Pettis on the European Crisis

From China Financial Markets Newsletter

Michael Pettis 

Seven steps to crisis

Step 1. The German savings rate rises. 

Thanks to the labor reforms, German wage growth dropped sharply, and with it the household income share of Germany’s GDP. As the household income share declined, and because the household savings rate remained flat, the household consumption share also declined. 

Because most consumption is household consumption, and Berlin did nothing to counteract the decline in household consumption, for example by increasing social spending, the total consumption share of GDP in Germany also declined during this period 

All goods and services produced by an economy (i.e. GDP) are by definition either consumed or saved. As Germans consumed a smaller share of all the goods and services they produced, by definition they saved a larger share. Germany’s saving rate, in other words, rose.

Note that Germany’s savings rate rose not because German households decided to become thriftier but rather because the growth in wages and overall income, and therefore in consumption, was suppressed by the Hartz reforms. 

Step 2. Weak consumption growth in Germany lowers private sector investment.  

Businesses expand production capacity usually because they expect demand for their product to grow. As consumption growth lagged, however, German businesses responded by reducing their investment growth rate to below the GDP growth rate.
When investment is equal to savings, everything that is produced is purchased either for consumption or investment purposes. The demand generated by investment absorbs all the goods and services that an economy has produced but has not consumed. In Germany however savings rose faster than planned investment. 

Step 3. As German savings began to grow faster than GDP, and planned German investment more slowly, there were four different ways in which the German economy could adjust: it could run a current account surplus, unemployment could rise, public sector investment could rise, or something could set off a rise in consumption faster than the rise in GDP. 

It could run a current account surplus. Germany could sell to foreigners the excess of goods and services it produced at home but could not sell in Germany. In that case Germany would also export the excess of savings over investment, and so run a capital account deficit. The value of the current account surplus would be identical to the value of the capital account deficit, with excess German saving financing the purchase by foreigners of excess German production. 

Unemployment could rise. German businesses could respond to growing inventories by cutting back production and firing workers. This would cause the total production of goods and services to drop. Total consumption would also drop as unemployed workers reduce their consumption, but because unemployed workers must still consume, the total production of goods and services would drop faster than total consumption, or, put differently, the savings share of GDP would drop. Rising unemployment, in other words, reduces the savings rate, not because consumption rises faster than GDP but rather because consumption declines more slowly than GDP.  

Public sector investment could rise. The German government could borrow the excess savings and invest it in ways that increase German productivity. Higher government investment would counterbalance higher savings and the decline in private sector investment so that German savings would no longer exceed German investment. 

A consumption boom could be set off. German investors could use excess German savings to buy assets like stocks or real estate. As asset prices rise, and the owners of these assets see their wealth rise, two things can happen. First, the “wealth effect” can cause Germans to increase their consumption faster than their income increases. Second, rising asset prices can cause them to increase their investment, especially in real estate. The first effect causes the savings share of GDP to drop and the second causes the investment share to rise, either of which retains the balance between savings and investment. 

Step 4. In fact Germany ran current account surpluses and capital account deficits, mainly with other European countries.  

For policy reasons Berlin and local German governments did not absorb the excess savings by borrowing and investing them locally. 

During this time European financial authorities were encouraging a convergence in interest rates among very different European countries with very different interest-rate histories, creating a sharp division between some countries, such as Germany, in which inflation had been low and interest rates historically low, and other countries in which inflation had been high and interest rates historically high, too. In the former the real cost of this available German capital was high, while in the latter, which we will call “Spain” in the rest of this essay, the real cost of this available German capital was low. 

Every economy consists of business and household entities with a wide range of risk appetites and optimism about the future, ranging from recklessness to prudence. When real interest rates are very low or negative in a growing economy, because of the diversity among businesses and households in their appetite for risk, inevitably some of them will borrow more than they otherwise would have in order to consume or invest more than might have been prudent. If we assume that Spain has exactly the same distribution of risk-seeking borrowers as Germany, and exactly the same distribution of reckless agents as Germany, and we offer Spanish and German borrowers equal access to capital, but at high real rates to the Germans and at low or negative real rates to the Spanish, most of the excess German savings will flow to Spanish borrowers and very little will flow to German borrowers. The difference between the two countries, in other words, is not in the distribution of reckless behavior but in the divergence in real interest costs. 

Some commentators have argued, bizarrely enough, that the causality is backwards, and that in fact all of the countries that we represent by Spain embarked on ill-advised consumption binges that occurred only coincidentally at the same time as Germany implemented the Hartz reforms. It was the subsequent collapse in Spanish savings rates, these commentators say, that caused them to wrest capital away from German investors, and the surge in their consumption that caused them to scoop up German tradable goods. It was Spain “pulling” capital and tradable goods out of Germany, in other words, and not Germany who was “pushing” capital and tradable goods into Spain. In the former case, however, Spanish borrowers could only have pulled capital out of Germany by forcing up interest rates, and by pulling tradable goods out of Germany, Spain would have also forced up the growth in German wages. The fact that European interest rates declined sharply during this period, and German wage growth decelerated sharply, would be extraordinarily counter-intuitive at best.  

Step 5.  “Spain” must accommodate the German current account surplus and the corresponding capital account deficit.  

Spain had been importing moderate amounts of foreign capital before all of this happened, but after the Hartz reforms, the distortions in Germany were so great that the amount of excess German savings pouring into Spain in a matter of 3-5 years increased by 20-30 percentage points of Spain’s GDP. Spain’s corresponding current account deficit also soared to among the highest levels in its history. Just as Germany’s soaring current account surpluses and capital account deficits reflected a rising excess of German savings over German investment, the soaring current account deficits and capital account surpluses in Spain had to accommodate a rising excess of Spanish investment over Spanish savings. These are automatic consequences of net capital inflows.  

There are four ways this could happen: Spain’s productive investments could rise, its non-productive investments could rise, Spanish unemployment could rise, or the Spanish consumption share of GDP could rise. 

Spain’s productive investments could rise. More available capital at lower interest rates increases the amount of productive investments in Spain, which causes Spanish demand for investment-related goods and services to rise, including for tradable and non-tradable goods and services. As unemployed workers are put to work, part of this demand is met by rising supply, but unless unemployment in Spain is extremely high, much of it must be supplied from abroad. 

Its non-productive investments could rise. More available capital at lower interest rates also increases the amount of non-productive investments in Spain to the extent that investors are unable to distinguish between the two. There are three reasons why non-productive might rise.   

First, the rush of capital into Spain can cause GDP growth to rise, which can cause investors, including local governments, to overestimate future demand for infrastructure, and this is all the more likely when widespread corruption creates strong incentives to over-estimate future demand. 

Second, when cheap capital pours into a country it can cause soaring asset prices, and as real estate prices soar, they create speculative demand for real estate, which creates even more scope for non-productive investment. Third, as German tradable goods increasingly displace Spanish tradable goods, Spanish investment in capacity is increasingly unproductive. For all these reasons, as non-productive investment in Spain rises, as in the case of productive investment, it causes Spanish demand for investment-related goods and services to rise, including for tradable and nontradable goods and services.

Spanish unemployment could rise. As German tradable goods increasingly displace Spanish tradable goods, Spanish investment in capacity becomes increasingly unproductive and Spanish manufacturers have to fire workers. Rising unemployment causes the savings rate to decline (as explained above). Before the 2008-09 crisis, however, fired workers were quickly hired by the rapidly-growing non-tradable goods sector, so the effect of the German tradable goods sector on Spanish unemployment was minimal until the crisis, with its effect being a shift of workers out of the tradable goods sector into the services and non-tradable sectors. 

The Spanish consumption share of GDP could rise. More available capital at lower interest rates increases the amount of speculative investments in existing Spanish assets, such as stocks, bonds, and real estate. As their prices rise, Spanish households, especially those with greater risk appetites, believe they have become permanently wealthier, and they respond by expanding the consumption share of their income. They fund this increased consumption either by reducing their savings or by borrowing against their assets. This causes Spanish demand for consumption related goods and services to rise. As unemployed workers are put to work, part of this demand is met by rising supply, but unless unemployment in Spain is extremely high, eventually much of it must be supplied from abroad.  

In three of these cases (excluding the third, rising unemployment) as Spanish demand for investment-related and consumption-related goods and services rose faster than Spanish supply of either, it had to import them from abroad, but because it can only import tradable goods (and some tradable services), an automatic shift had to occur in Spanish employment. Workers were transferred from the tradable sector to the nontradable sector, so that demand for tradable goods rose even faster, and this was resolved effectively by importing these goods from Germany.  This is a simplification, and technically incorrect, but we will continue to use it over the rest of this essay. The goods that Spain imports as a consequence of the German capital “push” don’t have to be imported only from Germany. They can be imported from other countries, which simultaneously increase their imports from Germany, so that the rise in Spain’s current account deficit will be exactly matched by a rise in Germany’s current account surplus even if the two do not occur bilaterally.  

Step 6. As speculation and cheap capital causes markets to rise, the Spanish debt burden will automatically rise until speculative price increases and a rising debt burden reach their limits.  

The different ways described above in which Spain could have responded to the increase in capital imports each has a different impact on the Spanish debt burden.

Capital that flows into productive investments does not result in a rising debt burden because the capacity to service debt rises as quickly, or more quickly, than the debt servicing cost. 

Capital that flows into non-productive investments causes the debt burden to rise because there is no consequent increase in the capacity to service debt, even as there is an increase in the debt-servicing cost. 

Capital that finances the increase in consumption also causes the debt burden to rise because there is no consequent increase in the capacity to service debt while there is an increase in the debt-servicing cost. 

When debt-servicing costs rise faster than debt-servicing capacity, the growth in debt is unsustainable and it becomes increasingly necessary to roll debt over as principle and interest come due.  

Rising asset prices and rising debt are self-reinforcing, but neither is infinite, and both will eventually be forced to stop rising. There are many triggers for the reversal, which we do not need to get into here, but once it happens, market prices fall, and it becomes more difficult to roll over the debt. This occurred in 2009, and the consequence was that German capital stopped flowing into Spain. As a result Spanish governments, businesses and households could not service existing debt to Germany and they could no longer fund the domestic consumption and investment that had previously been funded by German savings.

Step 7. When something is unsustainable, eventually it will stop. 

As Spanish and other peripheral European debt rose to levels at which creditors were increasingly worried about funding further debt increases, and as the underlying economies were damaged as resources were misallocated as a result of asset price distortions, all it took was a trigger to set off a system breakdown. The US sub-prime crisis served as that trigger. Once creditors became sufficiently concerned about the adverse impact of US events on underlying liquidity, they began to raise interest rates, reduce maturities and otherwise transform liabilities in ways that were highly selfreinforcing, and in a very short period of time deficit countries found themselves unable to refinance their external borrowings. Without balancing inflows on the capital account, their deficits had to collapse.  

By definition a collapse in the current account deficit can occur either in the form of a drop in investment or a surge in savings. Investment dropped when creditors became unwilling to fund new investment and as stock and real estate prices collapsed, and the savings rate rose as Spanish households cut back on consumption. The net result was a sharp drop in demand and a corresponding surge in unemployment. 

After the crisis there were a limited number of ways Germany and Spain could adjust. Once the rest of Europe was no longer able to absorb the German surplus, and because Germany took no steps to rebalance domestic demand but instead maintained the existing distortions in which German workers and German households retained a small share of GDP, the export of German savings abroad meant that the full European surplus, perhaps the largest ever recorded as a share of global GDP, had to be absorbed abroad. 

In light of the June 23 Brexit vote, it might be worth noting that the British current account deficit, which had ranged between 1% and 3% for most of the previous decade, jumped 3.6% in 2008 and dropped back to its normal range over the next two years. Since then, as the European surplus has surged, the British deficit has climbed steadily to over 5% by 2015 and substantially higher in the first quarter of 2016. This requires one or both of two British consequences, rising unemployment or rising inequality.

Lessons 

It's not just the outflows we need to worry about but the initial inflows.

Capital flows require more management (i.e. restrictions and regulations) if we want to avoid the negative consequences of unproductive capital inflows. This in turn requires a realisation that the 'market' cares about profit not productivity. Profit can be made in remarkably unproductive ways.

It's not cultural propensities that should be the major explanatory variable for economic outcomes. Rather it is macroeconomic flows shaped by policy (ie. institutions) that are most important. Culture and path dependency will shape what are considered to be appropriate policies. In sum, institutions matter more than culture, although culture may shape what institutions are chosen and developed in the first place.

For Australia, a negative spiral might begin with an external reassessment of investment opportunities or a decline in employment. Given the highly indebted status of Australian households this would reduce consumption and lead to a reassessment of the housing market.

A housing price collapse in Australia would lead to a reassessment of debt, a collapse in consumption and rising unemployment, which would lead to further house price falls and so on.

Australia has avoided falling into this negative spiral through a combination of good luck and some good policy. However the rise in debt and the failure of authorities to regulate credit will soon be seen as remarkably poor policy.

The Fallacy of Composition: Return of Global Imbalances and the Possibilities of Trade War

Excess saving is a major problem for the global economy. Just like those painful colleagues who think that arriving early is always virtuous, many commentators and policy-makers see export surpluses as a sign of moral superiority.

Such a view of the world is wrong not only in an ethical sense, but also in a rational one. For every export surplus there must be a deficit. The virtue of the mercantilist must be matched by the supposed iniquity of the consumer. Unless we start trading with another planet, there is no other outcome.

This is a fallacy of composition - the belief that what is true for the part is true for the whole. Not every country can run a trade surplus and absent the willingness of some countries - particularly the Anglosphere countries - to run deficits the whole model would fall apart. 

The surplus countries need to adjust, just as much as the deficit countries if we to restore some sort of balance to the world economy. 

According to Brad Setser  

East Asia’s current account surplus—its excess of savings over investment—has recently amounted to about as large a share of world gross domestic product (GDP) as it did prior to the global financial crisis. In 2015, the region’s four major economies—China, Japan, South Korea, and Taiwan—along with the city states of Hong Kong and Singapore had a combined current account surplus of $700 billion. Their combined surplus significantly exceeded Europe’s surplus. No region of the world currently contributes more to the global glut in savings. Outward flows of capital from East Asia present a challenge to the world economy, and this problem may grow in the next few years. 

East Asia’s surplus is all the more remarkable because it has reemerged despite two factors that act to reduce it. China’s investment remains at historically high levels and Japan’s budget deficit is around 5 percent of GDP. Both high investment and large fiscal deficits absorb significant amounts of savings at home. These two surplus-reducing factors are overwhelmed, however, by East Asia’s extremely high rate of saving. At close to 40 percent of GDP, it appears to be at a record level relative to the size of the region’s economy. Without a reduction in the savings rate, there is a risk that East Asia’s already large surplus will increase. To control its bad-debt problem, China may reduce credit creation and investment. To control its government-debt problem, Japan may opt for fiscal consolidation. In either case, policies that reduce domestic risks could give rise to new global risks.

While before the crisis the net European surplus was low (i.e. European trade and financial interactions with the rest of the world), it has been growing since that time as austerity reduces consumption and as the export surplus countries have continued to repress consumption in the belief that export surpluses are virtuous. If only Greece could be more like Germany they argue. But as we pointed out at the beginning this isn't possible for every country. Germany doesn't have to become like Greece, but it does need to reduce its export surplus and export some of its demand to southern Europe.

The United States trade deficit is likely to become an important marker of the success or failure of Trump's Presidency and while the deficit on petroleum products has been reduced since the crisis due to the US oil boom, its deficit in other goods has grown rapidly.

As Setser points out, despite the high investment of East Asian economies, savings are still higher leading to current account surpluses. It is important to remember that the current account = savings - investment. A surplus means an excess of saving over investment and a deficit means not enough saving to fund investment. The latter is the case for Australia.

All of this leads to global imbalances as captured by the graph below,  On top are the surpluses, which include the East Asian and European surplus economies. Note that with the decline of oil prices, the oil exporting countries are now running deficits. The largest share of the deficit side of the equation is taken up by the Anglosphere economies - the United States, the United Kingdom, Canada and Australia.

East Asia is the major contributor to global surpluses, but the European surplus economies have also expanded theirs. This is exactly the opposite of what needs to happen in Europe. To help solve the crisis in Southern Europe will require the surplus countries to increase their consumption and lower their savings. They need to increase demand in their own economies rather than importing demand from southern Europe. This is all the more important given that monetary union has negated adjustment via the exchange rate. 

The major global problem, however, are the East Asian surpluses. This is partly because they are larger and partly because they affect the United States to a much greater extent. Setser contends: 

There is an urgent case for a strategy to reduce East Asia’s savings rate to a level that the region can more easily absorb internally. The adjustment should be centered on China, where exceptionally high levels of savings no longer serve the same purpose as during the country’s catch-up phase of economic development. In the past, high savings allowed China to finance high levels of domestic investment without drawing on potentially risky, reversible, cross-border capital flows. However, with the gains from high levels of investment now reduced, a national savings rate that still approaches 50 percent of output is simply too high to be absorbed effectively at home or abroad. China’s high savings rate increasingly implies either bubbles in credit and investment domestically or large capital surpluses that have to be exported and that add to global risks. 

Although China is the prime source of the savings glut, South Korea, Taiwan, and Japan also contribute. Savings rates of 35 percent of GDP in South Korea and Taiwan generate more capital than can be absorbed domestically. South Korea’s current account surplus is just under 8 percent of GDP, about the same share of its GDP as the surplus of Germany, the leading non-Asian contributor to the savings glut. Taiwan’s surplus is at an even higher 14 percent of GDP, although the effect is mitigated by Taiwan’s smaller economy. Japan’s surplus of 3 percent of GDP is comparable to that of the eurozone as a whole. 

Over the past few years, the nature of the policy challenge posed by East Asia’s external surplus has changed. The region’s surpluses are no longer maintained primarily through intervention in the foreign exchange market, with the result that moving toward floating currencies is no longer a sufficient policy response to Asia’s trade surplus. The traditional U.S. economic agenda in the region— aimed at liberalizing trade, investment, and exchange rates—also misses the threat that East Asia’s savings glut poses to global prosperity. U.S. economic diplomacy now needs to advance policies that lower national savings in East Asia directly. These include the use of fiscal policy to support an increase in household consumption and reforms in high-saving East Asian economies to strengthen the social safety net and thereby lower private savings.

Given that the 'savings glut' or global imbalances were a major factor in the global financial crisis we should all be worried by these developments. A Trump administration is unlikely to accept the United States' traditional role in soaking up these surpluses. This means that unless East Asian surplus countries reduce their savings (and surpluses) we can expect a Trump administration to focus on what the United States can do. The easiest 'solution' will be to impose new restrictive measures on East Asian trade. 

This means that either East Asia adjusts its policies or the United States will force adjustment through trade measures. This could lead to a trade war as nationalist sentiments awaken in the trade arena and the surplus countries maintain their belief in their moral superiority for running trade surpluses. 

Rich Australians More Into Real Estate than the Rich Anywhere Else

I love the term High Net Worth Individuals (HNWIs). I'd probably love it even more if I was one or even if my dad was one. But considering the behaviour of the Whinearts, sorry Rineharts perhaps I'm better off being moderately well off.

Anyway ...

According to BRW, a HNWI is "a person with $US1 million ($1.05 million) or more in investable assets"

This graphic from Capgemini  shows that wealthy Australians are overweight property compared to the rest of the world and other economies. HNWIs in Australia have 40.6% of their assets in real estate compared to 20.8% for the rest of the world.

This means that they have done very well over the past decade or so as Australia avoided the crashes in other economies. It also means that a property crash in Australia will leave them relatively worse off. 

According to BRW, Australia increased its number of HNWIs in 2012 as did most other countries. 

The population of Australia’s HNWs ... jumped 15.1 per cent last year compared with 2011, according to the latest World Wealth Report from Capgemini and RBC Wealth Management ...

There were about 207,000 wealthy individuals in Australia in 2012 who sat on a $US625 billion pile of assets.

The research found that the world’s population and investable wealth of HNW individuals reached record levels last year, after increasing more than 9 per cent to hit 12 million people.

North America and the Asia-Pacific boasted the two largest HNW regions and drove global growth.

Asia-Pacific countries, including Indonesia, Australia, China, New Zealand and Thailand, posted double-digit growth rates.

 Its fair to say not everyone in the United States is still suffering from the ill effects of global economic crisis.

World Industrial Production: The Long Recovery in the Developed World

I'm currently writing an article about post(?)-crisis globalisation and I'm focused at the moment on the idea of decoupling. Supporters of the decoupling thesis argue that Asia or emerging economies are now considerably less reliant on the West for their growth.

Having read Eichengreen and O'Rourke's article tracking the global financial crisis (or Great Recession) against the Great Depression I was interested to see what had happen to industrial production. The authors did a couple of updates to the original 2009 article, but finished updating in 2010 when it was clear that the world economy was not continuing to track the GD, largely because of considerable state intervention that helped to bolster economic growth and avoid beggar-thy-neighbour economic policies.

Looking for recent stats on industrial production I came across this research from Yardeni Research.

The figures are quite staggering and show how badly developed economies have performed in comparison to developing (emerging) economies.

In the first graph, which covers the entire world minus construction, the impact of the financial crisis is clear as is the excellent performance in the lead up to the crisis.

But it is when we disaggregate IP that we get a clearer picture of the impact of the crisis.

Compared to Europe the United States has done reasonably well. Even Germany the so-called success story of Europe has not recovered to its pre-crisis peak.





While the developing world - especially Asia - has clearly outperformed Western economies, the
danger is that the impact of the crisis has simply been delayed in emerging economies and that they now face a period of retrenchment as investment (especially state-directed) slows and debt has to be repaid. Developing countries have benefitted from global supply chains involving China and the spur to their own investment from Chinese investment.

The idea that stimulus - especially in China - would enable emerging economies to ride out the crisis is ultimately dependent on renewed global growth, especially in the developed world. The US and European economies are still the major source of final demand for many of the goods made in the developing world often through regional production structures and global supply chains.

Recession and Recovery in the OECD

This from Macleans. Everyone else in the world knows Australia has done better than any other developed country after the global crisis, just not the right-wing ideologues like Judith Sloan, Adam Creighton and virtually everyone else at The Australian, who it seems are immune to statistical information and analysis related to events. 

To work out the relevance of location on the graph you need to know that being in the top right corner is a good thing because it means that the downturn in Australia was not very deep, initially because of Rudd government fiscal policy and Reserve Bank monetary policy and subsequently because of continuing demand from China.

The vertical axis measures the depth of economic downturn and the horizontal axis measures the strength of recovery from the pre-crisis peak of each country.