to be too long to submit as a comment, and because the questions lead to a far more complex answer than I had originally planned, it has become a blog entry in its own right. The questions arise in the context of a discussion of some of Steve Keen’s work among several regular commenters on my blog. Keen is an Australian post-Keynesian who heads the School of Economics, History and Politics at Kingston University in London.

I’ve known of Keen’s work for many years, and last year he spoke at my PKU seminar on central banking (as has Adair Turner, by the way). He is one of the most hard-core proponents of Hyman Minsky, and regular readers know that I think of Minsky as one of the greatest economists since Keynes. In the third chapter of my 2001 book, The Volatility Machine, I explain the ways in which developing countries designed balance sheets that systematically exacerbated volatility – and which eventually led to debt-based contractions or financial crises – in terms of a framework that emerges from the work of Minsky and Charles Kindleberger. This framework – something that many Latin American economists have no trouble understanding but which has been ignored by nearly all Chinese and foreign economists covering China – explains why three decades of economic expansion in China, underpinned by rapid growth in credit and investment, would lead almost inevitably to destabilizing debt structures.

Hyman Minsky’s balance sheets

Minsky is important not so much for the “Minsky Moment”, a phrase he never used, but rather because of his profoundly intuitive balance-sheet oriented understanding of the economy, something that set him completely apart from most contemporary academic economists who, for the most part, have barely begun to incorporate balance sheet dynamics into their analyses. Minsky’s insights include his now-well-known description of accelerating financial fragility, along with his explanation of why instability is inherent to the financial sector in a capitalist economy.

Most insightful of all, Minsky characterized the economy as a system of interlocking balance sheets, and because he taught us to think of every economic entity as effectively a kind of bank, with one entity’s assets being another’s liabilities, it follows that economic performance is partly a function of the direction and the extent in which the two sides of each balance sheet are mismatched. Because these mismatches vary as a consequence of past conditions and future expectations, when institutional distortions are deep, balance sheet mismatches in the aggregate can be systemic, in which case they determine how an economic system behaves and responds to exogenous and endogenous shocks.

Minsky’s framework made it especially easy to predict the difficulties that China would face once it began to rebalance its economy. China can be described as an extremely muscular illustration of Minsky’s famous dictum that “stability is destabilizing”. Its financial system was designed to meet China’s early need for rapid credit expansion, and it evolved around what seemed like permanently high growth rates and uninterrupted access to financing. Two decades of “miracle” levels of investment-driven growth, the role of the financial sector in that growth, and the unrealistic expectations that Chinese businesses, banks, and government entities had consequently developed, reinforced by sell-side cheerleaders, made it obvious that the interlocking balance sheets that make up the Chinese economy had added what was effectively a highly “speculative” structure onto the way economic entities financed their operations.

This would sharply enhance growth rates during the expansion phase, much like margin borrowing enhances returns when market prices are rising faster than the debt servicing costs, but at the expense of sub-par performance once conditions reverse. The process is actually quite easy to describe, and the fact that it caught nearly the entire community of analysts by surprise should indicate just how unfamiliar economists are with the approach championed by Minsky.

Ignoring the balance sheet framework does not always result in bad economics. When debt levels are low, and the economy close to a kind of Adam Smith type of economy, in which there are no institutional constraints and no entities large or important enough to affect the system as a whole, it makes sense to ignore liabilities and to analyze an economy only from the asset side in order to understand and forecast growth. Evaluating only the asset side would still be conceptually wrong, because both sides of the balance sheet always matter, but the difference between analyses that ignore the liability side and analyses that incorporate the liability side are small enough to ignore.

When conditions change in certain ways, however, the differences can become too large to ignore. The more deeply unbalanced an economy, the higher its debt levels, or the more highly systematically distorted its balance sheets, the more the two forecasts will diverge and the more urgent it is that economists incorporate the balance sheet in their analyses.

In a way it is like an engineer who builds a bridge using Newton’s equations rather than Einstein’s. In a motionless world, or in the close approximation in which most of us live, Newtonian errors are insignificant, and the bridge the engineer builds will carry traffic almost exactly as expected. As objects accelerate, however, these small errors eventually become vast, and the Newtonian bridge risks becoming useless.

In the early 1990s the models that most economists used to analyze and explain Chinese economic growth were good enough, like the Newtonian bridge in the slow moving world in which humans operate. By the late 1990s, however, the sheer extent of bad debt within the banking system should have provided a warning that mismatches and imbalances might have become large enough to invalidate the old models. They clearly did invalidate the old models over the next few years as credit misallocation accelerated, along with the depth and direction of now-unprecedented imbalances and highly self-reinforcing price changes in commodities, real estate, stock markets, and other variables – what George Soros might have cited as extreme cases of reflexivity.

Violating identities

To get back to the discussion in the comments section, a very brisk and active debate broke out among a number of readers over Keen’s claim that next period growth is a function of both this period’s economic conditions as well as this period’s change in debt. I won’t summarize the discussion, which is long and wide ranging, but part of the disagreements have to do with whether Keen’s dynamic model, which incorporates changes in debt, implies that the accounting identities I use are somehow invalid.

One reader, Vinezi, wrote “Michael has been repeatedly saying that he is using the same identities as the basis of his research for the last 10 years. All his insights presented on this blog, which, in my opinion, are spectacularly correct, are derived from the application of these very identities”. Vinezi then goes on to ask for my response to Keen’s rejection of these identities, most importantly the identity between savings and investment.

I don’t know if Keen actually rejects the identity, but I doubt that he does because he is too good a mathematician not to know that identities cannot be “accepted” or “rejected” like hypotheses or models. More generally I would never say that I am using this (or any other) identity as the basis for my research, as Vinezi states, because the point of research is, or should be, to test hypotheses (or, in a common but sloppy practice, to discover hypotheses). You cannot “test” accounting identities, however, because they are not hypothetical. They are true either by definition or as a logical necessity (which may well be the same thing), and there is no chance that they can be wrong.

I do refer often to basic accounting identities, but mainly because too many economists and analysts allow themselves to become so confused by balance of payments arithmetic, money creation, and so on, that they try to explain the relationships among different variables by proposing hypotheses that violate accounting identities. In that case their hypotheses are simply wrong, and rejecting them does not require any empirical support. Rather than use empirical data to “test” the identities, it is more accurate to use the accounting identities to “test’ the data. If the data seems to violate the identities, then it must be the case that the data is incorrectly collected or incorrectly interpreted.

The important point about accounting identities – and this is so obvious to logical thinkers that they usually do not realize how little most people, even extremely intelligent and knowledgeable people, understand why it matters – is that they do not prove anything, nor do they create any knowledge or insight. Instead they frame reality by limiting the number of logically possible hypotheses. Statements that violate the identities are self-contradictory and can be safely rejected.

Accounting identities are useful, in other words, in the same way that logic or arithmetic is useful. The relevant identities make it easier to recognize and identify assumptions that are explicitly or implicitly part of any model, and this is a far more useful quality than it might at first seem. Aside from false precision, my biggest criticism of the way economists use complex math models is that they too-often fail to identify the assumptions implicit in the models they are using, probably because they are confused by the math, and they would often be forced to do so if they weren’t so quick dismiss accounting identities on the grounds that these identities don’t tell you anything about the economy.

It’s true, they don’t. But arithmetic doesn’t tell you anything about how to build a bridge either. Unlike economists, however, engineers have no choice but to stick rigidly to the identities. While economists tolerate models that are not constrained by accounting identities because, for some reason, economists do not seem constrained by the need for their models of the economy to conform to reality, any engineer whose model for a bridge requires that two plus three equal seven would find it hard to build bridges, harder to find clients, and even harder to get a teaching job at any university. Remembering always to maintain accounting identities does not lead to true statements or to brilliant insights, but it does make it easy to reject a very large class of false or muddled statements. Just as logic doesn’t create science, but it prevents us from making bad science, identities do not create models, but they protect us from useless models.

Keynes, who besides being one of the most intelligent people of the 20th century was also so ferociously logical (and these two qualities do not necessarily overlap) that he was almost certainly incapable of making a logical mistake or of forgetting accounting identities. Not everyone appreciated his logic. For example his also-brilliant contemporary (but perhaps less than absolutely logical), Ralph Hawtrey, was “sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships”, according to FTC economist David Glasner, whose gem of a blog, Uneasy Money, is dedicated to reviving interest in the work of Ralph Hawtrey. In a recent entry Glasner quotes Hawtrey:

[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment an saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary.

This is a very typical criticism of certain kinds of logical thinking in economics, and of course it misses the point because Keynes is not arguing from definition. It is certainly true that “identity so established cannot prove anything”, if by that we mean creating or supporting a hypothesis, but Keynes does not use identities to prove any creation. He uses them for at least two reasons. First, because accounting identities cannot be violated, any model or hypothesis whose logical corollaries or conclusions implicitly violate an accounting identity is automatically wrong, and the model can be safely ignored. Second, and much more usefully, even when accounting identities have not been explicitly violated, by identifying the relevant identities we can make explicit the sometimes very fuzzy assumptions that are implicit to the model an analyst is using, and focus the discussion, appropriately, on these assumptions.

No surpluses on both the capital and current accounts

A case in point is The Economic Consequences of the Peace, the heart of whose argument rests on one of those accounting identities that are both obvious and easily ignored. When Keynes wrote the book, several members of the Entente – dominated by England, France, and the United States – were determined to force Germany to make reparations payments that were extraordinarily high relative to the economy’s productive capacity. They also demanded, especially France, conditions that would protect them from Germany’s export prowess (including the expropriation of coal mines, trains, rails, and capital equipment) while they rebuilt their shattered manufacturing capacity and infrastructure.

The argument Keynes made in objecting to these policies demands was based on a very simple accounting identity, namely that the balance of payments for any country must balance, i.e. it must always add to zero. The various demands made by France, Belgium, England and the other countries that had been ravaged by war were mutually contradictory when expressed in balance of payments terms, and if this wasn’t obvious to the former belligerents, it should be once they were reminded of the identity that required outflows to be perfectly matched by inflows.

If Germany had to make substantial reparation payments, Keynes explained, Germany’s capital account would tend towards a massive deficit. The accounting identity made clear that there were only three possible ways that together could resolve the capital account imbalance. First, Germany could draw down against its gold supply, liquidate its foreign assets, and sell domestic assets to foreigners, including art, real estate, and factories. The problem here was that Germany simply did not have anywhere near enough gold or transferable assets left after it had paid for the war, and it was hard to imagine any sustainable way of liquidating real estate. This option was always a non-starter.

Second, Germany could run massive current account surpluses to match the reparations payments. The obvious problem here, of course, was that this was unacceptable to the belligerents, especially France, because it meant that German manufacturing would displace their own, both at home and among their export clients. Finally, Germany could borrow every year an amount equal to its annual capital and current account deficits. For a few years during the heyday of the 1920s bubble, Germany was able to do just this, borrowing more than half of its reparation payments from the US markets, but much of this borrowing occurred because the great hyperinflation of the early 1920s had wiped out the country’s debt burden. But as German debt grew once again after the hyperinflation, so did the reluctance to continue to fund reparations payments. It should have been obvious anyway that American banks would never accept funding the full amount of the reparations bill.

What the Entente wanted, in other words, required an unrealistic resolution of the need to balance inflows and outflows. Keynes resorted to accounting identities not to generate a model of reparations, but rather to show that the existing model implicit in the negotiations was contradictory. The identity should have made it clear that because of assumptions about what Germany could and couldn’t do, the global economy in the 1920s was being built around a set of imbalances whose smooth resolution required a set of circumstances that were either logically inconsistent or unsustainable. For that reason they would necessarily be resolved in a very disruptive way, one that required out of arithmetical necessity a substantial number of sovereign defaults. Of course this is what happened.

The same kind of exercise eight-five years later, shortly after the euro crisis, made it clear that Europe was limited by similar accounting identities to three options. First, Germany could reflate domestic demand by enough to exceed the consequent increase in its domestic production of goods and services by at least 4-5% of GDP, and probably more (i.e. it had to run a current account deficit). Second, peripheral Europe could tolerate excruciatingly high unemployment for at least a decade, and probably more.

Third, peripheral Europe could leave the euro and restructure its debt with substantial debt forgiveness – or, which is nearly the same, force Germany to leave the euro, which would require much less debt forgiveness – causing losses in the German banking system at the same time that it caused Germany’s manufacturing sector to drop precipitously. (A fourth option, that Europe could run huge surpluses with the rest of the world, perhaps two times or more than its current surplus, was too implausible to consider, and although Europe is certainly running irresponsibly high surpluses, they are not high enough to allow Europe to grow.) So far Europe has chosen the second option, with a high probability, in my opinion, that before the end of the decade it will be forced into the third.

This is why we must keep accounting identities firmly in mind. They don’t tell us what to do, but keeping them in mind prevents us from proposing, or believing arguments, that are clearly inconsistent, or often simply idiotic. To take another immediate example, one of the few recent bits of cheer in our otherwise very glum world has been the almost teenagerish excitement with which David Cameron has been BFFing. It’s not all just unconditional friendship, however, and apparently he hopes to get big deals and significant inward investment announced in the next week. It sounds good, but, a firm grasp on the accounting identities would identify which kinds of “big deals” are likely to boost GDP and which merely to shift the locus of GDP creation.

More importantly, it would show that for a rich, developed country like England, inward investment almost always affects growth adversely (unless it brings technological and managerial advances with it) and never more obviously so than when interest rates are struggling against the zero bound and every country is urgently trying to export excess savings. As one of my exasperated PKU students asked me after class last Saturday when we discussed the president’s trip: “So everyone agrees that it is good for England to get much more foreign investment, and everyone also agrees that it is bad for England to have a much bigger trade deficit. Don’t they know it’s the same thing?”

Not everyone does, but to return to the reference I made to discussion in the comments section that started this essay, regardless of whether or not Vinezi is correctly interpreting Steve Keen on the savings and investment identity, does his claim – that an increase in debt causes a corresponding increase in GDP growth (and the conditions under which this is likely to be true correspond closely, I think, with current conditions) – imply that investment can exceed savings? Or as Vinezi puts it:

Steve Keen, ErikWim, Suvy & Willy2 claim that the mistake Michael makes is that he is using a “loanable funds model” in which savings and investment are “merely being matched with each other”. Steve Keen, ErikWim, Suvy & Willy2 are pointing to the new “endogenous money model” of the modern-banking sector in which investments can be made even without having the savings a priori. Yes? Would the “Steve Keenites” here please confirm that this is how all of you would like to correct Michael’s “flawed” identity? Michael, if you read this, would you please respond to their attack on your most fundamental research assumption?

Before responding I have two parenthetical responses. First, the savings and investment identity is not my “most fundamental research assumption” because it is not an assumption at all, and it cannot be meaningfully used in research. Second, the loanable funds model does indeed permit credit to be created “out of thin air” (it is perhaps what we would call the neoclassical tradition that doesn’t, although I have to admit I don’t always keep the lines between different traditions terribly sharp), and while there is much that I find deeply insightful in both Knut Wicksell – and I assume that his “cumulative process” is part of the intellectual tradition on which “loanable funds” is based – and his rival Irving Fisher, I don’t think of the work of either of them as supporting or opposing my use of the saving and investment identity to understand global imbalances.

It might seem that Wicksell denies the savings and investment identity because he says that the two are equal only when the money interest rate is set equal to the natural interest rate. We see that in a 1986 paper by Richmond Fed economist Thomas Humphrey (whose books are unfortunately out of print):

The cumulative process analysis itself attributes monetary and price level changes to discrepancies between two interest rates. One, the market or money rate, is the rate that banks charge on loans. The other is the natural or equilibrium rate that equates real saving with investment at full employment and that also corresponds to the marginal productivity of capital. When the loan rate falls below the natural rate, investors demand more funds from the banking system than are deposited there by savers. Assuming banks accommodate these extra loan demands by issuing more notes and creating more demand deposits, a monetary expansion occurs. This expansion, by underwriting the excess demand for goods generated by the gap between investment and saving, leads to a persistent and cumulative rise in prices for as long as the interest differential lasts.

This might seem indeed to violate my claim that any model that requires or even permits global investment to exceed savings is logically impossible, but this is only because the difference lies in what economists call the ex ante quantities. This means that at any given money interest rate (other than the natural interest rate), desired savings may differ from desired investment, but one or the other (or both) must adjust so that in the end they do equate, the result being a sub-optimal amount of investment. Excessively low interest rates in China (until 2012) meant, for example, that desired investment was far too high, and much higher than desired savings, but in a financially repressed system, as I have shown many times, low interest rates can actually force up savings by constraining the household income share of GDP, which is what happened not just in China before 2012 but also in Japan in the 1980s.

I think what Keen might actually be saying is that if investment in the next period is greater than savings in the current period – if it is boosted, so the argument goes, by the ability of the banking system to fund investment by creating debt “out of thin air” – this does not violate the identity, and it is not only possible, but even likely. (If by any chance Steve keen should read this, perhaps he might respond.)

Creating demand “out of thin air”

But it is possible not because banks can fund investment by creating debt “out of thin air”. This statement is either highly confused or it too-easily leads others into confusion. There is a related form of this question that often seems to come out of the MMT framework, although I have no idea if this is a misreading of MMT or if it is fundamental to the theory, but while banks can create debt, they do not automatically create additional demand. According to MMT, as I understand it, there is no limit to fiscal deficits because governments who control the creation of money can repay all obligations regardless of their taxing capacity simply by monetizing the debt (which of course means nothing more than exchanging debt which we call “debt” for debt which we call “money”).

A lot of people seem to think that this means the state can create demand out of thin air, and so demand created by the state can be added to existing demand with no other change, including no increase in savings. If savings and investment had previously balanced, according to this argument, and the state creates new demand, either this new demand is in the form of investment, in which case investment becomes greater than savings, or the new demand is in the form of consumption, in which case savings is reduced (savings is the obverse of consumption), and so once again investment exceeds savings.

This seems like a perfectly logical argument, except that it is perfectly impossible. For reasons that I will explain in the appendix to this essay, to say that investment is greater than savings is to say that the total amount of goods and services we produce is greater than the total amount of goods and services we produce, and that cannot be true.

So where is the flaw in the argument? It turns out that thanks to these same identities it is pretty easy logically to work out the flaw, and in fact to extend this process of working it out to show – and maybe this is contrary to what MMT implies, or at least to what many people think MMT implies – that there most certainly are limits to fiscal deficits, and that the state’s ability to monetize its debt does not mean that it can borrow indefinitely without, eventually, destroying the economy and undermining the credibility that allows it to borrow in the first place.

At the beginning of this essay I said: “When banks or governments create demand, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other, equally easily specified, cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand out of thin air, as many analysts seem to think, because doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.”

To work through the two different ways demand seems to be created, for convenience I will refer to the entity for whom demand is created “out of thin air” as Thin Air. Thin Air, in other words, is either the entity to whom the bank made a loan, or it is the government agency responsible for the deficit spending:

  1. In the first case, assume that we are in an economy in which there is absolutely no slack. Workers are fully employed, inventories are just high enough to allow businesses to operate normally, factories are working at capacity, and infrastructure is fully utilized.

If in this case Thin Air’s expenditures cannot be satisfied without diverting goods and services that are being used elsewhere. Whether the new credit or the deficit spending goes to support investment or to fund consumption, all the goods and services that an economy is capable of creating are already being used by other economic entities.

This means that if Thin Air wants to spend money to buy goods and services, it must displace some other entity that is already using the goods and services that are being created by the economy, and it can only do so by bidding up the price of wages or resources. As a result prices will rise, and these higher prices will reduce the real value of money.

As a result, and because higher prices reduce the total amount of goods and services that can be acquired with a fixed amount of money, every economic entity that is long monetary assets – assets such as money, deposits in the bank, bonds, or most expected payments, like wages, pension receipts, etc. – loses some amount of wealth equal to the reduction in the real value of these monetary assets. Everyone who is short monetary assets – anyone who has fixed obligations, for example a borrower, or an employer who owes wages, etc. – gains some amount of wealth. The losses of the former exceed the gains of the latter, with the balance representing a net transfer of wealth to the government or to the bank that created the loan for Thin Air.

The transfer need not occur only through inflation. In a financial system that is highly repressed, Thin Air’s actions might even be disinflationary. China’s case shows how. Until 2012 whenever credit was created by the system, it was done so at extraordinarily low interest rates – nominal lending rates were often negative in real terms, and were always a fraction of nominal GDP growth rates, and deposit rates were always seriously negative in real terms – and these low rates represented a transfer of purchasing power from net savers, who were households for the most part. In that case the consequent growth in production exceeded the consequent growth in consumption (because it repressed household income growth) and so was disinflationary, but once again Thin Air’s spending represented a transfer because it simultaneously suppressed consumption.

Demand can only be created “out of thin air”, in either case, by suppressing consumption or investment elsewhere (in the latter case it is often called “crowding out”). At the moment the new demand is created, there is no change in the real value of GDP, although of course nominal GDP can rise or fall, depending on whether the transfer is inflationary or disinflationary.

Either way, if the suppressed demand consisted of investment, investment in the rest of the economy declined, whereas if it consisted of consumption, savings in the rest of the economy rose. This reduction in investment, or increase in savings, is the exact obverse of the increase in investment or consumption set off by the new demand created “out of thin air”, so that at no point is the identity between savings and investment ever violated.

  1. In the second case, assume the other extreme, in which the economy has a tremendous amount of slack – there are plenty of unemployed workers who have all the skills we might need and can get to work at no cost, factories are operating at well below capacity and they can be mobilized at a flick of the switch, and there is enough unutilized infrastructure to satisfy any increase in economic activity.

In this case when loan creation or deficit spending creates demand “out of thin air”, in other words, it also creates its own supply. When Thin Air spends money to buy certain goods or services, those goods and services are automatically created by switching on the factory equipment and putting unemployed workers to work.

There is also a multiplier at work here. Assume that Thin Air’s spending is for investment, and that it plans to acquire $100 of goods and services for investment purposes. Because it has no need to build capacity or acquire inventory, the full expenditures will go towards paying wages. Let us further assume that the newly hired workers save one-quarter of their income.

As Thin Air pays wages, the workers will spend 75% of those wages on their own consumption, and they will save 25%. Their own consumption will require the production of additional goods and services, which will require hiring more workers. In order that Thin Air acquire $100 of goods and services, it can easily be shown that the total expenditures of Thin Air and of consuming workers will be the original $100 divided by the 25% savings rate, so that in the end GDP will rise by $400, consisting of $300 additional consumption and $100 additional investment. Because the increase in GDP exceeds the increase in consumption by $100, total savings will have risen by $100.

In an economy with enough slack to absorb Thin Air’s investment fully, in other words, the investment creates enough of a boost in the total production of goods and services that it becomes self-financing – it increases savings by the same amount as it increases investment. Notice then, once again, that at no point is the identity between savings and investment ever violated.

  1. In reality no economy will ever have zero slack, as in the first case, or full slack, as in the second, but instead will exist in some combination of the two. In that case Thin Air’s demand created “out of thin air” will partly be met by suppressing demand or investment elsewhere within the economy, and partly by creating the larger amount of goods and services needed to satisfy the increased demand.

An important point that is often obscured by the intensely political discussion about savings is that in the second case, in which the demand created by Thin Air creates its own supply, it turns out that the lower the savings rate, the more GDP is created by any additional spending unleashed by Thin Air. Savings automatically rises to fund investment by causing the total amount of additional goods and services produced to rise by more than the total amount of additional goods and services consumed, with the difference between the two, savings, rising by exactly enough to fund Thin Air’s investment (and the same can easily be proven to be true if Thin Air’s expenditures were actually in the form of consumption).

What this exercise shows, among other things, is that in an economy working at full capacity, a higher savings rate is likely to increase GDP by more than a lower savings rate, whereas in an economy operating with a considerable amount of slack, i.e. with high unemployment and low capacity utilization, a lower savings rate is likely to increase GDP by more than a higher savings rate. What this also shows is that in an economy that has recently experienced a crisis, with falling output to below capacity, there is a tendency for households to raise their savings rate, and because of the multiplier, as they increase their savings rate the reinforce the downward trend in the economy.

As an aside this exercise also helps to reconcile the monetarist tradition with the structural tradition (within which I think MMT belongs). The debate between the two is a debate that has been raging for hundreds of years, most famously during the debate over the causes of inflation during the Napoleonic War, with the monetarists, or extreme bullionists led most famously by David Ricardo, and the structuralists, or moderate bullionists, led most famously by Malthus. Neither side is right or wrong except under specified conditions. The monetarists operate in a supply-sider’s world of full capacity utilization and zero unemployment, whereas the structuralists operate in a Keynesian world of weak demand, high unemployment and low capacity utilization.

  1. In the first case, the monetarist’s world, if Thin Air’s demand is invested in a project that increases productivity by more than the reduction in productivity caused by the transfer of wealth, it is sustainable. Otherwise it is not. If Thin Air suppresses consumption to fund productive investment, it will always lead to higher growth. If Thin Air suppresses productive investment to fund consumption, it will always lead to lower growth

If Thin Air suppresses private sector investment to fund investment, it becomes a little more complicated, and depends on which of the two “investments” is more productive. Because monetarists usually do not believe that government can ever choose investment projects that are more productive than the market can, they would argue that if Thin Air were a government agency engaged in deficit spending, GDP growth would be reduced, because more productive investment by the private sector was suppressed in favor of less productive investment by Thin Air.

There are however many cases of highly productive investment that the government directed in the past which the private sector was unlikely to have initiated. Today, with the private sector unwilling to fund much productive investment because of weak demand, much private sector investment consists of buying assets, which is not productive. In countries that have weak infrastructure, if Thin Air, whether a government entity or a government-encouraged entity, were to build infrastructure, it would almost certainly lead to higher growth.

  1. In the second case, the structuralist’s world, as long as there is enough slack in the economy that the new demand causes an increase in output that is equal to the sum of new demand and the marginal cost of new output, it is sustainable. Otherwise we eventually revert to the first case.
  1. Monetarists always insist that if the government is to spend money, it should not be in the form of deficit spending. The expenditure should be fully funded by tax increases. Notice however that in the first case, the monetarists’ world, expenditures are fully funded by tax increases, but this tax consists of the inflation tax. The monetarists argue that deficit spending, aside from reducing overall productivity, is inherently inflationary and increases economic uncertainty by undermining the stability of money. This is likely to be true the closer we are to an economy that resembles the first case.
  1. Finally one of the stranger and more incoherent arguments used by China bulls to propose that China’s large and soaring debt burden doesn’t matter is that China “owes the money to itself”. In that case why not simply monetize or socialize the debt, as MMT seems to suggest? One of the reasons is that in a world without an infinite amount of slack, monetizing the debt is no different than paying taxes, except that the tax is borne by those who are long monetary assets, i.e. Chinese household.

If China were to monetize the debt, which is effectively what it did in the past decade to resolve the enormous amounts of bad debt it had accumulated in the 1990s, this would simply reduce the household share of GDP, just as it did then, and with it the household consumption share. Put differently, it would force up the savings rate, which is the opposite of what China needs to do it if it to limit the growth of its debt burden. And notice that as the savings rate rises, growth drops through the declining multiplier as the GDP impact of Thin Air’s activities increases the savings rate.

What this exercise shows is that fiscal deficits or credit creation are good for the economy when there is enough slack in the economy that Thin Air’s expenditures do not suppress investment or consumption elsewhere in the economy, and they are good for the economy if and when Thin Air’s spending is more productive than private sector spending. Otherwise they are bad for the economy and are not sustainable.

But we already knew that. Supply-siders have explained why it is the case in a well-functioning economy, and Keynesians have explained why it is the case when the economy is operating far below capacity.


Appendix – savings is equal to investment

While defining investment and saving as different names for the same thing might at first glance seem a useless exercise, in fact, as I argued most recently in my long review of The Leaderless Economy (Peter Temin and David Vines), it is a rich way of understanding the links among national economies within the global economy as a single system. “Savings” can be defined in a number of ways, but the most useful way, and the convention in economics, is to define the supply of all the goods and services an economic entity produces in any period as consisting of two things. The first is everything currently consumed, including things that are lost, thrown away, or that rot away to nothing.

What is left and stored for future use is savings. The intuition is fairly obvious: everything that the economy produces is either currently consumed (or used up in some way), or it is set aside for future consumption, and we define savings broadly as whatever we set aside for future consumption out of current income. The important point is that these are accounting identities and are true because of the way we defined them.

Supply is equal to demand (another accounting identity), so that we can restate the accounting identity by saying that the demand for everything produced is either the demand for stuff we currently want to consume, or it is the demand for stuff that we want to use for future consumption. We call the latter “investment”. We might find it useful to further distinguish between two kinds of investment. One, which we might call an increase in “inventory”, consists of taking some of the goods we consume and storing them for later consumption. The other consists of goods and services that we cannot directly consume, but we produce them anyway because they might help us produce even more goods and services for us to consume in the future. If we produce a hammer, for example, or a tractor, we will probably never want to “consume” either, but these can help us produce even more goods and services in the future.

Buying an existing asset is often called “investing”, but we can safely ignore its impact, either because we define investment as setting aside additional goods and services, or, if we decide to define the buying of existing assets also as investment, because in that case the existing asset is simultaneously an increase in investment and an equivalent increase in savings. Either way it does not change the result of our accounting identity at the time it occurs, although of course when enough money is invested in existing assets so that its price rises, we may feel wealthier and so reduce our savings, or, which is the same thing, increase our consumption.

Because the supply of all the goods and services that an economy produces is equal to the demand for all the goods and services that an economy produces, then as long as we are consistent in our definition of consumption, it is true by definition that investment is equal to savings. This is only the case, of course, in a closed system, like the global economy. In an open system, like a country, investment and savings are rarely equal, but the sum of the excess of savings over investment in some countries and of the excess of investment over savings in others must always equal zero – another accounting identity.

This is just a way of saying that all the current account or trade surpluses in the world must add up to the same number as all of the current account or trade deficits. I explain why in my review of The Leaderless Economy. This is also a way of saying why this statement by the St. Louis Federal Reserve Bank, provided to educate the public in their “Ask an Economist” program (how ironic), is wrong to the point almost of inanity:

Perhaps the most serious issue with foreign investment is that it effectively disguises a lack of domestic savings. But domestic savings are the result of Americans’ individual and governmental decisions and are only modestly influenced by foreign demand for U.S. assets. We have our economic destiny in our own hands.

Because savings and investment must always balance, the idea that the savings rate in any country is determined at home is nonsense. In countries that intervene heavily in trade and capital flows, this is almost true, but in countries that don’t, like the US, the truth is almost completely the opposite. The US does not determine its own savings rate, and almost cannot as long as it allows unlimited access by foreigners to its asset markets. Knowing the accounting identities would have made this very clear.


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