"Americans 'May' Feel Richer" But Michael Pettis Warns "It's Not Sustainable"

Submitted by Doug Pancoast via Controversial Truths blog,

"ControversialTruths.com" is truly honored that Michael Pettis agreed to do an interview with our site. Michael Pettis, as many of our readers already know, is a finance professor at Beijing University (commonly referred to as "China's Harvard"). On his site, he mentions his experience as a "Wall Street veteran, merchant banker, equities trader, economist, finance professor, (and) entrepreneur." I've read two of his most recent books The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy and Avoiding the Fall: China's Economic Restructuring and I personally guarantee you that Michael Pettis is a leading thinker when it comes to both the Chinese economy and the overall global balance of trade. He's one-of-a-kind individual who throughout his books is passionate about trying to judge things fairly...and not see economic issues from a single country's perspective or from a single ideological framework. When he speaks, you know you should listen because you're going to get information that is not only based on decades of experience both in the private sector and academia, but you're getting it from a person who seems to have absolutely no biases whatsoever. Michael Pettis is a diamond and we're so thankful he took so much time to answer our questions. Here is a transcript of the interview. Both the questions and the answers are here in their entirety. You do not want to miss this...

1.) I was so impressed with how fair and evenhanded you are in the book and how you try to consider the viewpoints of all sides. I try to do this in my own writing, but find that it is sorely lacking in today’s society (and indeed throughout much of history). How do you manage to stay so unbiased and so fair in a world where people are tempted to be so prejudice towards one side or another?

Thanks for saying that. To the extent that it is true I think in part it may be because I have grown up around the world and effectively with multiple nationalities, and perhaps this has forced me to break free of a very provincial attitude among economists, especially those from large countries like the US or China, that prevents them from recognizing that changes in one country can force automatic and predictable changes in another, even though they know the accounting identities around which the balance of payments is structured that require these adjustments. We know, for example, that the current account balance for any country is exactly equal to the gap between savings and investment, and we also know that the sum of current account surpluses around the world is exactly equal to the sum of current account deficits. It is therefore necessary that if one country, for whatever reason, creates an imbalance between savings and investment, it will force the reverse imbalance on another country, and yet it is hard to find an economist that understands the practical implications of globalized trade and capital flows. They usually prefer to base their explanations on an attack on their ideological enemies or a defense of their ideological friends. It is possible for Spanish economists, for example, to engage in a furious and highly politicized debate about the domestic policy distortions that “caused” the country’s savings deficit (one side blames workers for high wages and the other side blames bankers for dumb lending) without once acknowledging that both high wages and dumb lending might be, and in this case certainly are, the consequence of policies in Europe which the Spanish economy was unable to absorb in any other way.

Economists also too easily allow nationalism, ideological differences, or the pleasure of moralizing to guide their explanation even of issues that involve accounting identities. It should be very easy, for example, to understand why China has the highest savings rate in the world. China's extraordinarily high savings rate is almost wholly explained by the transfer mechanisms that subsidized rapid growth over the past two decades, leaving Chinese households with the lowest share of GDP perhaps ever recorded. Arithmetic, not to mention historical precedents, can easily explain why these transfers, which during this century amounted to as much as 5-8 percent of GDP annually, would drive down household consumption by driving down the household income share of GDP, and of course high savings are simply the obverse of low consumption.

But many economists, not to mention other kinds of experts, still prefer to attribute China’s high savings rates to Confucian values, which is all the more strange when we remember that just fifty years ago East Asian countries tended to have very low savings rates, and moralizing economists then had no trouble blaming them on Confucian values, which, by the way, for much of Chinese history had been criticized for encouraging laziness and spendthrift habits. Economists want eagerly to assign virtue or vice, but sometimes it is easier simply to stick with arithmetic.

2.) I’m dying to know your thoughts on the Keynesian vs. Austrian debate on monetary policy? Do you find yourself lining up with doves like Janet Yellen who believe low interest rates are good for employment or people like Ron Paul and Stanley Druckenmiller who worry about price distortions and asset bubbles?

There is as you know a political divide between economists who focus primarily on managing demand to prevent the underutilization of labor and capital (often called Keynesians) and those who insist that it is only by increasing savings, which usually means increasing wealth inequality and allowing the benefits of growth to "trickle down", that we can generate the increases in investment that drive long-term economic growth (often called supply-siders, or Austrians, although for some reason true Austrians seem to loathe supply-siders). The point to remember is that rising inequality or, especially in countries like China, a declining household share of GDP, tends to force up the savings rate without raising the investment rate, and sometimes even lowering it, but because savings and investment must always balance (another accounting identity often forgotten in the debate), the tendency to force up the savings rate must automatically be balanced by an increase in investment, an increase in consumer debt, or an increase in unemployment. This is just a matter of logic.

Because of the political divide between supply-siders and demand-siders, most economists either oppose any and every policy that increases the savings rate through greater wealth inequality, or oppose any hint of demand management, socially if it involves fiscal spending, but it turns out – once again using little more that simple accounting identities – that there are conditions under which either supply-side policies or demand-side policies will increase long-term wealth. In fact Keynes, Hayek, and the rest of them understood quite well what those conditions are. To simplify enormously, when productive investment in the US is constrained by insufficient domestic savings (and an inability to import foreign capital to make up the difference), supply-side policies can genuinely create wealth that trickles down to the general population. When the world is suffering from insufficient demand, however, clearly the problem we face today, income inequality and excess savings are the problem, not the solution.

So, I would argue, today we are very obviously in a "Keynesian" world of structurally weak demand, in which policy must be aimed at increasing either consumption (reducing savings) or increasing productive investment. It would be preferable to do the latter, but it is politically very difficult to increase investment in US infrastructure through higher fiscal deficits, and of course the private sector is reluctant to increase investment, especially in manufacturing, without a revival in consumption. Washington is absolutely correct, in my opinion, to want to boost American consumption, but the Fed seems to be trying to boost consumption by igniting another asset bubble in the hopes that, like before 2007, Americans will feel “richer” and so will consume more. This isn't sustainable, however, and will leave us, as Paul and Druckenmiller fear, even more heavily indebted and more dangerously exposed to the underlying weakness in demand.

Unfortunately this analysis leaves us with policy recommendations that are unpalatable to both sides of the aisle. The US government must take the lead in rebuilding US infrastructure, which probably means increasing government debt (although it also means reducing the debt burden by increasing the value of the economy by more than the increase in debt). The US must also increase US consumption, however not by igniting another asset bubble and letting credit cards work their magic. There are really only two ways to increase household consumption sustainably. One is to force a redistribution of income from the richest Americans to the rest. The other is to impose trade tariffs or, what amounts to the same thing, to tax foreign purchases of US assets, especially US government bonds, in order to drive down the current account deficit and so allow the US to retain a larger share of what has become the most valuable commodity in the world: demand. Needless to say it is hard to imagine either political party, or anyone associated with either the supply-side or the demand-side ideology, signing up to the whole program.

3.) Do you think there is a global currency war going on?

Of course there is. Historically whenever global demand is weak, and unemployment high, countries will try to gain a larger share of that demand by reducing wages or otherwise taxing households to subsidize production (devaluing the currency is just a way to tax the consumption of imports and to subsidize exporters). Unfortunately these policies reduce demand further by reducing real household income and, with it, the amount households can spend. This is why in the 1930s these policies were referred to as beggar-thy-neighbor policies. In effect they forced countries to respond to weak global demand with policies that reduced their own contribution to global demand while grabbing a larger share of the smaller total.

But we must remember that they are not doing this to be pests. In most cases they have little choice. In a world with few constraints on trade or capital flows, if you try to raise domestic consumption by raising household income – for example by cutting income taxes, or raising wages – your contribution to global demand will indeed rise, but your export competitiveness will decline, and so you may retain a smaller share of that greater amount. In a globalized world, without a globally coordinated no-cheating boost in spending, beggar-they-neighbor policies may be systemically crazy but they are individually rational.

4.) You talked a little bit about the future of currencies in your book. In the book, you seemed to think the Euro might not survive and the dollar would continue to be the world’s reserve currency. Is that an accurate depiction of your views or not?

The US dollar will remain the world's dominant reserve currency for a very long time, mainly because it is the only currency that exhibits anywhere near the needed level of credibility, mobility, and low transactional costs and, what is more, for all the huffing and puffing about "exorbitant privilege" no other country is willing to pay the considerable cost of allowing its currency to be accumulated by foreign central banks whenever these countries experience weak domestic demand. The only way this will change, I think, is if, and perhaps when, Americans decide that they are no longer willing to enjoy the "exorbitant privilege" and Washington imposes restrictions on foreign purchases of US dollar assets, as was the case until the 1960s.

Five years ago I would have told you that this would never happen, but two things seem to have changed. First, as Americans become increasingly aware that when foreign central banks amass hoards of dollars and prevent others, including the Fed, from reciprocating, they aren’t doing the US any favors (and if they were, why are they so determined to prevent other central banks, including the Fed, from returning the favor?). Their purchases are aimed at boosting domestic employment, and for the US their purchases must result either in an increase in US debt or an increase in US unemployment. This may sound surprising to many people, including, shockingly enough, to many economists, but is actually quite easy to prove, either by using balance of payments arithmetic or by looking at the historical precedents.

Second, it seems to me that the US is becoming increasingly isolationist, largely because it is increasingly uncertain that the benefits to the US of a US-dominated world order still exceed the costs. As a committed internationalist I know of course, and worry, that any US withdrawal – political, military, or financial – will be painful and chaotic in the short term for the rest of the world, and especially the developing world, which is why it is such a slow and difficult process. As President Obama knows better than anyone else, Americans want the US to be less entangled abroad, but paradoxically they are also very critical of any resulting chaos that is the inevitable consequence of the US turning inwards. The alternative, however, might be worse for the US and for the world if a US withdrawal eventually occurs, and occurs when the country is economically weaker and forced by circumstances to withdraw.

5.) In the book, you talk about the European economy and your belief that the EU will likely eventually need to break up. I totally agree. Can you talk about why Spanish and Italian bond yields have fallen so low recently and do you think it can possibly continue? What effect have the ECB's LTRO programs and Draghi's hints and pledges of QE had? Are Europe’s leaders correct to be spiking the football and proclaiming that Europe is saved…or do you still think that European leaders will ultimately be unable to make the adjustments that you say in your book that Europe must make?

This is why I am worried about the long-term prospects for the euro. Europe, in a sense, suffers from a contained version of the global weakness in demand and the consequent imbalances. When German wage growth was forced down during the last decade, it caused, or at least accommodated, both a rise in the German savings rate and a decline in the German consumption rate (which is of course the same thing and which by the way had nothing to do with an increase in the fabled thriftiness of Germans). It also accommodated or even caused a decline in German investment. As German savings were forced up beyond German investment, by definition it had to run a large and growing trade surplus, and for a variety of fairly well-understood reasons this surplus was always likely to be balanced within Europe. Without the ability of smaller European countries to intervene in intra-European trade, or to manage an independent monetary policy, the only possible response, as in the global case, was a rise in the indebtedness of peripheral Europe, or a rise in unemployment. We saw the former before 2008 and the latter after.

In 2008 I argued that unless Berlin were willing to lead a European response, centered on a sharp rise in German demand, something Berlin didn't want to do because it would cause either their debt to grow or their export competitiveness to be undermined, peripheral Europe had only two options: break up the euro, or suffer punishingly high rates of unemployment for a decade or more. Europe seems so far to have chosen the latter, but with extreme right-wing parties scooping up votes by baying for the blood of bankers, demanding a withdrawal from the euro, and blaming foreigners – whether immigrants, the US, or China – for their malaise, it isn't clear to me how long these countries can continue to choose unemployment.

As for why rates are so low, the answer I think is pretty obvious and widely understood. With low or negative economic growth, a serious threat of deflation, and the willingness of the ECB to do "whatever it takes" to prevent a suspension of debt payments, which would bring down both the German and the French banking systems, rates will stay low either until the German banks have managed to recapitalize themselves enough to withstand sovereign-debt restructurings (after which the ECB commitment to do "whatever it takes" will almost certainly disappear), or until investor confidence, sapped by the irresistible and unending growth in the debt burdens of these countries, disappears.

6.) Though "The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy" was published just last year in 2013, in today’s fast changing world (and 24 hour news cycle), that might seem like an eternity ago. You just talked about Europe. How do you feel the rest of the world (the U.S., China, Japan) have done in taking the steps necessary to rebalance global trade and the global economy?

The US was fairly quick to begin the adjustment process, as it always is, but worsening income inequality all but guarantees that we will not see sustainable consumption growth for many years, and political gridlock makes the rollout of an infrastructure-improvement program unlikely. I do think the next decade might be relatively good for the US, however, but any recovery can be postponed or even derailed by events in Europe or elsewhere. At some point, as Americans always have in their history when income inequality got out of hand and the economy was in the doldrums, there will be a reversal of income inequality driven by politics, although this reversal will probably go, as it always does, too far.

Away from the US, I have already explained why I think Europe faces many more years of high unemployment, and as for Japan, I really have no idea of how Tokyo will address its debt problem. As long as growth and interest rates are close to zero, we can all pretend the debt burden is sustainable, but any sustained nominal GDP growth will force Tokyo into a tough decision on interest rates. They can keep rates low, in which case the great reversal of the Japanese imbalances of the 1980s will itself reverse, and the Japanese consumption share of GDP will weaken (and investment probably will too in response), which means that Japan will depend even more on foreign demand to keep unemployment from rising. Or Tokyo can raise interest rates, in which case debt costs will quickly become unsustainable, although I think government liabilities are long enough in duration that Tokyo will have a few years to adjust. Basically if Japan could resolve its debt burden at the expense of anyone but ordinary households, I think it could start to grow sustainably again.

Finally, among the major economies, Beijing has eliminated most of the main mechanisms that drove growth in the 1990s but which resulted in the deep imbalances of the past decade, along with the country's surging debt burden. But that is just the first of two steps. It now needs to take the next, politically much more difficult, step of liberalizing the economy, increasing the household share of GDP, and paying down the debt, although if it monetizes the debt or otherwise forces households to absorb the losses, which is what happened after its last debt crisis in the late 1990s, consumption will not be able to grow fast enough to bail out the economy.

India is sort of a wild card. Among the major economies it is the only country besides the US not to suffer from awful demographics, and like the US it has a great source of sustainable demand in the upgrading of its infrastructure, but when it comes to organizing the political ability to do so it is probably in even worse shape than the US. I am no India expert, but my Indian friends tell me that their combination of a highly entrenched and brutally constraining bureaucracy and the determination of a growing segment of the Indian population to turn one of India’s greatest strengths, their impressive diversity, into a source of rage, violence and instability, may trump their many advantages. As for the rest of the developing world, including Africa, high commodity prices always revives enthusiasm and hope, and low commodity prices, which I expect, always dash it. I hope this time is different.

7.) In your books, you seem careful not to directly blame China for the global imbalances, but you do mention how different countries’ domestic policies contribute to the global imbalances. As a professor at Beijing University, what Bill Clinton once called “China’s Harvard”, do you ever feel any pushback from your contacts here in China regarding some of your criticisms of government policy?

China imposed a series of necessary and very difficult reforms in the 1980s, followed by an investment-led growth policy that had proven successful for many, many countries in the last 100 years, but like every one of the countries that had a similar "growth miracle", it also developed deep imbalances and waited too long before it began the rebalancing process (all rapid growth, as Hirschman taught us in the 1960s, is imbalanced, and the imbalances must eventually be reversed). This is why I didn't think it made sense to "blame" China. It was following an historical process that nearly every developed or middle-income country, including the US, has followed, and now it faces the challenges that some overcame and some didn’t.

Given the very touchy nationalism that exists within China, of course I was criticized by some Chinese, although since I don't really criticize government policy so much as try to describe systematically the Chinese economy and place it as firmly as possible within its historical contexts, ultimately their criticism can only be that I failed to believe that China was gloriously exempt from historical processes. But it was not just aggrieved Chinese nationalists who were angry at me. I was far more criticized by foreign economists, especially by sell-side analysts, not so much for failing to support the overhyped nonsense that was the consensus for many years, but rather because I suggested, perhaps rudely sometimes, that any serious understanding of economic history, or of the experiences of other developing countries, or even of how balance sheets worked, made most of their claims about China’s growth prospects absurd. While these analysts were diligently compiling reams of data and processing them with all the resources Wall Street can dedicate to selling its services, I – and, I should add, a number of other economists – rejected their work as being useless and, what was worse, useless in a fairly obvious and predictable way.

But touchy nationalists and sell-side analysts aside, I never felt any pushback from Peking University or from the authorities and no one tried to prevent me from analyzing and writing about the economy. On the contrary, I think many Chinese economists, both among policy makers and among their advisors, read what I wrote very sympathetically and many agreed with my views, often even before I started writing about them. In fact if you read between the lines it is pretty obvious that as far back as 2007 many policy advisors in Beijing, along with Premier Wen, understood far better than most economists writing about China the kinds of imbalances that China was generating, and how difficult it was going to be, especially politically, for the adjustment process to take place.

There was always a popular myth among foreign China bulls, and it still exists today, that any skepticism about the Chinese growth miracle marks you out as a foreigner, because every relevant Chinese economist agreed fully with the ecstatic hype that the press and the sell-side were saying about China. But that was never true. You were far more likely to see skepticism and even serious concern among Chinese economists than among foreign economists, and I have only to mention the likes of Yu Yongding, who is both admired as an economist and influential among policymakers, who actually once jokingly accused me a conference of being too much of an optimist.

8.) In another of your books, "Avoiding the Fall", you mentioned that you expected that Chinese economic growth would not be steady in the future, but that China would likely avoid a hard landing. There’s a lot that goes on here behind the scenes in China. Sometimes, the government can be quick to take action. Other times, they can be a little slow. Has the new leadership of Xi Jinping and Li Keqiang impressed you with the actions that they have taken to try and rebalance China’s economy for the future?

Because I, like all but a group probably no more that 50-100 people, have no idea about what exactly is happening within leadership circles, I can't really answer except to say that on the surface President Xi and Premier Li are doing pretty much what we would have expected if China were to embark upon a successful rebalancing – one which would, of necessity, be opposed by what in China are referred to as the "vested interests". Given the opacity of the system of course we must always be prepared to find our assumptions wildly mistaken, but on the surface it looks like the Xi-Li administration is working its way successfully through what will nonetheless be a very difficult process.

9.) How confident are you about the global economy in the short-term, the medium-term, and the long-term (bearing in mind that Keynes famously once said that, “In the long run, we’re all dead.”)

Not to be flip, but when JP Morgan was asked to predict the direction of the stock market, he is supposed to have replied "It will fluctuate". As good enough an answer as that was, I would add that in the past 200 years whenever we have had a global crisis, we seem to lose confidence in ourselves and begin to lambaste democracies and decentralized economic systems for their inefficiencies and their inability to implement the "right" policies quickly and forcefully. But let’s not undervalue the inability of decentralized political and economic systems also to implement the wrong policies quickly and forcefully. Decentralized systems tend to correct mistakes relatively early, and do a pretty good job (or maybe a terrible job, but better than the alternatives) at economic adjustment. Growth always creates imbalances, and the important part always turns out not to be how quickly we grew during the good times but rather how successfully we adjusted from the imbalances.

This is why the political, legal, social and financial institutions that constrain the adjustment process for each country are so important. Not all growth miracles, for example, are followed by successful adjustments and more long-term growth. In fact they rarely are. The fastest growing country in history was probably Argentina in the four decades before 1914, but the subsequent decades nonetheless turned out pretty badly. We'll just have to wait and see how different countries adjust from the great imbalances of the past two decades. Global economic growth, to steal JP Morgan’s prediction, will fluctuate.

10.) Can you talk about deflation? Some say that deflation causes consumers to persistently put off purchases while they wait for prices to fall. I feel this violates everything we know about what happens to demand when prices fall. But if prices do fall in a prolonged deflationary period, it would make debt repayment much harder and make defaults more likely. What are your thoughts and what effect would wholesale debt restructuring have on both wealth and economic growth? What is better for average people: trying to slowly inflate away debt or global debt restructuring?

It really depends on the circumstances. I am not an economist so much as a balance sheet guy, and I can tell you that inflating debt, or monetizing it in any other way (e.g. financial repression) simply transfers wealth from those who are long monetary assets (usually households) to those who are short. Deflation does the opposite. Generally speaking I would argue that in most countries we need to boost the wealth of median households at the expense either of the state or of the economic elite, but in the case of the latter I also recognize that we have to do so carefully. Income inequality may itself be the outcome of a highly desirable incentive structure that rewards innovation and entrepreneurialism. I know this answer is sort of a copout, but the specific circumstances of each country matter, and I don't want my having gotten a few things right in China to tempt me into trying to punch well above my weight.


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