Many of you know of Michael through his work on China, but before he moved to Beijing, he was in New York trading and underwriting Latin American debt. The Volatility Machine—a great book that for reasons I do not understand is now extremely expensive—was informed by those experiences. So it was great to talk with Michael about Argentina’s ongoing financial crisis and new president Javier Milei’s goal of eventually replacing the Argentine peso with the U.S. dollar.

We covered a lot of ground, including the similarities between pre-Peron Argentina and the antebellum American south, development experts’ changing views of Latin America vs. East Asia, why Pettis thinks that Peronist import substitution gets a bad rap, and the political economy of debt forgiveness.

Hope you enjoy! Full edited transcript below the fold.

Remember, subscribers cover our cost of production. Paying listeners get to listen to the full recording and read the full transcript.

Related links:

Argentina and the Limits of Fiscal Space — The Overshoot

The Economic Development of Latin America and its Principal Problems — ECLA (Raúl Prebisch)

The Terms of Trade and the Rise of Argentina in the Long Nineteenth Century — Joseph Francis

Matt Klein: Hello! And welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to take a look at a country that’s been in the news quite a lot very recently because of their recent elections, which is, of course, Argentina.

It’s reputed to be one of the few countries to have steadily declined from being one of the richest in the world per capita to, at best, a middle-income country. It has been in an ongoing financial crisis for the past five years. Some more skeptical people might argue it’s been in an ongoing financial crisis for the past 50 years. It just elected a new president, Javier Milei, who wants Argentina to eliminate its central bank, eliminate a whole series of ministries, and abandon the peso for the U.S. dollar.

Matt Klein: And I think this will be a fun topic for us because, even though you’ve been in China for over 20 years at this point—and have developed a major reputation for that—you cut your teeth on the Latin American debt crises. And being widely read and financially economic history, this is a topic that you’ve spent a lot of time thinking about over the years, as well as something we discussed in our book insofar as it related to the history of financial crises and financial globalization. So I think this should be a really interesting conversation.

Michael Pettis: I think, Matt, you’re not allowed to have a conversation on the Argentine economy without making reference to a quote by, I forget who, who basically said there are three types of economies in the world: there are advanced economies, there are developing economies, and then there’s Argentina. And I think that gets at how strange the economic history of Argentina has been.

Matt Klein: You know, I’ve heard another version of that joke where there’s a fourth one, which is Japan, but we could maybe save that for another time.

Michael Pettis: Well, yeah, that was a joke in the 1980s. We don’t believe that anymore.

Matt Klein: Right. So let’s get started with what for me is kind of the basic question, which is: if we zoom out and look at Argentina from the late 1800s, it looks a lot like Australia and Canada. It is a New World society populated overwhelmingly by European immigrants; the wealth of the country is almost entirely in commodities; the land is very conducive for extracting agricultural or industrial products and then exporting them; and there were strong ties to the British Empire.

And yet, if we look at the trajectory of those three countries, Australia and Canada more or less end up kind of developing in similar ways—obviously, there are important differences—but Argentina goes in a completely different direction, starting around sort of the 1930s/1940s. What is the argument for why that happened? Maybe you can kind of lay out what you think has happened.

Michael Pettis: Well, you know, in my early career days… As you know, I was involved in trading and capital markets, specializing particularly in Latin America. I did, I think, the second bond issue by the Argentine government after it had finally returned to the markets after the debt crisis of the 1980s. And it’s sort of a joke that if you put two Argentines in a room and ask them what happened, not only will you get completely different answers from each of them, but one of them will end up having to kill the other one. It’s a really hotly debated topic.

There are people who argue that things went seriously wrong in the 1930s. Others argue that things began to go wrong after World War II, under Perón. And still others will argue everything was fine until the 1970s, and then things went seriously wrong there. It’s hard to say.

It didn’t really show up in the cities and it didn’t really show up in the industrial side. Argentina was a very typical poor country, by that standard.

It was the very wealthy landowners that brought up Argentine per capita income to advanced country levels. The stereotype of Argentina in the 1910s and the 1920s was the romantic Argentine polo-playing-millionaire. They were all supposed to be millionaires, and I suspect it’s probably because either they were, or they were extremely poor.

Matt Klein: Right. There’s an interesting thing I found recently: the economic historian Joseph Francis was looking into this, and he made the point that if you look at development indicators other than GDP per capita, Argentina does not look like a rich country by the standards of the late 1800s or early 1900s, whether it’s education, or health, or things like that. Instead, it looks a lot more like a poor country.

From that perspective, what we see from the 1930s onwards looks a lot more like convergence to those indicators rather than some kind of surprising decline. I don’t know if that’s really the right way of thinking about it, but it’s an interesting perspective.

Michael Pettis: Well, it’s sort of consistent with what I’ve heard, which is that really Argentina was not a rich country. Certain Argentines were fabulously wealthy because of the incredible productivity of the agricultural sector. And so they brought the averages up, but median incomes were probably way below the average income.

Matt Klein: So then one question would be: even given that, what changed in the past—depending on your time horizon, 50 years or 80 years or 90 years—to lead to the divergence in reported GDP per capita between Argentina and Australia, Canada, or even the United States?

Michael Pettis: With such high levels of income inequality, what ends up happening is that Argentine wealth gets exported into England or the U.S. or places where it’s safe, and you don’t really develop strong enough domestic demand to boost the domestic services industry, domestic manufacturing, et cetera, et cetera. That could be one of the explanations. I’m not really sure. And as I said, it’s such a hotly debated topic that almost anything you say—if there is any Argentine listening to us, he or she will almost certainly disagree. It’s just a very hotly debated topic.

Matt Klein: Right. One other comparison—and maybe this is too speculative—is to think of New Zealand. This is also a country that has gotten quite wealthy from agricultural wealth. It doesn’t really have a manufacturing sector. There are other parts of the economy, and they’re not unproductive, but nevertheless, it seems that a lot of their wealth comes from this agricultural productivity, particularly for having a lot of grass for raising lamb and so forth.

Is it just the institutional quality and the distribution of that wealth that leads to such different outcomes? Are there other things that we can think about or point to? In your conversations with Argentines, what are the sort of things that they might say?

Michael Pettis: One of the points that we make in our book is that it’s not just productivity that matters; it’s the distribution of the benefits of that productivity. Perhaps the argument is that Argentina was very productive, but that productivity wasn’t well distributed, unlike, say, in New Zealand, where it’s much more evenly distributed, and so you’re capable of building up a modern economy.

But you know, one of the things that I’ve heard repeatedly is that there is an institutional problem within Argentina. It’s the central government that is primarily responsible for raising revenues by borrowing and raising taxes, and it’s the local governments, the state governments, or provincial governments that do most of the spending.

Now, I don’t know if that’s changed. That used to be a very common argument back when I was trading Argentina. The convertibility law, which was in, I think, in 1991, was a kind of dollarization, in part to make it impossible for that to happen. You could not spend more than you raised in revenue because you had to borrow, effectively, in dollars. The borrowing was in pesos, but the convertibility law created a currency board in which every peso was, in theory—turns out, not in practice—backed by a dollar.

Before that, Argentina had a currency called the austral, which was created in 1985 as a way of dealing with the hyperinflation of the peso. So they went from the peso to the austral, but the austral was even more hyperinflationary, so they went back to the peso under the convertibility law, through a currency board.

For those who don’t know what a currency board is, a currency board replaces a central bank. And what happens is that the currency board issues currencies only to the extent that they are 100 percent backed by something else, in this case, U.S. dollars. So for every dollar that entered into the currency board, they would then create one peso.

The disciplinary impact is a little bit like a really hard gold system. The disciplinary impact is that if you keep borrowing dollars, people become nervous about your ability to repay the dollar, and so you get cut off from the financial markets. And that was supposed to be the straitjacket that forced provincial governments to operate within the budget of tax collection of the central government.

Of course, that didn’t really work. The currency board broke, I think it was in 2001. We can talk about why that happened, I was very involved in that on the trading side. But, in a sense, dollarization, which is probably not going to happen very quickly, if it happens, would be an attempt to repeat the convertibility of 1991 and force a budget constraint onto the Argentine government.

Matt Klein: You know, this gets into a good segue to the next general question I have about all this, which is: you’re looking at our book, or looking at some of the events that you just described, Argentina has been a very frequent participant in financial crises, whether it’s global phenomena or sort of idiosyncratic ones. I think it’s one of the most frequently defaulting sovereigns in modern history. Why is that?

Michael Pettis: There are different reasons for different crises. The first really famous crisis, the first global one, was in 1890. That resembles the Mexican crisis of 1994-1995, in the sense that Argentina had a gold backed currency, like many other countries, but it was an economy that had great difficulty in maintaining the gold backing of the currency. They borrowed a huge amount in the London markets for municipal improvements, most famously the municipal water system, which was underwritten by—I think they were the oldest English bank at the time—Baring Brothers. And very famously, they got into trouble.

It was a massive default. It brought down Baring Brothers. The only reason they didn’t go bankrupt is because the Bank of England basically corralled a whole bunch of banks together, including Baring’s great enemy, the Rothschilds, and forced them to bail Baring’s out.

Weirdly enough, in the 1930s, when everybody in Latin America defaulted, the one exception was Argentina. And that really strengthened their reputation, which allowed them to be among the biggest borrowers in the 1960s and 1970s. But, of course, that ended with the debt crisis of 1982, and ever since then, they’ve been a regular defaulter. The argument has always been this gap between provincial borrowing and central government tax collection.

Read more

This month’s episode digs into how China suddenly became a massive exporter of motor vehicles, swinging from a persistent pre-2021 trade deficit of around $40 billion in finished passenger cars and trucks to an annualized surplus of more than $30 billion.

As in many other societies, China’s motor vehicle sector is a microcosm of the broader economy. In the Chinese case, abundant subsidies for producers have collided with weak income growth and diminished confidence among consumers, generating a surplus that is attributable to weak domestic demand rather than higher output. That has big implications for the other major motor vehicle manufacturing hubs, particularly Europe.

But as we discuss, the flood of cheap Chinese electric vehicles could actually be a salutary shock if it forces Europeans to do what they should do anyway to increase their own investment and consumer spending.

Hope you enjoy! Full edited transcript below the fold.

Remember, subscribers cover our cost of production. Paying listeners get to listen to the full recording and read the full transcript.

Related links:

Danish Weight Loss Drugs vs. Chinese Cars: Two Models of Export Booms — The Overshoot

In Green Tech, Overcapacity is a Boon — Martin Sandbu, FT

EU Must Choose Between Cheaper Power or Protecting Wind Industry — Bloomberg

Matthew Klein: Hello, and welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to look at China’s sudden emergence as a global exporter of cars, trucks, buses, EVs, and what that means for the rest of the world.

Matthew Klein: This is a really striking development, because it’s really just in the past couple of years that China went from exporting essentially no finished vehicles at all—there was a bit of an auto parts export industry, but not for finished vehicles—to exporting, at current rates, about $75 billion annualized over the past few months. It’s now the biggest exporter, in terms of units, not in terms of dollars, but in terms of units, the biggest exporter of finished cars and trucks in the world, surpassing Germany and Japan.

This is a huge change.

It’s a change that I think a lot of people—at least in the United States—have probably missed, because those vehicles are not coming here for various reasons. But there’s a lot of those exports are showing up in places like the rest of EM Asia, Africa, Russia, Latin America, and recently, Europe. Europe has been getting a huge influx of electric vehicles, which is a sector where, even though European car manufacturing has been traditionally a major part of the European economy, for electric vehicles, their producers have generally been a little slower on the uptake.

A lot of Chinese cars, which are coming in at much lower price points, have been extremely competitive. People are still wrapping their heads around this, because you don’t normally see a transformation this rapid. The idea that you can go from exporting essentially nothing to being the largest exporter by volume in the world in two years is really striking.

A little bit of that is Tesla opened that big factory in Shanghai a couple of years ago, but a lot of this has to do with the local Chinese brands, such as BYD and others. You see some BYD buses in the United States, but for passenger cars and trucks, you don’t see that so much. It’s a really striking development and it has a lot of big implications. It is causing a lot of angst for automakers, particularly, I think, in Europe, and to a lesser extent in Japan and Korea.

They made about 28 million finished vehicles in 2018. This year, so far, they are only producing at that same annualized rate. That’s a really striking fact here. Which raises some questions about this export surge. It is obviously not a function of higher production in total, but something else. It must be that the domestic market is relatively weak.

First of all, why is it that the Chinese domestic auto market has been weak for so long?

This downturn actually preceded COVID and all of that. It really started in 2018-2019. Michael, you’ve been in China this whole time. What is your sense of what’s been driving some of those trends? Was there just a lot of excess capacity or manufacturers anticipating more Chinese demand domestically than made sense? Or was it always the assumption that they would have to be going big on exports? What is your sense of how the industry evolved?

Michael Pettis: Well, I’m not really an automobile industry expert, Matt, but there are a couple of things that seem to have mattered. One is that the rate at which Chinese were buying cars wasn’t really sustainable. You have to remember that the Chinese entered the century with extremely low car ownership. Part of the rapid growth was simply going from zero to whatever the equilibrium level is. And once everyone had their cars, the amount of car purchasing was going to drop significantly.

The other thing that’s mattered a lot is that there were really heavy subsidies given to buyers of cars by local governments and by the central government. The perception, at least within the press here in China, has been that a lot of people bought cars because of these subsidies. Now these subsidies are no longer being paid out. Beijing is reluctant to do so, and local governments seem like they can’t really afford to do so. And so a lot of that heavily-subsidized purchasing seems to have dried up.

The other thing that matters, in a more general way, is that, as you know, consumption has been generally down. It’s been down for two reasons. One is that during the COVID period, wage growth slowed significantly. Then more recently with the collapse in real estate sales and the decline in property prices, plus rising unemployment among the young.

And there is increasing uncertainty, because one of the big problems with the unemployment data is that there’s a lot of hidden unemployment.

It’s always like, “we’ll pay you in six months, we’ll pay you in six months.” So between all of those things, it’s probably not a surprise that car purchases have come down a lot.

Matthew Klein: That makes sense, with durable goods consumption generally being more cyclically sensitive, you have to be confident about your income prospects. I know very little about how the domestic car market dynamics work in China. Are they financed typically, the way they are in the U.S., where either you lease or you put down some money and then you mostly pay it out over, say like the next five, six years? How does that work usually?

Michael Pettis: Yes, they are financed, but I don’t think the financing is as long. I haven’t bought a car here, so I can’t tell you from a personal experience. But my closest friend bought a Tesla recently, and I know he paid full cash. I don’t really know what the financing terms are, but obviously they weren’t good enough to justify borrowing

Matthew Klein: I wonder if that’s something that’s changed one way or another, by becoming tighter. I guess the subsidy removal is probably the most important point, as you mentioned, but I wonder if that was another potential factor.

Michael Pettis: The subsidy removal was a big thing. And I think there was always a sense here in China that there were not only subsidies for buying, but there are tremendous subsidies for the production of automobiles, particularly electric vehicles, but automobiles more generally. And I don’t know how many major car manufacturers there are in China, but there are a lot. And there was always the sense that at some point there was going to be ferocious competition and winnowing down.

And it seems clearly China is doing the other, which is what Japan did in the 1980s and a number of other countries, too. They’re really focusing on the export market.

Matthew Klein: It’s interesting because you were talking about electric vehicles, and I think it’s maybe important to drill into this a little more. It’s very reasonable to make the point, as you did, that if China goes from a society where almost no one owned cars 20 years ago to a society where many households do own cars, and the rate of car ownership is not necessarily comparable to say like, you know, Europe and United States per person, but pretty high relative to China’s level of development, then car buying should slow down.

But at the same time, we’re in a situation where there’s a global push, and also a push, at least officially from the Chinese government, to change the mix of the motor vehicle fleet very quickly; to turn it over from essentially all internal combustion engines as recently as a couple of years ago to being all electric. China’s official policy, which Xi Jinping has committed to, is for China to have essentially net zero carbon emissions by 2060. Maybe it’s challenging given the manufacturing capacity that had been built up, but I can imagine a situation where Chinese auto sales would still have to be very high—even if everyone already had a car they wanted—just because you’re trying to turn over the fleet from one set of engines to another. And yet that doesn’t seem to be happening.

Michael Pettis: We had two big surges in car buying. One was, until quite recently, everyone bought a car. When I came to China 20 years ago, you didn’t have traffic jams. Now you’ve got massive traffic jams in all the major cities. Epic traffic jams at times. The other thing is in the last four or five years, it seems more and more people are shifting away from gasoline cars to electric cars. You see them all over.

Matthew Klein: If you look at the aggregate—Beijing may or may not be representative here—but if you look at like the aggregate data that the China Association of Automobile Manufacturers put out, for example, you can see that the new production and new sales of electric vehicles is relatively high; it’s about a third. But still, as a share of the total stock of vehicles on the road, electric cars must still be quite low, I would think.

It seems more likely that the other issues you’re pointing out—there just isn’t the money available, either because incomes are too low or because it was only possible with a subsidy that’s since been withdrawn, or things like that—are responsible. Do you have a sense of how officials, and academia, and think tanks are looking at that?

Michael Pettis: Not really. I’m a confirmed bike rider.

Matthew Klein: Fair enough! I guess the public transit in Beijing is a reasonably good alternative.

Michael Pettis: Yes, the subway system is very good.

Matthew Klein: It’s also interesting because if you look at the mix of exports—I remember when I was first looking into this, and you see some people saying, “oh, well it’s fine because if China is producing lots of cheap electric vehicles and selling them the rest of the world, that’s actually good for the, the energy transition.”

And yet, while China does export a fair amount of electric vehicles, the bulk of the exports are conventional internal combustion engine vehicles, because that still represents the bulk of what Chinese manufacturers are producing. Maybe I’m going too much into the details of this particular industry, but I wonder: given the subsidies that had existed for making electric vehicles and the subsidies for batteries, which partly explain the competitiveness of China’s electric vehicle sector, it seems like the total aggregate productive potential of the Chinese motor vehicle industry is still heavily geared towards internal combustion engine cars. Is that your sense as well?

What do you think has happened there?

Michael Pettis: I’ve been told—and again, I’m not an expert on the automobile industry—but I’ve been told that China completely dominates internationally in the sale of cars for under $12,000. A lot of their cars are going to developing countries much more so than to the U.S. and Europe.

Matthew Klein: Some of those are electric vehicles. I guess a lot of them are also conventional—

Michael Pettis: I think most of them are conventional gas engine cars. The big electric vehicle sales are domestic. The problem with electric vehicles, of course, is that you need the charging stations. China has a very good network of charging stations, but I think if you go to other developing countries, they don’t, so it becomes very impractical to buy an electric vehicle.

Matthew Klein: That makes a lot of sense. The subsidies may have been withdrawn, but there was a period of time when it seemed like the government was very focused on promoting the development of the electric vehicle sector and creating a lot of incentives, both for consumers and producers.

Michael Pettis: Subsidies on the manufacturing side haven’t been withdrawn. It’s the subsidies on the purchasing side that have been withdrawn.

Matthew Klein: What was the rationale for that? Especially given all the discourse now about how consumption is too low anyway. It seems like an easy thing to do. One might think it would be a straightforward thing to put back.

Michael Pettis: I think it had reached the point where subsidies were no longer causing a significant increase in purchases. There was a sense that the amount of purchases wasn’t sustainable to the relative to the amount of supply and that at some point they were just going to have to back away. But honestly, I can’t really tell you, Matt. I don’t really know.

Matthew Klein: Ironically that turned out not to be correct insofar as supply has now come back to where it was and purchases of domestically-made vehicles have not, and that’s why the export surge has manifested the way it has.

Moving on to the impact on the rest of the world. Obviously, if you’re looking at places that don’t have their own domestic car industries, which are poor and historically have not been able to afford motor vehicles—as you said, a lot of China’s exports are so dominant in the under $12,000 per unit set—that seems like a pure win for the world, because places that were not able to have transportation now can afford it.

At the same time, Chinese exports are also making really remarkable headways in European auto markets because in Europe you have lots of strong incentives for people to buy electric vehicles. Chinese electric vehicles are much cheaper than the ones that are made in Europe—to the extent that Europe makes any—and Europe has no real restrictions on imports of anything from China, or at least vehicles from China, and that’s led to the very rapid and sudden emergence of a trade deficit in Europe with China on vehicles. They are importing a lot of electric vehicles from China, and there is concern among a lot of European policymakers and business leaders about what that means for the future of the European auto industry.

I know you talk to a lot of Europeans coming through Beijing. What are they telling you about how they’re feeling about all this?

Michael Pettis: Within Europe, as you can imagine, perceptions are sort of split. The biggest concern about Chinese car exports is Germany, obviously, because Germany relied very heavily on its own manufacturing industry. I would assume that countries like Spain are also fairly concerned about that.

But it seems to me that it’s caused a change in the perception within Europe—or at least within parts of Europe—about the whole issue of trade. For a long time, the Europeans had been arguing that the current trading system worked perfectly fine. When I say Europeans, I really mean a group of Europeans, including Germany. They said that there was really no need for deficit countries to intervene in any way with the existing trading patterns. That seems to have changed pretty dramatically.

Read more

Welcome back!

Europe often gets left behind in discussions about the global economy, with many analysts preferring to focus on more “exciting topics” such as the U.S., China, or, sometimes, the grab-bag “emerging markets” category.

But Europe is the third-largest economy in the world (second-largest until relatively recently) and has long played a major role in shaping global outcomes that affect everyone. That was why Michael and I spent so much time in Trade Wars Are Class Wars discussing Europe and how changes within Europe fit into our overall understanding of the past several decades.

In this episode, we review what happened, and then continue the story to see what has changed since the pandemic and Russia’s war on Ukraine. The edited transcript is below the fold. Remember, subscribers cover our cost of production. Paying listeners get to listen to the full recording and read the full transcript.

Related links:

Europe's Imbalances in Pandemic and War — The Overshoot

EXPORTWELTMEISTER: GERMANY’S FOREIGN INVESTMENT RETURNS IN INTERNATIONAL COMPARISON — Franziska Hünnekes, Maximilian Konradt, Moritz Schularick, Christoph Trebesch and Julian Wingenbach

Global Imbalances Tracker — Council on Foreign Relations

Dijsselbloem under fire after saying eurozone countries wasted money on ‘alcohol and women’ — Financial Times

Subscribe now

Matt Klein: Hello! And welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to look at Europe’s internal and external imbalances, how they’ve evolved in response to the pandemic and Russia’s war on Ukraine, and more importantly, what those changes might mean given the patterns we identified in our book Trade Wars Are Class Wars.

Matt Klein: The thing that we pointed out is that the common narrative is that the euro is formed, the European Union adds a lot of new members, and then there’s this problem of “competitiveness”. The idea is that Germany is this paragon of efficiency and high-quality industry, and then these other countries come in and supposedly they’re not as good: their workers are “lazier”, or whatever. And this is the common narrative. And you still hear people saying this even now, and that this explains the problems and those countries just need to have more “structural reforms” to make their labor markets more competitive.

One of the big points of making our book is that’s just completely a backwards way of understanding what happened. The significant change was actually in Germany itself. What happened there was partly a consequence of reunification, and more importantly, was a consequence of how policy elites and business elites understood the experience of reunification—and what they chose to do in response to that in the early 2000s.

So even though the growth in sales of these businesses, many of which were globally oriented, continued to chug along at a normal rate, there was no commensurate increase in domestic consumption and domestic investment. That is what led to Germany’s trade surplus. That’s something I think that a lot of people don’t understand. We spent a lot of time in our book trying to explain this.

It’s really striking: if you look at the change in Germany’s current account balance—which is essentially the difference in all the income earned in Germany and all the money spent by German residents—that change in the current account surplus from 2000-2007, when it went from being more or less in balance to being very, very large, that almost perfectly matches the increase in the total profits generated by German nonfinancial companies. The idea that it had to do with “prudence” or anything like that, it’s just not right. It came at the cost of lower living standards and a big shift in the distribution of income. So that’s what happened there.

Germany, of course, is only part of a much larger global system. That couldn’t have happened in isolation. Thinking about how the Euro crisis played out, what the origins were, the question is what would be the ramifications of the changes in Germany? What was the counterpart to this big shift in the distribution of income within Germany and the big decline in domestic German spending relative to domestic German production? That happened in the rest of Europe. You have a lot of connections to Spain, Michael, maybe you want to lay out how that played out?

Michael Pettis: Sure. What happened in Germany is that before a set of labor reforms in the early 2000s, wage growth kept pace with growth in productivity and growth in GDP. After the so-called Hartz reforms, wage growth fell behind, and as a result, the household income share of GDP declined exactly in line with an increase in the business profit share of GDP.

And as we point out in our book, business profits are all saved. Household income, particularly among workers, is mostly consumed.

Ordinary Germans were no more or less thrifty than they had been in the past, but total savings went up. And if total savings go up, ideally that should fund an increase in investment, so that investment goes up as consumption goes down and there’s no change in demand.

But that’s not what happened. In fact, the investment share of GDP for a few years actually declined. So those of you who remember your accounting identities will remember that if savings go up and investment doesn’t—or worse, if investment declines—then by definition, you have to run a current account surplus. Also, by definition, you have to export those excess savings, and that’s really key because those excess savings [unconsumed production] could have remained in Germany, or they could have gone to other countries.

And it’s very interesting to see what happened. When the euro was created, not all countries in Europe had the same inflation rate. The countries in what we started to call “peripheral Europe” had higher inflation and the countries like Germany and northern Europe had lower inflation. With the creation of the euro, we saw a convergence in European interest rates, but not a convergence in European inflation.

And that’s very important because what it meant was that real interest rates in countries like Spain—and because I was born and grew up in Spain, I’ll use Spain as an example for all of peripheral Europe—real interest rates were very, very low, and even negative. Whereas in countries like Germany, real interest rates were positive. So it’s not surprising that the money flowed heavily into areas where the, uh, where, where interest rates were negative. You had German savings flowing into Spain, Portugal, Italy, etc. into the banking system.

The reason was not that suddenly Spaniards became better credits. The reason is that the Spanish banking system was flooded with inflows, particularly from Germany, directly and indirectly, and they had to lend it out. And the way you increase loans is you reduce your lending standards.

In addition, with this flood of money coming into Spain, asset prices soared. I remember the stock market did really well, but what did superbly well was real estate. Real estate just exploded.

I’ll give you a little anecdote here. I think it was in 2004 or 2005, I had gone home for the holidays. And my mother decided to have a very big New Year’s Eve party and it was pretty big. It was something like 70 people came before midnight. The tradition in southern Spain is that you go somewhere before midnight, you have the dinner, you have the drinks, you cheer for New Year’s, and then you travel from house to house meeting other friends. So quite a lot of people came to our house that night. I remember I’d had several drinks. I was probably feeling particularly philosophical at the time.

Everybody was making tons of money off of real estate. I remember thinking this can’t be a good sign, when no one does any real work. Everyone is simply building apartments.

Matt Klein: If you look at the cumulative investment in housing in Spain and in Germany in the 2000s, even though Spain is a country with less than half the population, or about half the population, there was more cumulative investment net of depreciation in Spain, substantially more, by the eve of the euro crisis than in Germany, and, larger than in France and so forth.

Michael Pettis: You can still go to parts of Spain where there are buildings that are 10 or 12 years old, but they’ve never been lived in. There’s just apartment building after apartment building that nobody lives in. Because at the time, real estate prices were going up so quickly that it was a guaranteed way of getting rich: buy an apartment even if you haven’t seen it and sell it in three or four years and buy a Mercedes. I think Mercedes were selling like hotcakes in Spain at the time.

Now, why does all that matter? It sounds like a good thing. We had a great party. It matters because you had banks that were lowering their lending standards in order to increase their consumer loans. You had surging real estate prices and surging stock markets, which made Spaniards feel much richer than they otherwise were. It turned out to be fake wealth, but at the time they felt very wealthy. And as a result, they increased their spending, they reduced their savings. When you go through all of these different aspects, what ends up happening is that the Spanish savings rate collapsed at exactly the same time that the German savings rate surged.

Matt Klein: Before we go further, because some of these terms might be confusing to some listeners who aren’t as familiar with the official macroeconomic accounting definitions the way we talk about them: when we hear the word “savings”, what it means is it’s literally everything that’s produced, or all the income that is earned, minus whatever is consumed immediately. That’s why normally you say savings and investment have to balance, because by definition, globally, everything that’s produced is either consumed or is an input to investment. So that's where that comes from.

That’s on the real side. And then on the financial side, when we say that savings “flow” from Germany to Spain, for example, that has two implications.

One is that the counterpart to German businesses continuing to sell goods and services—mostly goods—in line with global economic growth, even as the German domestic economy is weak, is that the rest of the world must be buying an increasingly larger share of what those German businesses are producing, because they’re not selling to their home market. That’s one way of savings flowing: the German excess production is exported.

The other side is, as you mentioned, to the financial system. You can look at the data on German banks, for example, being very aggressive in foreign lending before 2008 and accumulating claims on banks elsewhere, including, notably in Spain, Ireland, Greece. That’s how those balance out.

And in fact, those have to be simultaneous events. Those Mercedes that you mentioned seeing all the people in Spain buying are the corollary.

They were accumulating lots of savings from the German companies that were generating those profits from sales abroad. And of course, they couldn’t have generated those profits unless other people were buying. All of these things had to fit together simultaneously. That’s how that worked.

Until, as you mentioned, it stopped. Because as soon as someone somewhere decides, “I don’t want to keep buying debt assets or lending to people who may or may not be able to repay it with those increasingly outlandish investment projects,” then you have a sharp reversal.

Michael Pettis: Now, as you mentioned, Matt, the standard story is, “well, the Germans are very hardworking and thrifty and everyone knows that the Spaniards love to have siestas and go to the beach and things like that.” And of course it’s not true. Spanish workers work more hours every year than German workers.

And there wasn’t really a change in culture. Savings didn’t go up in Germany because Germans suddenly became “Germanically thrifty”. And they didn’t collapse in Spain because the Spanish suddenly became crazy about spending money. It had to do with structural changes in the distribution of income in Germany and the impact of all of these inflows into Spain.

So if German savings went up [and German investment went down], then either investment in the rest of the world had to go up, or savings in the rest of the world had to go down, because at the end of the day, savings and investment must balance.

Investment didn’t go up. There was some investment in a lot of nonproductive empty apartment buildings, but basically, savings had to come down in Spain and in the other peripheral European countries in order to balance the inflow of savings from Germany.

The way they came down is again very structural: you had a wealth effect that caused people to feel richer than they were, which meant they spent more than, than they should have. And then you had banks that were eager to expand consumer loans, and they lowered their lending standards enough.

So notice what happens: as German savings flowed into Spain, Spanish savings had to decline to match that. You can’t have an excess of savings globally.

Matt Klein: I just want to point out briefly, we talked about the quality of the savings, but surprisingly, if you look at the national savings rate in Spain, maybe not the household savings rate, but the national savings rate actually was flat during this period. What happened was that there was a huge increase in investment. So savings net of investment—the current account balance—did deteriorate quite dramatically.

But this is an interesting point. Investment increased so much in Spain—there’s some other countries where the dynamics were slightly different—but at least in the aggregate, I think it’s because the government budget surplus increased, in Spain, that’s how that played out.

Michael Pettis: And some of that investment turned out to be quite good. You know, Spain has some of the best transportation infrastructure in the world: high-speed trains, great highways. Unfortunately, a lot of it turned out to be not just in useless real estate—apartment buildings that remained empty—but… There’s a huge airport built not far—well, it’s actually pretty far from Madrid. And it was going to be this spectacular new airport that was going to become one of the centers of aviation in Europe.

Matt Klein: Don Quixote airport actually, that’s what they called it, I think, because it was in La Mancha.

Michael Pettis: I knew it had something to do with Don Quixote. Or maybe it should be Sancho Panza, I don’t know. But I don’t think an airplane has landed there yet. Certainly no commercial airplane has ever landed there yet. You had a lot of these really crazy projects, and what they required was a surge in debt in order to finance them. Now, had they been productive, the surge in debt would have been sustainable and not a problem. But in 2008-2009, at the beginning of the global crisis, people suddenly started becoming very nervous about debt levels in countries like Spain, Italy, Portugal, et cetera, and the funding dried up.

Read more

Michael and I were not expecting to discuss China again quite so soon, but the surprising and persistent weakness of the consumption, production, trade, and investment data are all so striking that we felt compelled to dig in.

We cover what Michael has been seeing on the ground, how the government might respond, the constraints facing the central government, why Richard Koo is right (or wrong) about what China can learn from Japan, why Chinese policymakers are like Herbert Hoover, what America’s recovery from Covid might teach China, the plight of China’s young graduates, and what has happened to architecture majors—among other things.

The edited transcript is below the fold. Remember, subscribers cover our cost of production. Paying listeners get to listen to the full recording and read the full transcript.

Subscribe now

Related links:

China's Missing Post-Pandemic Rebound—The Overshoot

Why US debt will continue to rise—Michael Pettis

The National Development and Reform Commission held a special press conference to introduce the promotion of private investment—NDRC

New Top Document Promoting China's Private Economy—Pekingnology

Richard Koo on China's Risk of 'Japanification'—Odd Lots

The old approach to US-China relations no longer works—Stephen Roach

China Used to Be an Architect’s Dream. Now, It’s Becoming a Nightmare.—Sixth Tone

Matt Klein: Hello! And welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss what's been happening in the Chinese economy since the end of “Covid Zero,” which was at the end of last year. Many of us, including me, were expecting a strong recovery, particularly on the consumption side. But so far that hasn’t happened. And month after month, we’ve been hit with fairly disappointing economic numbers.

Matt Klein: So just to get started, maybe we can talk about what people had been thinking, and why you and others were relatively optimistic at the end of last year and the beginning of this year, which was when the government announced the end of the restrictions associated with suppressing the pandemic.

Michael Pettis: During the Covid period, not just in China, but in most countries, you saw a contraction in consumption. That’s particularly important in China because consumption is already very low and consumption drives business investment. What we’d seen during the three years of Covid was a year of significant contraction in consumption that was then followed by a reasonable recovery. In 2020, Chinese GDP grew something like 3%. But consumption, along with business investment and exports, actually contracted. So more than 100% of the growth was driven by the kinds of things that China is trying to back away from: investment in the property sector and investment in infrastructure. And one of the ways we see that is that China’s debt/GDP burden worsened significantly in 2020—it went up by 25 percentage points.

In 2021, however, we had a very different year. GDP growth was around 8%, but that was driven largely by a major recovery in consumption. It was not a full recovery, it was a partial recovery, but still, consumption grew by about 9%. Business investment was strong. Exports were strong. So you had pretty high quality growth. One of the things that I’ve mentioned many times before is that when the quality of growth is high, you don’t see a significant increase in the debt burden. And in fact, the debt to GDP ratio went down for the first in a very, very long time.

Last year, we had another bad year. You had the terrible lockdowns, most notoriously in Shanghai, but in a lot of other places too. And once again, growth was fairly slow. The high-quality growth, which again is consumption, business investment, and exports, did quite poorly. Much of the growth was the kind of growth that, again, China doesn’t want. And once again, we saw a surge in the debt/GDP ratio, something like 12 or 13 percentage points.

So many of us were expecting, not a repeat of 2021, but a partial repeat, where some of that contraction in consumption—which was a forced contraction when you’re locked at home and you simply can’t go out and consume to the same extent you used to—that some of that was going to recover this year. We’d see consumption grow reasonably quickly, not enough to make up for last year, but partially to make up for last year. And as a result, business investment would do reasonably well. So we would be able to achieve the 5% growth target quite easily. And more importantly, It's not just 5% growth or 6% growth. It would be a high-quality growth.

But month after month, we’ve been very disappointed. We saw a partial recovery in February and in the beginning of March. And after that, it pretty much fizzled out. We’ve had very slow growth. And we’re seeing that in all of all of the relevant numbers. The consumption numbers are very weak. The retail sale numbers—the monthly proxy we have for consumption, because we only get consumption every three months—have been very, very weak.

While the rest of the world is still dealing with inflation, China is dealing with deflation. We had a little bit of inflation in January but every month since then we’ve had deflation. Chinese exports are down a bit, but Chinese imports are down a lot. That’s another indicator of domestic consumption.

That creates a lot of questions about what happens in the second half of the year. There are many, many people in Beijing who think that we still need to wait a little bit longer and that consumption will revive. Perhaps it will, perhaps it won’t. We don’t really know. It’s very hard to predict these things. If it does revive, we’ll probably get a partial revival in business investment. But if we don’t, we won’t. And I think most economists agree that exports are not going to grow this year because the global economy isn’t doing very well. The property sector has been badly hurt and is not going to recover.

When you go through all of the possible sources of growth, there’s really only one left: renewed spending on infrastructure, which is something Beijing doesn’t want to do because China already has way too much infrastructure. And this is the big source of debt. But that’s the big question that we’re all asking ourselves: Will we see a partial revival in infrastructure spending? If that happens, that’s bad for China in the long term, but at least it delivers growth in the short term. And for political reasons and employment reasons, Beijing is very concerned about seeing an increase in economic activity over the rest of this year.

Matt Klein: I definitely want to follow up on a few of those points. But before doing that, I want to highlight that this is a surprise, because a lot of the indicators one might look at—not necessarily economic indicators, but just indicators of what life is like as a person living in China today—show that there has been a tremendous normalization. Since the end of last year in terms of the experiences that normal people actually have. So I think that’s part of the reason why it’s surprising that consumption hasn’t revived. Maybe you can give us a sense of what that contrast is like and why, given this, it is so surprising that we’ve seen such a weak recovery.

Michael Pettis: In many ways life seems to have gone back to normal. If you travel around Beijing, it’s full of people. There are terrible traffic jams. The subways are full, the city is full of tourists. But it’s a little bit distorted, because when you look at the various components of consumption, catering and travel have come back very strongly—that’s the number one area of growth among all the various types of consumption.

Number two, interestingly enough, is gold jewelry, things like that. You sort of wonder why are people buying so much gold and jewelry. Could it be because they’re very optimistic and everyone's running around getting married and things like that? That seems unlikely. Could it be as a way, not so much of consuming, but as an alternative way of saving? We don’t really know, but we’ve seen this in the past.

Automobile sales are up largely because of a lot of support from the government. But most other goods, durable goods, et cetera, are way down. So on the one hand, China looks like it’s fully recovered from “Zero Covid”, but it’s still not showing up in the in the numbers.

Now, one of the things that’s been interesting to me this year is that a lot of people who weren’t able to come to China in the last 3-4 years have returned to China for visits, and I meet with quite a lot of them: academics, business people, investors, bankers, government people, et cetera, And all of them seem to think that the level of depression, the level of anxiety, the level of nervousness is much higher than they’ve ever seen before in China. It’s hard for me to tell because I’ve been here during this whole period, although it seems to me that anxiety certainly has gone up.

And this, of course, is something that that Beijing worries about a lot. If you’re nervous about the future, you’re unlikely to spend. If you don’t spend, we’re not going to get a recovery in the economy. And if we don’t get a recovery in the economy, of course, you’ll continue to be nervous about the future.

Matt Klein: Right. There’s a real reflexivity there. It’s interesting too, because, as you said, the government in Beijing, the authorities, they do want consumer spending to rise. And you see lots of independent academics and analysts talking about this, think tankers, university deans, and people like that. It seems like there’s a consensus intellectually that there has to be more consumer spending. And yet there doesn’t really seem to be much of a policy response. I guess the People’s Bank of China sort of has been asking banks, but not asking very hard, to see if they can charge less mortgage interest on existing mortgages.

But otherwise, it doesn’t seem like there’s been really kind of any major significant initiatives that match the sense of urgency or intellectual consensus that there should be more consumer spending. What’s your sense of what explains this disconnect? On the one hand, people seem to understand what's going on, there’s a belief about what should be done, but then there’s not really actually any follow through, or not much follow through.

Michael Pettis: Well it’s incredibly frustrating. By now, almost everyone agrees that it’s vitally important to increase the consumption share of GDP because that’s what needs to drive growth. The two big sources of growth are consumption and investment, and there’s way too much non-productive investment in China, so you have to bring that down. But if you bring that down, either you bring up consumption or you reduce GDP growth, and of course, they don’t want to reduce GDP growth. So by a process of elimination, you must increase the role of consumption in economic activity.

But there’s only two ways you can increase the consumption share of GDP in any economy: one is you can increase household debt, in other words, get households to borrow more money to consume. China did this in the last 7-8 years, to the point where household debt in China as a share of household income is among the highest in the world. It’s higher than in the U.S. Beijing is very concerned about not encouraging any additional household debt.

So that leaves the only other way, which is to increase the household income share of GDP. In other words, give workers more money, improve, the pension system, reduce fees and payroll taxes. There are lots of different ways of doing it. Even make the subway free, or build cheap housing and give it to the poor, or rent it very cheaply to the poor. There’s lots of ways of doing that.

But when you look at all the talk about boosting consumption—and I tell you, you can pick up the People’s Daily, and every single day there’s another article saying we are going to boost consumption—and then you read through what they’re planning to do and you see that none of them, or very, very few of those proposals actually boost household income. They’re more along the lines of “let’s make the shopping experience happier, let’s have shops stay open later at night.” Or “let’s improve delivery on the internet,” et cetera, et cetera.

But the problem is that when you as a typical household think about spending money, your constraint is your income. Let’s say you have 100 of income and you decide for whatever reason that you’re going to save 15. That means you get to spend 85. And if I can figure out a more enjoyable way for you to spend that 85, you’ll be happier when you spend that 85. But you’re still not going to spend more than 85. That’s the problem. Most of the proposals are really what we would call supply side proposals, they’re not really demand side proposals.

And it’s really intriguing to try to understand why that’s a problem. Part of it is institutional. But I was reading on one of my favorite topics, which is the 1930s, and as I was reading about Herbert Hoover, who was a very smart guy, but during the early days of the depression in 1930-31, he could not bring himself to deliver income to households directly.

He was more concerned about making them “lazy” than about creating demand, so his policies were all supply side policies: “If only we can give more money to businesses, then they will go out and hire more workers and household income will go up.” The problem is that businesses couldn't sell what they were producing, and so subsidizing them further didn’t really solve the problem. They still weren’t going to hire workers. And it seems like we’ve been caught in that sort of Herbert Hoover trap here in China.

Matt Klein: That’s a great point. I remember a couple of years ago when Xi Jinping introduced, or reintroduced, the concept of “common prosperity”, and then people were very excited about this. There was a lot of potential about what that could mean and how that could fit in potentially with this rebalancing agenda. And then there were these caveats of, “well, obviously, we don’t want to end up—” I think actually, you can correct me if I’m wrong, but I believe that they explicitly made comparisons to Latin America and said, “we don’t want to end up like them.”

I remember being struck by that tension there. You can recognize the macro imbalance, but then you don’t want to address it because there’s a not entirely unreasonable concern about how you might affect micro behavior and incentives. But at the same time, if you let that concern get in the way too much, then you prevent yourself from doing the macro policy that you need.

Read more

This month we take a look back at the ructions in the U.S. banking system since early March, what they mean, and how the financial system might look different going forward as a result. Along the way we cover everything from interest rates in China to Depression-era banking regulations to central bank digital currencies.

The first 15 minutes are free for everyone, but the full conversation—and full transcript—are for paying listeners. Please consider subscribing to get the full experience! As a reminder, all paid subscribers to The Overshoot are eligible for a substantial discount to paid subscriptions for UN/BALANCED.

Related links:

Thoughts on the Bank Bailouts — The Overshoot, March 13 2023

Banks Are Blowing Up While the Economy is Strong. Time to Worry? — The Overshoot, May 10 2023

Bank Regs Are Excess Profit Taxes — The Overshoot, July 20 2021

How a Regulatory Tweak Will Affect Banks, Money Funds, and the Financial System — Barron’s March 26 2021

Silicon Valley Bank bid report — FDIC

Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank — Michael Barr, April 28, 2023

Signature Bank bid report — FDIC

FDIC’s Supervision of Signature Bank — FDIC, April 28, 2023

First Republic Bank bid report — FDIC

Parachute Pants and Central Bank Money — Randy Quarles, June 28 2021

Economic Report of the President — Council of Economic Advisers, February 1970

Thanks again to White+ for the music and to George Drake Jr. for producing!

The full transcript is below, lightly edited for clarity.

Matt Klein: Hello, and welcome back to UN/BALANCED, a listener-supported podcast about the global economy and the financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss what’s been happening to the U.S. banking system as interest rates have risen and some banks have gotten into trouble. Some relatively large banks have blown up. The U.S. government has spent over $30 billion bailing out a few of the larger depositors, and a lot of surviving banks don’t seem to be in great shape.

Matt Klein: But first, I would like to make a brief special announcement. As you probably have noticed, there was a longer gap than normal between our previous episode and this one, and I’m happy to say that we have a very good reason, which is that my wife gave birth to our second child back in March, shortly after we recorded the previous episode that we released in April.

Everyone is doing great now, thankfully, but since the baby arrived a few weeks before her due date, we were not able to record as many episodes in advance as we’d hoped. We should be back to our regular monthly schedule from here on out. Thank you all for your understanding. Now back to the main event.

Michael, we both started our careers in the midst of major banking crises, and those experiences have played a large role in our thinking and in our historical interests.

Michael Pettis: Let me interrupt just so that people don’t think it was in the midst of the same major banking crisis. Your banking crisis happened much later than mine.

Matt Klein: Yes, that is a fair point! Nevertheless, I do think that experience has shaped our mutual interests. Looking at this latest episode, what I find interesting is that in some respects, it perfectly fits the template of how banks get into trouble. But at the same time, in other very important respects, it’s very different from what you and I lived through in the 2000s and the 1980s.

So maybe we can start by just going through kind of a quick, straightforward narrative of what actually happened with the beginning of this crisis with Signature Bank and Silicon Valley Bank back in March.

Why did these banks blow up when they did? All banks, what do they do? They borrow from one set of customers and they lend to some other set of customers, either by making loans or by buying bonds or something like that.

And the trick is to borrow from people who don’t want to get their money back anytime soon. And then you make loans to people who will pay you more because there’s some kind of risk involved. If you can manage that spread, then you make a nice profit and everyone’s happy.

So you look at their call reports that they file with regulators and overwhelmingly they’re borrowing uninsured deposits from businesses. Not even the operating deposits that businesses use to make payroll, but the longer-term non-operating deposits.

Now, if you look at what regulators say when they classify the risks of depositors and how banks and bankers should hedge against those risks and what kind of assets they should hold against those deposits, these are considered the absolute riskiest flightiest characters. And yet, these banks were holding relatively long-term assets that could not be sold on short notice without taking some kind of a loss.

On top of this, and this is what I think is kind of most interesting here, is that a lot of these deposits weren't even any earning any interest. Now, in 2021 or 2020, that doesn’t really matter, right? Because the interest rates you get on short-term money were effectively zero, regardless. So if you’re getting zero interest on a bank account versus zero interest on a Treasury bill, who cares?

But by the time you get to the end of 2022, the interest that you can get holding onto the safest possible short-term assets—short-term Treasury bills, or an overnight loan directly to the Federal Reserve—you can get yields of 4% or more. And yet these banks, for the most part, were still paying something on the order of zero. Maybe a little more than zero, but basically zero.

So the mystery to me, in part, is: why would these business customers even keep their money there in the first place? If you’re a corporate treasurer, it is not very hard to get a better yield for your shareholders and fulfill your fiduciary responsibilities. Nevertheless, that’s the situation.

Then you have a situation where both of these banks owned a bunch of bonds that were underwater in various ways, particularly Silicon Valley Bank. They had bought a lot of mortgage bonds during 2021, when mortgage bond yields were very low. Rates went up quite a bit since then, and what happened is that some depositors said, “well, this is going to be a problem.” And they start to leave the bank. The depositors see that there’s a loss, but more importantly, the bank sees that there’s a potential loss, so they try to raise capital to cover it, but then the depositors get very upset.

It turns out the deposit base for Silicon Valley Bank in particular was very concentrated among startups and venture capital firms. Those venture capital firms in particular could effectively advise their startups on how to behave and what to do. And they pulled their money very quickly. The post mortem says something like 40% of their deposits left in the course of a day, before they were shut down. Banks can’t respond to that.

So the interesting question here is, on the one hand, this is obviously very standard: the way banks fail is if someone stops lending to them, they fail. That’s just a very basic function of how banks are constantly borrowing. If they can’t roll over the debts, they blow up.

But there’s some interesting differences here in terms of what happened.

That’s actually not what happened at all. They were holding very safe assets, which if they’d held to maturity, they would’ve been paid back exactly what they thought they were going to get. Yet nevertheless, they blew up. That is obviously very different from a lot of the stereotypical examples.

What are you thinking of in terms of some of the historical examples that might spring to mind here? What makes this similar and what are some of the interesting differences?

Michael Pettis: Traditionally there are two reasons why banks can get into trouble. One is they become insolvent and the other is that they have horribly mismatched balance sheets.

In this case, there may have been an insolvency issue because the value of their assets dropped relative to the value of their liabilities. Typically, banks have insolvency issues because they make bad lending decisions. This was not a bad lending decision; this was a bad balance sheet management decision.

But they always run the risk of mismatches between liabilities and assets, because it’s the job of the banks to convert short-term savings into longer-term investment. Whenever depositors want their money back—whenever the liability side of the balance sheet contracts—that puts pressure on the asset side of the balance sheet.

To me, the really interesting story here is the stickiness of deposits—or the lack of stickiness of deposits. I had always learned, and I’ve always taught in my banking classes—maybe I’ll teach it less, or teach it with all sorts of restrictions—that there were certain types of deposits that bankers loved. Those were basically retail deposits. And the reason they love them was because it took an awful lot to get them to move.

Many banks are able to calculate what they call the “franchise value” of the deposits.

If you have a lot of institutional deposits, for example, if I’m a treasurer at a company, and I deposit $100 million in your bank, that $100 million is incredibly mobile. If another bank, if a JPMorgan calls me up and says they’ll give me five basis points higher yield, it’s worth my while to take my money out of your bank and put it into another bank and to get the five basis points of higher yield. By the same token, if a friend calls me up and says, “we’re hearing rumors about your bank”, it’s worth my while to move money out as quickly as I can.

But if I’m a retail depositor with $40,000 or $50,000 in the bank, it becomes much more complicated. First of all, I can’t move my money really easily. I have to take off a morning or an afternoon from work to go to the bank to move the money. This is the old days. It’s obviously not true today, but in the old days there was a cost of doing that, and my professor used to call it “shoe leather costs”. You have got to do a lot of walking around to get your money out of the bank and into another bank. So in that scenario, it would take quite a lot to get me to move my money.

I would need a huge difference in interest rates; another better or equally good bank would have to offer me a lot more money before I would take my money out of the bank and move it into that bank. 1% on, on $40,000 is $400. That’s $400 in a year. That’s not nothing, but if I think that the other bank is going to catch up within a month or so, it’s hardly worth the effort to move my money out. If I hear a rumor, I’m going to need a lot more than a rumor before I’m going to go through the hassle of going to the bank, taking time off from work, going to the bank, waiting in line, et cetera, et cetera.

So now it seems to me there isn’t a huge difference between a small depositor and a big depositor in the sense that either of them can move money very quickly, very efficiently. I don’t know if you can do it in a few minutes, but certainly you can do it in less than an hour at the first sign of trouble or at the first sign of differences in interest rates, et cetera, et cetera.

I’m not living in the States, I’m certainly not out in California, but it seemed to me that part of the problem may have been that this stickiness of deposits, which was a great asset for banks, has basically collapsed to zero, or close to zero, so there’s no longer any franchise value in deposits. They can move around at an incredibly rapid speed for extremely low cost, and therefore they’re much more volatile than they used to be. Would you say that that was one of the big problems with Silicon Valley Bank?

Matt Klein: I think there’s an element of that. Although I also think it’s worth stressing that both Signature Bank and Silicon Valley Bank didn’t really have the kind of franchise value and deposits that we think of with a normal retail bank because they didn’t really have retail customers. In that sense not much has changed. In retrospect, I think they arguably had a negative franchise value in their deposits because of the kinds of clients that they had.

But to your point, the normal default thing that makes sense is that if you’re a corporate treasurer and you’re managing large sums of cash, you would be very sensitive to differences in interest rates and risk.

It’s kind of analogous to the situation you had in the 1950s or 1960s where the bank would not pay you interest, but you’d get a toaster, essentially. That’s kind of the thing that they offered, where you wouldn’t get interest—you’d be vastly underpaid compared to Treasuries or lending to the Fed or things like that—but there were other ancillary benefits.

In the case of Silicon Valley Bank, they offered very favorable mortgages to rich individuals. There’s an interesting question there of individual venture partners getting a very good deal on their mortgages and then pushing all of their venture funded companies to put cash there. That’s an interesting dynamic.

Signature Bank went in different direction. They really catered to the crypto industry. And they had all the systems set up that made it easier for various crypto businesses to pay each other in dollars internally through the bank. Again, that creates an interesting dynamic where, if the crypto industry tanks, as it did basically starting in the beginning of 2022, they’re pulling out their deposits for reasons totally unrelated to anything else happening.

With Silicon Valley Bank as well, you had a huge influx of deposits as various venture backed companies were raising a lot of cash. And then they stopped raising cash and they started burning that cash, and that started naturally pulling deposits back. These were underlying problems.

And those deposits are correlated in a very unfortunate way, as it turns out, with interest rates, which is also problematic if you’re using those deposits to finance longer-term debts that then lose a lot of value as interest rates rise.

It’s kind of interesting to think “why would someone want to buy these businesses and assume the deposits?”

The normal thing is that when a bank fails and the government steps in, or not, there’s some kind of resolution and then there’s a takeover process. The Federal Deposit Insurance Corporation will make sure that insured depositors get seamless transition of service. And the feeling usually is “oh, well it’s good for a bank to do that because those deposits are valuable.” As you said, retail deposits are sticky. That still seems to me mostly, in the aggregate, mostly to be the case. And yet these deposits probably are not ones you’d want.

Michael Pettis: Not only are they ones that you probably wouldn’t want, but it seemed to me that Signature Bank was a particularly surprising event. During the big period of consolidation of the banks in the 1970s and 1980s, the classic argument was that small banks are overly exposed to a particular part of the economy, and so that increases the probability of default, right? If your economy, if your town does badly, the bank will collapse, and so you wanted to be diversified to protect yourself.

It’s incredible to think that no one considered the possibility that there may be a significant contraction in the crypto industry and how that would affect the balance sheet of the banks.

Read more

Section Outline

0:33 China’s 2023 GDP growth target and the post-”Covid Zero” outlook

18:01 What should we think about the personnel shifts at the top of China’s economic policymaking apparatus?

23:50 Regional variations within China, the “negative convexity” of local debts, and implications for the hukou system

Related reading

Why the Bezzle Matters to the Economy — Michael Pettis

China's radical plan to limit the populations of Beijing and Shanghai — The Guardian (March 19 2018)

Matthew Klein: Hello and welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss the news out of what in China is referred to as the Lianghui or “The Two Sessions”. These are the annual sessions of the National People’s Congress, which is the legislative body in China, and then the Chinese People’s Political Consultative Conference, which is sort of an advisory group. These meetings are very important for setting the economic and other goals for the year. And we’re going talk a little bit about what has come out of it and what it may mean for the Chinese economy.

Matthew Klein: So maybe you could give us just a little more background for those of our listeners who, unlike you, have not been living in China for the past two decades and are less familiar with these terms. Can you give us a little more sense about what previous iterations of these two sessions have signaled for the years ahead? What have been the biggest changes that have come out recently that give us some guidance for 2023?

Michael Pettis: Well, the sessions cover a lot of topics. But for those of us who are interested in China from an economic and financial point of view, the most important things that come out every year in these meetings is that we get the expected budget for the year. That tells us something about the amount of debt that’s going to be raised—and more importantly in recent years, the amount of transfers from Beijing to local governments to make up for their shortfall in income.

The other really big news—the one that we all wait for—is when they formally announce the GDP growth targets for the year. Now, we typically have very good rumors during the December work conference about what they’re going to choose for the GDP growth target, and those are usually confirmed, not always, but usually confirmed in the two sessions meetings in March.

By now I suspect that most of our listeners know that Li Keqiang, the outgoing premier, on the very first day of the two sessions in his speech announced that the GDP growth target for this year would be 5%. Now, many of us knew that this was likely to be the growth target because these were the rumors beginning in December.

But in recent weeks there was an awful lot of press citing analysts at various investment banks who thought the target may be much higher: 5.5% to 6%. Each province in China and most major cities also have growth targets for the year, and those were all released earlier in the year. If you look at the growth targets for the provinces on a weighted average basis, they are collectively projecting growth of around 5.8%, 5.9%. So that’s the context within which to understand this 5% growth target.

Matthew Klein: The thing that’s striking to me about this 5% is on the one hand you could say, “oh, that’s slow compared to the longer-term history of Chinese economic growth,” where you had many years of 10% or almost 10% yearly GDP growth. You could also say, given the fact that the economy basically didn’t grow at all in 2020 or in 2022, that if you had some sort of reasonable trend baseline of what would’ve happened had there been no pandemic since 2019, you would need a tremendous amount of growth in 2023 just to catch up to that trend.

One would think that with the relaxation of pandemic-related controls that you’d get a lot of that naturally, with all the pent-up demand and savings and so forth that have been accumulated over the past couple of years. You could say that 5% or even 6% you could imagine being on the low side.

I’m curious how you think about that and what that might mean in terms of the target. Or maybe this is like a U.S. corporation where they give soft guidance on purpose?

Michael Pettis: Well, it may help to look back at some of the growth rates. Before 2016, we regularly had the kind of growth rates you were talking about: 6%, 9%, as high as 13% in some of the years. But from—I’m just looking at my data here—in 2016, we had 6.9%, 2017: 6.9%, 2018: 6.7% 2019: 6.0%. That, of course, was the last year before Covid, and during the three Covid years, we’ve had an average growth rate of around 3.6%, but that was very unevenly distributed. In 2020, growth was 2.2%. Then in 2021, growth was 8.1%; a huge recovery. And then in 2022, growth was 3.0%.

So to go back over those numbers again, in 2020, China grew by 2.2%, but what Beijing refers to as “high-quality growth”—that is, unlevered growth, which is mostly driven by consumption, exports, and business investment for the most part—that was actually negative in 2020. More than 100% of the growth was generated by the kind of things China says it wants to avoid, which is investment in the property sector and investment in infrastructure.

They want avoid it because they are way overbuilt on both so a lot of that stuff is non-productive. One of the ways you would expect to see that, if that were the case, is that debt levels would jump especially high during those years in which high-quality growth is low or negative, and low-quality growth more than nearly all of the total. And in fact, the debt to GDP ratio in 2020 rose by—I don’t have the numbers in front of me—I want to say 24-25 percentage points.

In 2021 we got a partial recovery and the debt/GDP ratio actually dropped by about 4 or 5 percentage points. Most of that 8.1% growth was really high-quality growth driven by something like a 9% increase in consumption. And then last year out of that 3% growth, almost all of it was low-quality growth: consumption grew by about 1%. Not surprisingly, the debt/GDP ratio rose by 11 or 12 percentage points, the second highest ever. So what we’re looking for this year is not a repeat of 2021, but sort of a partial repeat of 2021 where we get both a high growth number, or relatively high growth number, but more importantly, much or most of that growth being what Beijing refers to as “high-quality growth”.

Matthew Klein: Just to add to what you were saying, China’s National Bureau of Statistics, when they track fixed asset investment excluding real estate—which includes infrastructure spending and includes business investment—one of the ways they publish it is they distinguish between private fixed asset investment and state owned or state controlled fixed asset investment. And just to corroborate what you were saying, in 2020, private-sector growth in fixed asset investment was just 1% for all of 2020 compared to 2019. And in 2022 it was 0.9%. That is extremely slow growth, which fits with what you’re saying.

Following up with what you were saying before, why wouldn’t we expect a repeat of 2021, in terms of the magnitudes? Because as you were saying, the overall growth impact of 2022’s Covid restrictions was actually pretty comparable to 2020, both in terms of overall GDP growth and in terms of consumption and private fixed asset investment. Why wouldn’t we expect that kind of a snapback? Do you think there are other constraints that might impair or prevent that kind of recovery this time around?

Michael Pettis: Well, part of it is because in 2020—the bad year—unemployment didn’t really seem to go up that much and there was less downward pressure on wages. There was downward pressure on wages, but less so. Much of the reduction in consumption in 2020 was simply the flip side of an increase in savings. Part of that extra savings was a permanent increase in savings, which is what happens when uncertainty rises: we all spend less and save more. But a lot of it was an increase in unwanted savings, and we saw a big recovery there. Also, don’t forget that in 2020, real estate prices were still going up and the real estate sector hadn’t been badly hit, which is what happened towards the end of 2021. So there were a number of things that suggested that 2021 was going to be a pretty spectacular year in 2020.

In 2022 now you have the real estate sector, which isn’t performing well, and declining real estate prices may have hurt consumption through some kind of wealth effect.

It’s hard to get the data, but people talk about youth unemployment being around 20%. All of that seems to have combined to make Chinese households much more cautious about spending money. Plus we don’t have the motor that was the real estate sector.

One other point that I should mention—it’s less important, but it’s very visible—is that Chinese exports exploded in 2020, 2021, and 2022. By the end of 2022 they started slowing significantly.

Matthew Klein: That is a really good point that China, especially in 2020, and to a lesser extent, also in 2022 that the Chinese economy was able to rely to a certain extent on foreign demand to supplement or substitute for domestic consumption.

Just to follow up on this, because I would love to know more what your perception is: these points about economic weakness driving the shortfall of consumption 2022 and things like uncertainty in youth unemployment, the property sector and the changes there that you mentioned and the way that flows through to local government financing, which we can talk about later, are obviously very important.

Or do you think there are other deeper issues that are holding back consumer spending in a way that wasn’t necessarily the case a few years ago?

Michael Pettis: I think the uncertainty is very important. I think the lower income is very important. Last year, real per capita consumption was actually down something like 0.2%. I think that’s the first time that’s ever happened since the reform and opening up. There are a lot of things that are included in there.

I think medium term, China’s got a huge problem, but short term, I’m relatively optimistic. I think growth will be closer to 6% than to 5%, but I always warn people that I’m speaking to that there’s a lot of uncertainty around that as of yet, because we’re counting on a very big reversal of last year’s consumption contraction. But it’s too early in the year to really say what happened. The first two months are characterized by Chinese New Year, which has a big distortionary impact on spending. 2023 was the first Chinese New Year that we’ve had without Covid restrictions in three years. So that may have changed people’s behavior in ways that are hard to predict or hard to understand.

The other important thing was that Covid swept through China in December, January, and a good chunk of February. It still had an impact on people’s activity and on people’s spending. So we don’t really know yet. We don’t really have good data on whether or not there’s been a significant rebound in consumption. I would guess we really want to see what happens in March and April.

But if you look at the trade data, they’re really pessimistic. We always get trade for the first two months of the year together because of the impact of Chinese New Year. And for the first two months of the year, exports were down 6.8%. This is like the, I don’t know, the fifth month in a row that it’s been down. That’s very worrying.

With imports so weak, that suggests to me that in the first two months of the year, consumption was probably not nearly as strong as we would’ve liked it to be. Now, like I said, the first two months of this year are so weird that you don’t want to draw too many conclusions from it. But it does look so far that it hasn’t started off great. I’m hoping that it gets much better in March and April so that we can count on a reasonably good year.

Matthew Klein: That’s really striking. Imports being down somewhat relative to exports had been the pattern, as you know, for the previous several years. But that was, I think, based on the assumption that China’s Covid restrictions were much harsher than the restrictions in the rest of the world, and therefore that the ability of Chinese producers to produce was going to be always relatively better than the ability of Chinese consumers to consume. Maybe it’s because of the impact of the virus itself, getting so many people sick and dying and so forth in the first few months outweighing whatever benefit there would’ve been initially from the lifting of controls?

Michael Pettis: I also think it’s in the way Beijing has responded.

Read more

The first 20 minutes are free for all, but the full conversation—and full transcript—are for paying listeners. Please consider subscribing to get the full experience!

Subscribe now

Related Links:

Whither Globalization? And What Would that Even Mean, Anyway? (Matthew Klein)

Fighting Global Protection: Why the Economist is Mistaken (Michael Pettis)

Britain can learn from Singapore on savings (Martin Wolf)

CFR Global Imbalances tracker (Benn Steil)

The peak globalisation myth (Richard Baldwin)

Mary Poppins bank scene

Thanks again to White+ for the music and to George Drake Jr. for producing!

The full transcript is below, lightly edited for clarity.

Matthew Klein: Hello, and welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss globalization—what it is, how it’s doing, and something that’s come up a lot recently: whether or not the U.S. government is endangering it via green subsidies and “Buy American” provisions.

Matthew Klein: Let’s ask the big question, which I think a lot of people don’t necessarily ask when we try to grapple with this topic, which is: what is globalization? How should we think about that? And then maybe from there, we can question of whether it’s good or bad or not.

Michael Pettis: I think globalization is one of those words that’s both extremely useful, but also fairly useless, in the sense that I don’t really think it makes sense to talk about one “globalization”. I think there are lots of different kinds of globalization.

You know, Keynes famously discussed these various types of globalizations—and I’m paraphrasing him, of course, because he never used the word “globalization”. But he talked about the globalization of ideas, which he was all in favor of, by which he meant the free flow of information and ideas around the world. He talked about the globalization of trade, in which he was largely in favor. He talked about the free flow of goods and services around the world, but he did recognize that there were limits, or he believed that there were limits to the optimal amount of free trade around the world.

I’m sorry: before trade, he talked about the globalization of migration—the free flow of people back and forth, which he was also very strongly in favor. He recognized there were limits, but he was very strongly in favor of that. And then finally he talked about the globalization of capital, which of course is the free flow of capital around the world. And he was very skeptical about that.

So in his hierarchy: totally free trade in ideas; pretty much free trade in the flow of people around the world; constraints on the free trade of goods and services around the world, but generally a good idea; and significant constraints on the free flow of capital around the world. And we can talk a little bit about particularly what those last two things mean.

The other thing I would add to this issue of globalization is something that you and I have discussed and have written about, and that is that the free flow of goods around the world can occur in many forms.

One of the things that I think we try to distinguish in in our book—and it’s certainly something I’ve been speaking about a lot recently—is that there is a trading system in which countries compete by increasing productivity, and there is a very different trading system, which is the trading system I think we actually live in, in which countries compete primarily by putting downward pressure, directly or indirectly, on wages.

As we explained in our book, the latter form of free trade is exactly the free trade we don’t want, because it’s the kind of free trade that puts downward pressure on global demand and global growth, whereas the former kind puts upward pressure on global demand and global growth.

So let me stop there and just say that what we really should be talking about is not globalization, but kinds of globalization and the globalizations that we want.

Matthew Klein: That of course leads to the question of why we ended up with the globalization that we did. If we’re looking at historical context, you mentioned Keynes, who’s always a very good guide for understanding any kind of big question.

Someone I also think about—someone who I think is often misinterpreted—is Ricardo. He wrote one of the original arguments that people often use for free trade, which is now called “comparative advantage”. I remember reading the original source when we were working on our book, and I was very struck by the way that he phrased the argument. There were all of these caveats involved, in particular regarding the free movement of capital.

Otherwise, what he thought would happen was, if you have a situation where, in his hypothetical example, you could produce more at lower wages—both more wine and more cloth in Portugal—then instead of having a system where people in England would produce the cloth, which is what was supposed to be their comparative advantage, and people in Portugal would produce the wine, which was supposed to be their comparative advantage, that instead you’d have capital, and possibly labor, but definitely capital, move from England to Portugal. And then everything would get made in Portugal and nothing would get made in England.

He thought that that was a bad thing! And he said, well, the good news is people are going to be afraid of foreign investment because it’s too risky and difficult with the communications technologies and the political turmoil and the threats of war that we have. And what’s interesting, of course, is that in the 200 years since he wrote that, a lot of that has changed. It’s interesting how that caveat—whether or not it’s right—has been forgotten by the people who cite comparative advantage as an argument for free trade in goods.

Keynes does bring up that link and I think it relates to this question of: why is it that we ended up with the globalization over the past few decades that we did? Why did we end up with a globalization based very much on this idea of “competitiveness”, not by increasing output per hour in the context of rising wages and rising consumer power, but rather in the context of just squeezing workers and having a lower and lower share of output going to workers?

It doesn’t seem like it had to have happened that way. I don’t think it always was that way. People talk about the trentes glorieuses—those three decades after the end of World War II when you saw, at least within the non-communist or Western alliance bloc, a big increase or rebound in global trade. Back then, globalization wasn’t about wage suppression. What do you think changed that put us in the situation that we’re in now, or have been in recently?

Michael Pettis: It’s an interesting question because a lot of things have changed, and a lot of these are sort of self-reinforcing processes. But one of the things that I think we don’t think about when we think about economics is that when a lot of our economics was produced, particularly in the 19th century in the time of Ricardo, et cetera, there were significant frictional costs on the movement of everything across borders. Information flows were quite expensive. Migration flows were even more expensive. There were significant frictional costs on capital flows and on trade flows.

And because these costs have impeded growth, there’s been the sense that what we really need to do is reduce frictional costs across the board.

And of course, I’m thinking primarily about the cost of capital. It was quite difficult for developing countries in the 19th century and for much of the beginning of the 20th century to access the savings they needed to fund investment.

And so much of what happened in the 1960s, 1970s, and 1980s from a developmental point of view was focusing on ways to improve the flow of capital into developing countries by lowering frictional costs. And I would argue that frictional costs are so extremely low that we've sort of come on the other side of that where capital flows now become a problem, perhaps because frictional costs are so low.

The other really big change I would argue is that economics was developed… You know, I remember when I was studying economics, one of the definitions of economics was the management of scarcity. And that idea of scarcity is really implicit in a lot of our economic thinking, particularly the scarcity of capital. So Martin Wolf recently came out with an article in the Financial Times, in which he said that investment in the United Kingdom was extremely low, which is of course correct. But according to him, what England needed to do to address that was to take pages out of Singapore’s book and take steps to boost savings.

I disagree with that very strongly, but I think there is almost automatic sense that if you don’t have as much investment as you like, it is probably because you are unable to access savings. And this is really an unstated assumption because the moment you state it, it becomes sort of hard to believe it.

Matthew Klein: It’s worth just stepping in very briefly and say that “savings”, macroeconomically, is literally just GDP—in other words, the value of everything that you produce in your country—minus whatever it is you consume. And so in practice, the only way to increase savings is either you find a way to produce more, which is obviously preferable, or you force people to consume less. There’s no other way to do it. And in practice, if you do force people to consume less, then the question becomes: what happens? How do businesses respond? And what are the ramifications, the second and third order ramifications, of that?

Michael Pettis: I’m glad you said that because that’s the key point. Globally, if you reduce consumption to boost savings, then either investment goes up or investment doesn’t go up, in which case production goes down, and clearly you want to avoid the ladder. So the question then becomes: what drives investment? And I would argue that a hundred years ago, what drove investment was the almost infinite backlog of unmet investment needs, and what constrained investment was the lack of savings.

Today we don’t have that problem. What seems to constrain investment, at least in advanced economies like the U.K., is the lack of demand.

We may be moving a little bit away from our original discussion about globalization. But I think the important point is that much of the discussion about the benefits of trade and capital flows started from a very different set of assumptions, particularly the assumption that we simply don’t have enough savings, so anything that increases savings, or increases the flow of savings, must be a good thing. That is why I would say the globalization that we’ve sort of ended up with is really a globalization driven by the globalization of capital.

Matthew Klein: So, I would just want to say that I think this was not a digression. I think it actually was very relevant for exactly the reason you said. And you know, you’ve reminded me of something, which is, for reasons due to my personal life, I’ve been watching the movie Mary Poppins many, many, many times. One thing that’s striking—I don't know if you remember the movie, but this movie is set in 1910, which is interesting because it’s very much in the period of John Hobson’s Imperialism, which was an inspiration for our book.

There’s a scene in the movie where the children are going with their father to go to the bank, and the boy has with him two pennies, two pence, “tuppence”. And he wanted to use it to feed the birds. And his father [we recorded this early in the morning SF time, George Banks didn’t say this, it was Dawes Sr., sorry] goes, “Feed the birds? If you do that, all you get is fat birds. No, you should deposit the money in the bank.” And the boy goes, “well, why?” And the response is, “well, if you deposit the money in the bank, then we can finance all these investments.” And all the investments are all abroad: they’re plantations of tea, or canals, I presume something like the Suez Canal, there are railways in Africa, and “fleets of ocean greyhounds.”

It’s really striking listening to the song. Of course, it’s funny in context, but this actually is very relevant commentary about what globalization was like back then. There was this choice, essentially. You have some extra money and you can spend it on consumer goods, and maybe in the case of the birds that might create more demand for bird seed or something. Who knows if that’s the best use of that money, but alternatively, even in the U.K. at that point in time, over a hundred years ago, the sense was that the best investment opportunities were outside of the country. I’ve really developed an appreciation for that scene the more I watch it. I think it relates very much to your point about how the way we think about globalization now is shaped by the constraints on globalization from, you know, 100, 200 years ago.

Michael Pettis: I haven’t seen Mary Poppins in an awfully long time. I mostly remember Dick Van Dyke’s accent, but I think in 1910, it probably was almost true by definition, that if you invested your tuppence, you would end up with more bird seed than if you had bought bird seed. The question is whether that continues to be true today. Today, I think that’s no longer true.

If you invested in developing countries, then probably you will end up with more bird seed, because developing countries do have—not all of them, China doesn’t—but many developing countries do have significant investment needs that are constrained by the lack of domestic savings and the unwillingness of foreigners to invest savings.

The irony is that if you invest your tuppence rather than buy the bird seed, you might end up with less bird seed. I think that’s the big change that’s taken place.

Matthew Klein: That leads to a really interesting question. Why were so many investment flows going the “wrong way”? Places that already had the most physical and intellectual capital per person, at least as measured in national statistics, were getting the most investment inflows, whereas the places that seemed like they might have benefited more from foreign investment were suffering from a lack of investment. Obviously, we’re not the first people to notice this. This was a commentary people were making at least 20 years ago, I think.

Michael Pettis: For those who are interested, Benn Steil at CFR, the Council of Foreign Relations, has a really good page in which he identifies all of the flows from and to in the form of the current account surplus. The flows, of course, are just the obverse of the current account surplus. What he shows, completely contrary to all economic theory, is that rather than capital flowing from rich countries to developing countries, it flows from a group of rich and developing countries, and around 70 to 80% of it ends up in the Anglophone economies, mostly the U.S. and the U.K., which I think is what you’re referring to.

Matthew Klein: Yes, that’s right. This is not a new phenomenon either. It’s striking because, for all the faults we can talk about with Edwardian capital markets, at least in principle, it would make sense for savers in an advanced economy, if they were looking for the highest return investment opportunities, to be looking at places that were underdeveloped and lacking infrastructure.

Building a new railway in Africa in 1910, to use the Mary Poppins example, would theoretically—you could imagine why it might have a higher return than building another railway somewhere in England, which already had built out its railways over the previous 50-60 years. That kind of globalization would’ve made sense if we’re thinking about the benefits of reducing constraints on the flow of capital and finance, and yet it’s mostly not what we’ve seen. And that’s what I'm curious about.

There are plenty of places in the world we can identify that would benefit from more investment that really have to face the difficult tradeoffs between consumption and investment because “savings are scarce”. They just aren’t producing enough to meet all their material needs.

I’m curious what your view is on this. You wrote the Volatility Machine, which talks some about these questions, and I think arguably a lot of this stuff has just gotten worse since then. So I’m really curious: looking back, why is that the world we ended up with?

Michael Pettis: That’s a question that I often ask my students, those who are going into PhD programs. It’s something worth thinking about. In the 19th century, and up until the Second World War, money flowed into developing countries. It was risky, but it still made sense. The profits generally more than made up for the losses from time to time. Even in the best developing countries, such as the United States, we had crises pretty regularly, most famously in 1837. The British lost so much money in their investments in the U.S. that they were absolutely furious. But that happened quite regularly, and yet they never abandoned the U.S., because basically it was still profitable to invest in the U.S. They invested in other countries too.

Now, one cynical view is they invested in their colonies, so they never worried about debt repayment because they could always send in the Navy. It turns out that that’s one of those stories everybody knows, but it’s very hard to find real examples of that. Certainly, for investments in countries like the United States, they weren’t able to send in the Navy and collect. Nonetheless it was considered quite profitable.

Read more

00:41 — What Michael has experienced living in Beijing during the transition from “Zero Covid” to “let it rip”.

09:51 — How the surge in commodity prices has affected Europe, Japan, and the major energy exporters other than Russia

29:54 — What the war has meant for Russia

34:06 — What the rest of the world can learn from Russia’s experience, and why Germans and Japanese might regret saving for retirement by investing mostly in other rich countries

Matthew Klein: Hello and welcome back to UN/BALANCED, a listener-supported podcast about the global economy and a financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss how the ideas we laid out in Trade Wars Are Class Wars, which is the book that Matt and I published a couple of years ago, help make sense of the economic and financial consequences of the Russian invasion of Ukraine, which of course is one of the big stories of the last year.

Matthew Klein: And we’re really looking forward to getting into that. But first, what I really would love to talk with you, Michael, about is all the things that you’ve been experiencing and seeing living in Beijing over the past few months with China’s transition from “Zero Covid” to essentially a herd immunity strategy. I’d love to get your sense of what that’s been like, being on the ground.

Michael Pettis: It’s what we continue talking about almost all the time here in Beijing. Now one of the things that shows how quickly things are changing in China—and in the biggest cities more specifically—is I had a meeting at my house earlier today with some people from the Israeli embassy. [We recorded on January 12.] The meeting was scheduled at 4:00. And by 4:20 they were sending me frantic messages saying, “We’re stuck in traffic, we’re going to be late, we’re stuck in traffic, we’re going to be late.”

And I thought that was pretty funny because, you know, traffic in Beijing has been really horrible. Beijing is famous for the terrible traffic. But in the last two, three years, we completely forgot about that. Because of the “Zero Covid” policy, nobody ever went out and you could travel from one side of town to the other side of town in half an hour. And now as we’re returning to normalcy, we’re all remembering how bad the traffic is.

It’s no longer possible to drive quickly across town. It takes an hour or an hour and a half. That's a story about how quickly things are reverting to normal here in places like Beijing, Shanghai, and a few others of the what they call the “first tier” cities.

It feels like we've gone through most of the Covid wave. I’ve been trying to think about how many of my friends here haven’t caught Covid, and I can only think of one person who’s told me he still hasn’t caught it yet. Everybody else has caught it. And so I would say almost everybody in the first tier cities has gone through that first wave of covid. So in a couple of weeks it will be behind us.

But not necessarily for China, because in the second- and third-tier cities and in the rural areas, they haven’t really caught the wave. But this year, Chinese New Year comes very early, so everybody is going home for the New Year to be with the family. What everyone’s pretty much expecting is that the next really big wave of Covid will hit the smaller cities, the towns, and the rural areas, and we’ll get a huge spread of Covid there. That’s going to be much more problematic because those areas simply don’t have the medical facilities that we have in Beijing, Shanghai, et cetera.

The bad news is that the death rates are pretty high. I heard this really astonishing statistic in the Chinese Academy of Arts and Sciences, which is, you know, you get elected to once you’re very prominent and probably older.

That’s the bad news. The good news is that it’s happening so quickly that probably by the end of February, beginning of March, most of China will have gone through the big covid wave, and so we'll start to see a real opening of the economy fairly soon—I think much earlier than people expect. So that’s the good news.

And then a story that you might find funny. It shows you how entrepreneurial people in China can be. There are various variants of covid that are sweeping through Beijing, and they seem to have very different impacts. The variant that I had was really minor, basically for about a week I was too tired to do much work. Otherwise, I was okay. But other variants have been really, really painful. People have been out of commission for more than two weeks with a horrible sore throat so bad that they can barely drink.

So about two or three weeks ago, we started to see on Weibo, which is the Chinese Twitter, that people were advertising that they had the better variant, the less painful variant. And for a fee they could come to your house so that you would be guaranteed the better variant and you would be protected from the worse variant. I don’t know how many people took advantage of that, but it just goes to show how quickly people have adapted to the new conditions. So I think we’re going to continue to see that.

Matthew Klein: That’s a fascinating story. Well, I certainly hope everyone is able to get through it as safely as possible.

I know one thing you wrote about recently, which I thought was striking, was the extent to which a lot of people within China were not fully prepared for Covid being quite as virulent as it would be when they did the sudden switch in policy. Is there a debate now among people within China about how things could have been done differently? Or is that just not how people approach this question?

Michael Pettis: There is a very big debate, not very public, because it’s very hard to have this debate without asking some potentially embarrassing questions. But what’s surprised many people is the way we went within one or two weeks from “Absolutely no way we’re ever going to open up, ‘Zero Covid’ has been incredibly successful and it will continue to be incredibly successful” to “Covid is not a problem, go ahead and catch it, it doesn’t really matter.” And a complete openness.

Now, we all knew at some point that this was going to happen, right? I spoke to people like you and other friends in the U.S. and Europe, and what you guys made very clear to me is that these new variants are spreading so quickly that there’s simply no way you can prevent it from spreading in a country like China. And people have known this for quite a while.

For example, I used to get my Covid tests over at my hospital because this would give me a chance to talk to doctors and nurses that I knew.

And I would say by the early summer—

Matthew Klein: Sorry, this was last March?

Michael Pettis: Yes. Last March or April.

Matthew Klein: Wow. Okay.

Michael Pettis: By the early summer, everyone in Beijing knew. It was just very clear that there was no way to stop the spread of Covid. So you would’ve imagined that if you know that, you know at some point you’re going to have to abandon “Zero Covid”, then obviously you should prepare for that point. And you should choose the best time to abandon “Zero Covid”, which most of us would argue would probably be in August and September of last year or March or April of this year. Don’t abandon it in the middle of the winter.

And yet, that’s exactly what they did. And they were completely unprepared for it, not just in terms of medicine. There was a black market for anything Covid-related—incredibly high prices because there was shortage of everything. Even things like ibuprofen, you couldn’t get, it was impossible to get except at incredibly high prices.

But other things too. So for example, in the first wave, nobody went out because they were so terrified of Covid. After three years of being told that “Covid is a disaster and we’ve protected you from it,” many Chinese not surprisingly believed that getting Covid would be a terrible, terrible thing. And so one of the things that happened is people stopped going out and donating blood. So blood supplies in the hospitals in China pretty much collapsed. The country was totally unprepared for it.

And so you ask yourself, the big question that people are asking, and you know they’re not answering it in public, is: how is it possible that China was so unprepared when they abandoned “Zero Covid”? Didn’t they know they were going to abandon it? After all, everybody knew that they had to do so.

So there are all sorts of questions about information flows—whether people at the top level of government are getting the same information that the rest of us are getting—because they really seemed unprepared for the incredibly rapid shift. They went from “Zero Covid is absolutely the right policy and don’t you dare take a step against that” to within a week or two, total openness. “Do whatever you want. You don’t need to test. We’re ending all quarantine. And don’t worry, it’s not a problem.” It’s a big surprise. There are all kinds of debates as to what really went on.

Matthew Klein: I’m still really struck by that point you made about how people back in March and April, which is when Shanghai was in the midst of its lockdown, were saying that “Zero Covid” was unsustainable, even then.

Moving on to lighter fare: war and death and famine and all that.

We mentioned at the beginning that the Russian invasion of Ukraine, and all the consequences of that for the world economy, are things that we obviously didn’t talk about in our book. Yet nevertheless, the framework that we laid out in our book and the examples we discussed are very helpful for thinking through some of the major consequences in how to analyze the situation. They’ve been very helpful for me personally, I think for you as well, and a lot of people who are trying to understand what's going on.

I think one of the most obvious points, and this is something we sort of hinted at the end of our previous episode, is that the large increase in commodity prices—because both Ukraine and Russia are such huge commodity producers in the war and that has disrupted a lot of the production and flow of these commodities to the rest of the world—has had some big implications for global imbalances in particular, among some of the major surplus countries pre-war, namely Europe and Japan and Korea. Although interestingly not China.

But in those others, the surpluses have really contracted. At the same time, we’ve had huge surpluses in some of the big energy producers, Norway, the Gulf, and Russia. Uh, you know, maybe you can lay out for us, sort of, you, you were saying that people in, you know, that policy makers in, in the places where the surplus have contracted in Korea and Japan and in Europe are now quite concerned about all this.

Maybe you can kind of lay out more about what they’ve been telling you and how you’re seeing this.

Michael Pettis: I was speaking to some officials from the South Korean Ministry of Finance, and they were very concerned about that because the current account surplus has disappeared. I think it’s even gone into a small deficit, and they thought that this was a terrible thing for South Korea and represented a major negative change going forward. I’ve read that in Japan they’re having a very similar debate. In Germany they’re having a very similar debate.

I try to think my way through “what does it mean for the current account to go from a big surplus to zero or a small deficit because of a rise in commodity prices?” And whether this is something that we have to, or they have to worry about forever. Well, the first thing, and, and maybe we’ll have a chance to discuss it later in this podcast, is whether losing your current account surplus is indeed a bad thing. I would argue that it isn’t. But nonetheless, there are many people who believe that growth is synonymous with running a current account surplus.

So the question then is: why would a rise in commodity prices cause the current account surplus to contract? And many people might say, “that’s sort of a dumb question.” If you’re a commodity importer, then the rise in commodity prices means that your imports are going up. And if your exports don’t go up, then by definition your current account surplus should contract. But of course, that’s not really, certainly in my opinion, I’d say in our opinion, because we’re very clear about this in the book, that’s not really the right way to think about trade surpluses.

Changes in your export revenues are redistributed domestically and the way they’re redistributed will then end up affecting such things as consumption and savings.

So that’s a long way of saying that I prefer to think about the current account surplus as the excess of savings over investment. That’s the definition—one of the definitions—of a current account surplus. So when a country’s current account surplus contracts, by definition, something must have happened in that country, because the external account must be perfectly accommodated by changes in the internal account, right? The two of them have to balance.

So when your current account surplus contracts—by definition—either your savings declined or your investment went up. Because the gap between the two must simultaneously contract.

So when I think about a country like South Korea or Japan or Germany or any of the persistent trade surplus countries, the question then is if you see a significant rise in commodity prices in your commodity imports then how does that affect your savings-investment imbalance? Well, it’s very unlikely that surging energy prices would cause you to increase investment. On the contrary, you might expect a slowdown in the economy—

Matthew Klein: Maybe it should, but yeah, you’re right. That’s not usually the impact.

Michael Pettis: It should, if the government decides to increase investment to match the rise in commodity prices. And there are reasons they may do so, but it’s very hard to do it quickly. So it’s unlikely that South Korean investment rose. So what’s much more likely is that there was a reduction in South Korean savings, right?

So why would a rise in commodity prices cause savings to go down? And I would argue the most likely way, and it’s probably the way it happened in all of these countries, is that importers—manufacturers, because they have to pay much higher commodity prices—that squeezed their profits. And remember that business profits are part of the savings. Businesses save all of their profits. So if you see a squeeze in the profits of businesses, then you’re basically seeing also a reduction in overall savings.

Now, how sustainable is that?

Well, the first way businesses tend to react to a significant increase in their input prices is with a significant reduction in profitability—until they’re able to raise prices by enough to pass the higher input prices over to their customers. So if you believe that the commodity price increases are permanent, then over time you have to raise the price at which you sell goods. And as you raise the prices, you basically pass on the increase in commodity prices over to your customers who ultimately are the consumers, right.

So what I would argue is that a rise in commodity prices represents a temporary decline in the current account surplus until either commodity prices go back down again or until businesses are able to pass on the increase to their clients, to their customers. What that tells me is that the contraction in the current account surplus is only temporary. For there to be a permanent reduction, you would really need a significant redistribution of income within South Korea, and that hasn’t really happened.

Matthew Klein: Two other quick points to add here, which are I think are relevant and interesting. In I believe all these countries, certainly in Germany and Japan, I don’t know as much about the Korean situation, the governments have laid out very expansive proposals—they actually implemented proposals to subsidize prices both for business and consumer customers for energy. And so essentially the other mechanism by which savings are being reduced is that the government budget deficits are increasing rather dramatically in these countries.

That’s probably the healthiest response here, in the sense that you have, of all the financial entities within the country, the one that is most able to absorb the extra debt temporarily is doing that in order to prevent people from having very extreme short-term declines in living standards.

But that’s also, and to your point, unless commodity prices remain very high—if they do remain very high, the government support is probably going to be withdrawn because of the view that consumers need to adjust—or commodity prices won’t remain high, in which case that government support is going to be pulled back.

The other component, which I’m not sure how much this applies in the case of Germany, but it certainly applies in the case of Japan, which is very interesting, is that while the trade balance has been blowing out due to high commodity prices, there’s been an almost commensurate increase in the income surplus. All of the dividends and interest and so forth on Japanese foreign investments has been rising very dramatically relative to the bills that Japanese are paying to the rest of the world. So that has been moderating the impact of the higher commodity prices.

I think they may be unique in that respect, but it’s an interesting dynamic. It may also to a certain extent apply to Korea, but it’s an interesting dynamic there.

Michael Pettis: It probably applies less to South Korea, although as a surplus country, we know that South Koreans have accumulated, accumulated a lot of assets abroad. But it is something that I think that probably all of the countries that have run persistent surpluses should, in theory, be experiencing. Because if you own more U.S. assets and U.S. interest rates go up, your return on foreign assets should also go up along with that.

But I think really the key point is something that we talk about in our book quite a lot: the reasons for persistence surpluses have to do with the distribution of domestic income. And that’s why I would argue that if there’s been no real change in the ability of workers and households to demand a higher share of what they produce, then the change in the current account surplus or in the trade surplus is only likely to be temporary. Because at the end of the day, what matters is not whether commodity prices go up or down, but what matters is the distribution of domestic income.

Matthew Klein: So this presents an interesting question about the other side, which is the surpluses that have increased dramatically, particularly among the energy producers like Norway and the Gulf. Those presumably are also just as temporary. How are you thinking of that and the corresponding financial outflows?

Read more

Subscribe now

Subscribing compensates us for the time we spend to put the show together and also helps cover our production expenses, such as sound mixing and transcriptions. Paid subscribers to The Overshoot can get access to UN/BALANCED for just $20/year through a special link that will be delivered by email.

If you like what you hear (or read) please feel free to share this episode with your friends, family, and colleagues. The complete transcript (lightly edited for clarity) is below the red line. Thanks to White+ for the music and to George Drake Jr. for producing.

References and related reading

“The Saving Glut of the Rich” — Mian, Sufi, and Straub (2021)

“Indebted Demand” — Mian, Sufi, and Straub (2021)

Trade Wars Are Class Wars, 32 Months Later (Part 1) — Matt Klein

Trade Wars Are Class Wars, 34 Months Later (Part 2) — Matt Klein

Matt Klein: Welcome to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss how we think about the ideas we laid out in our recent book, Trade Wars Are Class Wars, and try to help make sense of the past few years.

Matt Klein: So one of the things that’s really been striking about what’s happened—particularly in 2020, but also more recently—has been the variety of the responses that we’ve seen from different governments and how they’ve been so uneven, and what that has meant for global imbalances and trade and financial flows.

In China, the government didn’t do very much at all to help ordinary consumers. In the U.S. there is now a consensus the government did maybe “too much”. You see variation within Europe. It’s really striking that this happened at all. And I guess I’m really curious why it happened the way it did. Michael, you’ve obviously been living in China, studying China, an expert on the Chinese political economy for decades. Were you surprised at all when the Chinese government responded in the way it did in 2020?

Michael Pettis: It’s hard to say whether or not I was surprised. In one sense the response was, pretty dramatic—and dramatic in the wrong way. On the other hand, for quite a long time, I’ve been arguing, and you and I have discussed this many times before, that there seem to be real institutional constraints on the ability of China to implement the types of policies that would’ve been considered the right policies.

And pretty obviously, I think the really big problem that we’ve seen in China is that almost all of the stimulus is focused on the supply side of the economy. And so what was weak about the economy, which was Chinese consumption is very weak, actually declined. The consumption share of GDP fell about at least three full percentage points from where it was in 2019.

But why don’t you talk a little bit about the U.S. and the European response, and then we can see how together that fits in with the Chinese response and created the kinds of imbalances that we’re seeing.

Matt Klein: Sure. So in the US the, I would say, pleasant surprise as an observer, was that it seemed like there was a consensus among officials in both parties to avoid the kinds of mistakes that hampered the recovery from the 2007-9 financial crisis. The consensus was not necessarily to do as much as was needed, but doing what people thought was a lot early on at the beginning and just shoveling money out the door.

It ended up having to be iterated several times to get the results that people wanted because they overestimated how quickly the pandemic would resolve itself. That interacted with the limitations of the administrative capacities of the state to do things like targeting unemployment aid. So instead of saying, “okay, everyone’s going to get 100% of what they were previously paid” they said “we’re just going to add on a flat $600 a month,” that sort of a thing.

The net effect was to pump an enormous amount of money into the hands of consumers. Not just consumers, but the ordinary people who’d often been disadvantaged in terms of their ability to afford what they wanted to spend because they weren’t particularly high up on the income distribution.

This horrible viral pandemic was so destructive—particularly for public health, which particularly affected people who tended to be at the lower end of the income distribution because those were the jobs that couldn’t be done remotely, and those people were more likely to get sick and they were more likely to get laid off. Yet, despite all that, the net effect of the economic policy response was actually that it was one of the most effective anti-poverty programs the government had ever done, at least for the period of 2020 and 2021. Which is really remarkable.

Many of those changes that the government put in place were designed to be temporary and they’ve since unwound, so that’s no longer the case, but it is nevertheless very striking that whether it was direct distribution of the “economic impact payments” (the checks), or the enhancements to unemployment benefits, or various other measures, the eviction bans, the debt forbearance, the combination ended up being a massive anti-poverty measure, and that dramatically increased disposable household incomes. Not so much the business sector, but they were helped indirectly.

That was obviously sort of the diametric opposite of what the Chinese government did, which as you said was supply-side oriented. One thing that really struck me about the Chinese response, looking at it, and I don’t know how much of this is sort of institutional political constraint versus administrative capacity constraint versus a judgment that it wasn’t the right thing to do, was the lack of unemployment insurance coverage. And the implications of what that meant for the very large population of migrant workers who’d come to Chinese cities from the countryside and then ended up essentially having no resources to fall back on when they lost their employment. What was your sense of what motivated that kind of non-response?

Michael Pettis: Um, you know, there’s a lot of puzzle about it. So, for example, last week I had a meeting with an extremely senior academic, the dean of a major economics department of a major university. For obvious reasons, I’d rather not say who he is. But we had a discussion about that and he was telling me that among his associates, among other economists that he speaks to, there was this widespread recognition that the Chinese response had not been the correct response.

And in fact, he told me, “I’ve strongly argued, and lots of other people have strongly argued, that we should have taken at least 1 trillion of the stimulus, or take a trillion of new stimulus, if that’s what it takes, and direct it to the household sector in the form of consumption vouchers, or in the form of stronger social security benefits, pensions, whatever, but just given them a trillion renminbi.”

Which is about $150 billion, or a little less than 1% of GDP to the household sector. And I thought that was a really interesting comment, because first of all, it’s not a very big number. Let me just read you some numbers here. In 2019, total consumption in China was 55.8% of GDP.

Household consumption is much, much less, below 40%. But, you know, to give you a comparison, in most other low-consuming countries the consumer share is around let’s say 65% of GDP. So this was an incredibly low number, and in 2020 it had dropped to 54.3%, so from 55.8% to 54.3%. Then it rose a little bit in 2021 to 54.5%, and then finally in the third quarter of this year, it was 52.4%. In other words, it was 3.4 percentage points lower than it had been before the pandemic. And, that’s just the third quarter. The first two quarters were much worse, but I sort of exclude them because they were very exceptional quarters.

So when you think about the amount of, of rebalancing that needs to be done, you’re really talking about at least three to four percentage points of GDP, which means more than that in terms of a redistribution of income, just to get back to the really horrible levels of 2019.

So a group of academics are talking about 1 trillion renminbi. China’s GDP this year will probably be 130 trillion renminbi. So we’re talking about 0.7, 0.8 percentage points of GDP. It’s not a huge number. And yet he said that there seems to be no chance of passing that. And I asked him “why is that?” And he said he wasn’t really sure. He felt part of the reason is that Beijing is very worried, and you’ll remember Xi Jinping actually said this in a speech, that we have to avoid doing what Latin America did and sort of convert our workers into welfare workers.

But even accepting that argument, it’s not as if the big problem in China is that workers are getting too much or have been getting more than they deserve. On the contrary, workers in China, households in China, generally most of whom are workers, receive the lowest share of GDP of any country in the world. And that’s gone down really substantially in the last three years. So it’s hard for me to believe that the concern is that if we pay workers too much, we’re going to create a “welfare society”, because that’s clearly not what’s happening.

And so what I would argue is that there are all sorts of institutional constraints that make it very difficult. And you know, “the institutions” are sort of a vague word, but the way I think about it is for over 30 years, you’ve had a very successful growth model that systematically transferred income from the household sector to subsidize manufacturing. That’s been such a powerful model and there’s been so much growth that inevitably you had, you know, all of the political and business and financial institutions and even household institutions, borrowing practices, et cetera, have been structured around either formally or informally this particular type of system.

Subscribe now

It’s very easy for economists to say, “well, let’s just switch it over: take a trillion away from what we were doing and redirect it.” But it’s very hard to do. And I think China literally doesn’t have the systems for doing so. They’re in the process of trying to figure their way around. So you mentioned the U.S. and Europe. Their response to Covid was basically to boost demand in China.

The Chinese response to Covid has been to boost supply. Even that’s been quite tough because the economy’s been very, very weak, but there have been enormous amounts of subsidies thrown into the supply side of the economy. But what they haven’t been able to do, is even with sluggish growth and output, they haven’t been able to keep incomes in line with that growth and output.

This is getting to be a long answer, Matt, which is a problem with me always.

Matt Klein: No, this is fine!

Michael Pettis: But you’ll remember in our book, our balance of payments approach, we point out that this is an accounting identity. It’s not debatable. The current account surplus and, you know, let’s call it the trade surplus, is by definition equal to the excess of savings over investment. And the problem is that when the consumption share of GDP goes down, by definition the savings share of GDP goes up. GDP is consumption plus savings.

And if savings goes up, there’s only two ways that can be resolved. Well, there’s a third way, but the two other ways it can be resolved is either the trade surplus must go up, because if savings goes up relative to investment, by definition, the trade surplus is higher. Or, you prevent that gap from widening so that as savings goes up, investment must go up. The problem is the private sector isn’t investing at all. Investment growth in the private sector has been flat, not surprisingly, with consumption.

So, they’re not investing. So if you want investment to go up, it’s got to be basically public sector investment in infrastructure. And as you and I have discussed many times before, China has probably the best in infrastructure in the world, and certainly much better infrastructure than its level of development requires. And so if you spend more on infrastructure, which they don’t really want to do, then you know, then the debt burden explodes.

So I said there’s a third way out, and the third way out is not to do either, in which case output goes down and you, you rebalance in the form of rising unemployment. Remember: unemployed workers have a negative savings rate. That savings-investment constraint tells you there’s only three things China can do, thanks to its policies of subsidizing the supply side. One is to increase its trade surplus, which is problematic, because it becomes ever more reliant on the rest of the world.

The other is to increase domestic investment in infrastructure, which is also problematic because it means a surge in debt. And then the third option is to allow unemployment to rise, which of course nobody wants. So that’s the problem. We’ve got ourselves caught up in China. And I think the focus on consumption in the rest of the world was a nice match for China, but it’s not sustainable. And so, you know, the big question is what happens next?

Subscribe now

Matt Klein: Yeah, it’s really striking that what ended up happening was that China’s trade surplus expanded very, very dramatically. I remember, and I’m sure you remember, that before the pandemic, there was a lot of talk about how China’s trade surplus was shrinking, and the current account was naturally heading down to zero for some reason, and that has completely vanished.

The trade surplus and the current count surplus are basically at all-time highs in China. And in fact, there’s now controversy about the extent to which the current account surplus may be understating the trade surplus. There’s a weird discrepancy between what the customs data are showing and what the balance of payments data are showing. And it’s very difficult to make out what that means—

Michael Pettis: Well, I suspect what it means is that there’s flight capital disguised within the current account.

Matt Klein: So in other words, the customs data are correct and there’s financial outflows that they’re not capturing, is what you’re saying. That would certainly make a lot of sense. It’s consistent with the kind of response you were describing, which is that either the trade surplus has to expand or investment expands, or output goes down. I guess they’ve done a mix of output being lower than it otherwise would have been.

You mentioned that household share fell, and I think that’s really important to recognize. Who benefited, in your estimation? I mean, someone, someone, even if the whole economy is smaller than otherwise, there would’ve been someone who I guess is at least relatively better off. Who do you see as being the beneficiaries there of this particular approach?

Michael Pettis: Well, a study done by Renda, by People’s University, last year showed that what happened in China is frankly not very different from what happened in the U.S. and in Europe. If you order the various households within China in terms of income level, you know, the top 10%, the second 10%, the third, etc. those all the way down the bottom suffered horribly from the impact of the pandemic. And the higher up you went, the less pain there was, until in the top 30, in the top three deciles, their incomes actually went up quite substantially. I think that’s the story in the U.S. and in Europe too, right?

Matt Klein: Well in the U.S. it’s complicated. With labor income, that’s how it worked out initially. But then you have sort of the offsetting factor of the government aid that I mentioned. So a lot of people at the lower end saw their incomes go up.

In Europe, I think it was more balanced. They kind of did an intermediate approach where they actually had the administrative skills to support businesses and to keep people on payrolls. So there was more help to keep people employed and paid—much more than in China—but not as much as in the U.S. relatively speaking. So Europe and Japan and Canada were kind of in the intermediate stage. But yeah, in terms of market income, in the U.S., the layoffs were overwhelmingly concentrated at the low end. It’s just that the net impact was offset by the government aid that you didn’t see in China.

Michael Pettis: Yeah. Now you had an article in the Financial Times not so long ago, in which you talked about this and you argued, correctly, I think, that the problems in China actually for the first time in a long time benefited the rest of the world because of its impact on inflation. Can you go through your argument?

Matt Klein: Yeah. So this is also something really kind of significant for, I think, understanding how our view of the book relates to the world today. You know, we are very much now in a world where there is not enough stuff, whether it’s manufactured goods or physical commodities. Or at least it seems like there isn’t enough stuff to meet global demand, and that’s put a lot of upward  pressure on prices and created a lot of challenges for consumers in a lot different places. It’s very acute in terms of energy, to a lesser extent food and other things.

To the extent that Chinese policies have been suppressing domestic consumption and domestic demand, it means that they’ve been reducing what historically has been voracious Chinese demand for a variety of raw materials, particularly energy and industrial metals. In the past, it’s been a problem that Chinese demand has not been sufficient to absorb production elsewhere. And it had been leading to sort of a “great glut”. But right now, it’s basically helping prevent energy prices from being higher than they otherwise would be, whether it’s coal or natural gas or oil, and probably other commodities, whether it’s more iron or copper or things like that.

Chinese consumers have been suffering horribly for this, but there has at least been some attendant benefit for consumers in the U.S. and Europe and in places that quite frankly have less disposable income, but that are also dependent on energy.

I think the reason that’s interesting is that it really kind of goes against something that we wrote about in the book, which I’m grappling with myself. We made a point that there is a superabundance of unused productive potential, and that the reason that there’s all these trade conflicts comes from the fact that there’s this excess of supply relative to demand. Not that there’s too much supply, because there are obviously plenty of poor people and poverty in the world, but that for various reasons, we have been living below our means. And that’s one of the reasons why inflation had been quiescent and it’s why it was so problematic that the Chinese political economy and elsewhere were leading to under consumption.

Subscribe now

And so now we’re in a world where it doesn’t seem like that’s quite right. I’m really curious. I have my own views on sort of how to reconcile this, and I’m really curious how you’re thinking about the return of inflation over the past couple years and how that relates to our views about how prosperity is not a scarce resource. We don’t have a zero-sum world, but at least right now it does look a little bit zero-sum in the sense that if China were fully going back to work and production and consumption, then oil prices would be much higher in the rest of the world. And that would obviously be painful.

Michael Pettis: My response is that unfortunately we can’t really take the Covid world as very representative. There have been a lot of disruptions caused by the pandemic in China, in Europe, and the U.S., et cetera. And so what we may be seeing with these high prices is an attempt by the global economy to make adjustments, and the adjustments are always slow.

Now whether this is the case or not, we’re not really going to know until Covid is behind us. So, you know, I would want to see this continue for a few years before I thought that we really were in a different supply constrained world. I continue to think that the real pressure is demand constrained.

And the reason I say that, which is the reason in our book, is because that’s simply the way, uh, rising income and equality works, right? When income inequality goes up, you’re basically transferring income from those who have a higher propensity to consume to those who have a lower propensity to consume. And so the only way you can maintain existing levels of consumption is with a rise in household debt. I know you’ve seen those papers by Atif Mian, Ludvig Straub, and Amir Sufi, which would sort of make that point domestically in the United States. I still think we’re in that world.

We’re in a world of very uneven distribution of income. There may have been a temporary reduction in that because of stimulus policies implemented by Washington, Brussels, et cetera. But I don’t think the underlying problems have changed. Until we see a major redistribution of income, I think we’re going to be a demand-constrained world much more than a supply-constrained world.

And by the way, remember that the way you resolve the demand constraint is either through a rise in unemployment or through a rise in debt. And the Fed and the ECB have always chosen the latter rather than the former, and debt continues to rise very quickly.

Matt Klein: Yeah. I guess one interesting follow up thought I wonder about: if we were to have the kind of healthy rebalancing, redistribution, whatever we’d want to call it, of incomes to get to our kind of preferred world from the pre-pandemic world we were writing about—would that be inflationary? What would be the kinds of things that we would look for in terms of knowing that that was what was happening and what would be the ways that policymakers might potentially want to think about managing the transition in a way that would make it palatable?

Because it seems like—one thing that’s been striking to me is that even when people’s incomes are rising enough to more or less match what’s going on with inflation, that inflation is very unpopular. And that seems like a big inhibition to even a temporary adjustment. I’m sort of curious, based on looking at this and also obviously, you know a lot about little Latin America and other places, how would you think about those tradeoffs?

Michael Pettis: Let’s start off with the perfect scenario, right? The scenario in which there are no frictional costs that prevent adjustments. In that case, what’s the impact of rising wages? If the US were a developing country with very high investment needs, then rising wages could limit the amount of investment. That happened in the US in the 19th century. As you know, that was made up by very large inflows of savings from England and the Netherlands.

But in a well-functioning system, what high wages do is they force businesses to invest in productivity-enhancing technology. And it’s interesting, you know, I don’t want to be too pedantic here, but when you look at British innovations in the 18th century, they were mostly about better ways of harnessing energy. And when you look at American innovations in the 19th century, they were mostly about increasing the productivity of workers. You could argue that that made a lot of sense because wages in the United States were extremely high. They were the highest in the world, and so businesses were constantly trying to increase workers’ productivity as a way of reducing labor costs, which were extremely high.

So in a very well-functioning system among advanced economies—I’m not talking about developing economies, which have a very different sort of setup—but among advanced economies, as household income rises, demand for goods and services rises with it, and businesses would be forced to respond to that rising demand by increasing investment. And because that rising demand would come almost by definition with rising wages, they would be investing very heavily in productivity-enhancing technologies.

So it’s possible to redistribute income for wages to have a much higher share of GDP without inflation. In fact, you know, in the 1950s and 1960s, we had almost no inflation. And yet the distribution of income was far more, how do I put it? There was a much less unequal distribution of income in the 1950s and sixties than there was today. So high wages aren’t really inflationary.

If you had really rapid increases in wages—faster than the ability of the business sector to respond—then presumably you could get temporary increases in inflation. But I think even the most leftwing analysts don’t really think it’s possible to have a really rapid redistribution of income. I think that’s likely to be a slow process. So what I would argue is that perhaps the inflation was caused by these very large one-off transfers. But what we need are a permanent set of transfers spread out over a long period of time, and then you can have rising wages without rising inflation.

Subscribe now

Does that make sense to you?

Matt Klein: Yeah, that makes sense to me.

Just trying to play sort of Devil’s Advocate with myself here, and with you, I’m thinking about the assumption that, in a market economy, if there’s more consumer spending that will encourage more production. And if there isn’t enough productive capacity, it will lead to more investment that will create that capacity. That’s what businesses want to do. They want to be able to meet customer demand. And yet in the past few years, for the most part, we haven’t seen things play out that way. And I think you make the point that the pandemic has gotten in the way, and I think that’s reasonable.

And you can make the point that, you know, the magnitude of the spending power increases was very large in this one-off sort of way, and that created challenges. I just wonder, are there other potential limitations that we might be needing to think about? Were there these capacity constraints that businesses were sort of either unwilling or unable to overcome, leading to the inflation that we've seen?

Not just in the U.S. This seems like a global problem. Even China, right? China has not had the inflation issues that we’ve seen elsewhere, but they also have had a massive underperformance consumer spending, like 11% below trend in yuan terms. It doesn’t seem like anyone has really avoided this kind of tradeoff here.

Maybe it’s just the pandemic, maybe it’s the one-off nature of the pandemic response, but the thing I’m wondering about, and it keeps kind of bothering me in the back of my head is the non-response of businesses, even if they’re trying. And that instead of responding with more production, more investment, it seems like it’s shown up in prices much more than I would've guessed. And maybe that’s a function of the pandemic. Maybe that’s a function of the one-off nature of the spending power increase. But it does make me wonder, because everything you said makes sense to me. It’s what I think. It is what is intuitive. It is what is born out in the historical data. But it hasn’t really quite lined up with the past couple of years and that, and it makes me concerned.

Michael Pettis: One of the mistakes that people can sometimes make from our thesis is to assume that because of this rise in income inequality—part of which, you know, was a function of the way our global trading system works—that that weakened demand by transferring income from those who consume most of their income to those who consume very little of their income, i.e., the rich.

But remember, that’s not necessarily the case. There’s two ways you can get consumption to grow. One way is by getting household income to grow. And the other way, if household income doesn’t grow, is by getting household debt to grow. So I would argue a redistribution of income is not necessarily going to show up as much more rapid growth in income. It should show up in some more rapid growth in consumption, but a lot of it will show up as much slower growth in debt. The Fed won’t need to encourage credit expansion in order to keep unemployment from rising if there are income transfers from the rich to the poor or from the non-consuming parts of the economy to the consuming parts of the economy.

And then the other point I would make is that we never want to get caught up in this idea that high wages are inflationary, because we know in previous periods in American history when the income of the bottom 20%, the bottom 50%, however you want to count it, was much higher than it is now, we were able to maintain very low inflation rates. So it’s some other mechanism that’s causing inflation. It could be one-off redistributions, one-off large redistributions of income, but it isn’t the redistribution process that’s driving the inflation.

Matt Klein: Right. That does make a lot of sense to me, and hopefully we’ll see that. I guess the real test would be if we see an increase in the personal saving rate, but more importantly, because obviously there’s so much variation within the household sector, a reduction in the aggregate growth rate of debt, which is not something we’ve seen. We saw it in the beginning of the pandemic, when credit card balances fell a lot. But we’ve not seen that more recently. And I think that’s a good way of thinking through all of this.

Subscribe now

Michael Pettis: Yeah, I think that reinforces the argument we made in the book, which is it’s either going to be an increase in household debt or an increase in income that’s going to drive consumption. And so that temporary increase in income was matched with a reduction in the increase in debt.

Matt Klein: Yes.

Michael Pettis: One of the things that a lot of people noticed about our book is that we were pretty hard on Germany. We argued that imbalances within Germany, particularly the very low share of income workers were receiving in exchange for very rapid growth in business profits was really at the source of Germany’s fabled “hard work and thrift”, and was responsible for the very large imbalances within Europe that came closely destroying either the Euro or the European Union.

And, um, in recent years, you've been much kinder to Germany, so what's going on?

Matt Klein: That’s a great point. Yeah. And we definitely should talk about what’s happened in Europe. The problem, as you said, was that for almost 20 years in the run up to the pandemic, you had a situation where the German government was just very, very tightfisted in its responses to any kind of economic problem.

Public investment net of depreciation was negative. You had a situation where the welfare state was deliberately cut back in order to basically force people who are sort of at the edge of precarity—maybe they would have retired early under the old system—were pushed into these very low paid part-time jobs.

It was not a good outcome for many ordinary Germans. And since many German businesses weren’t exposed to the domestic market, but to the global market or the European market, the net effect was that you had an increase in Germany’s trade surplus, where exports just kind of kept chugging along at whatever the global growth rate of GDP was and imports lagged very dramatically because the domestic economy was so weak.

This was starting to turn right before the pandemic. And I think there were two things we can look at, at a very sort of granular level. One is the governing coalition that came into office starting after the 2017 election: the Social Democrats, got the finance ministry. And they’d spent enough time, even though they’d been in government much of this time as junior partners, or even leading some of the welfare cuts in the early 2000s, they, I think, had internalized some of the message that the government had gone too far in squeezing the public investment—it had become within Germany, increasingly a prevalent view that the quality of infrastructure investment was actually quite weak.

There’s a stereotype I think we have outside of Germany that, “oh, you know, they have great trains, right?” But it’s actually not true anymore. I mean, that was true maybe 30 years ago. But the roads and bridges collapse or they’re shut down for being unsafe. The trains are slow. There was a story recently about Switzerland, basically there’s some train connection from Germany to Switzerland and they had to essentially change what they’ve been doing. The Swiss side, basically said, “no, we don’t trust the Germans to actually have the trains run on time.”

Michael Pettis: I don’t know if you’ve been in Spain recently, but contrary to the stereotypes, Spain has much better transportation infrastructure than Germany.

Matt Klein: It's been a few years, but I do remember—I was there on my honeymoon actually, and yeah, the trains there are phenomenal. That was a build out, one of the really quality investments that was done in the 1990s and the early 2000s. I think it’s exactly right that there’s a stereotype of what Germany is like versus other countries, but it’s not really accurate on those dimensions.

Subscribe now

The Social Democrats, they get the finance ministry in 2018-2019 and they start to realize this and public investments start ticking up. It’s way too low relative to the backlog of needs that have accumulated. But it is improving and I think it’s something encouraging.

And at the same time, around 2018-2019 globally, there’s a big slowdown in manufacturing trade. Whether it’s due to the policies of the Trump tariffs or whether it’s due to internal changes in China or both or whatever, that ends up hitting Germany disproportionately hard. In fact, the German economy was kind of on the verge of either shrinking or stagnating in 2019, basically before the pandemic is hitting, and that was already creating pressure for more kind of domestically demand driven growth. They didn’t have a solution for it, but I think that sort of planted the seed.

The pandemic then hits and the German government, uncharacteristically relative to sort of what we might have thought based on their past behavior, they go all out. And in fact, relative to the size of the German economy, the amount of money the German government spent to support consumers, to support businesses initially was on par with what was done in places that were very generous, such as the United States. On top of that, they also put in a lot of credit guarantees and other things like that. Now, the United States ended up exceeding German government spending through subsequent programs that were put in later. But if we’re focusing on the initial, say, six months, Germany was right up there.

Moreover, they also—and I think this was really important and not what one might have expected—they were willing to partner with France and with Spain and Italy and put forward this joint plan for saying the EU as a whole is going to issue EU debt and that is going to finance a package of aid for all of Europe.

Something that got less attention, but was also significant, was this joint unemployment reinsurance scheme, which was modeled very much on what exists in the United States. Each country, each national government would administer its own unemployment insurance system, but if that system ran out of money, they could borrow at zero from this centralized fund and then have a very, very long payment window to repay it if they needed to. Which maybe is not the ideal system, but still a big improvement compared to what existed before.

The German economy didn’t do phenomenally well—there were a lot of other things going on—but it’s striking that the German economy did reasonably well and the domestic economy actually did better. Part of the reason German economy did only okay was that the trade account was not helpful.

And if you look at countries that felt relatively more constrained in their ability to provide that kind of aid, such as Italy for example, they spent a decade plus before the pandemic essentially in a slow-moving financial crisis and the government there was much more cautious. Even though in theory, the European Central Bank was buying a lot of bonds and trying to encourage more debt issuance, they were still very cautious, they didn't want to put themselves in that kind of position. Their economy shrunk more than Germany’s, that’s not good. But to the extent that their recovery was more export-led there was a bit of an internal rebalancing within Europe.

Now there obviously could have been better outcomes for everyone if all those governments had been more expansive. But I think that’s encouraging. And we’ve seen that more recently in response to the energy crisis as well, where the German government—now I should note there was an election in between there. In 2021 there was a German election. And for the first time in quite some time, the leading Christian Democratic party lost, and they were not in government. They’d been in government continuously since 2005 and holding the chancellery. At the end of 2021, you have a new coalition coming into office led by the Social Democrats.

Now the Social Democrats were the people who put in the welfare cuts of the early 2000s and they were junior partners of the Christian Democrats for much of the period since then. This could have meant a lot of continuity. And in fact, the Chancellor, Olaf Scholz, campaigned as being a continuity chancellor saying, “I’m the normal sober one. I’m the closest to Angela Merkel, who you, the German public, all like.”

And yet the coalition they ended up forming with the Green Party and then with the Free Democrat Party, which is sort of a libertarian grouping within Germany—because of the experience of the preceding two decade plus, because the 1990s were not a great time for Germany either, but for slightly different reasons—there was a social consensus to say, “we’re going to do more investment.” And that ended up happening.

And the way around it with Germany’s debt limit was they said, “oh, we can come up with a special fund that’s outside the debt limit.” And the Free Democrats are basically happy to go along with it saying, “we have a dedicated fund, we’ll do that.” And in fact, we’ve seen that in the past year really being important where suddenly we have a dedicated fund to deal with an energy crisis or a dedicated fund to deal with defense spending because the Bundeswehr had been neglected for basically since the end of the Cold War. And at this point adding up to being several hundred billions of euros of additional spending, which is significant for an economy of that size and significant, even for Europe as a whole.

We’ll see how it all plays out. I think there’s still room for more European-level solidarity and thinking less about how one country does what’s best for itself, but thinking about Europe as more of an integrated economic system. But there is a lot there to be encouraged about. It’s a slow process. We’re talking about a consensus of experts that has governed the country for a long time, being unwound in the face of experience. But I think, I think broadly speaking, it is encouraging.

Subscribe now

I remember at the end of 2021, I was most optimistic about how things were going to unfold in Europe based on the changes I was seeing there and really many other places in the world. Japan’s another interesting one. But I think that it’s really encouraging and heartening to see that kind of change, because that is something that, as you said, we were very critical of. Maybe not because they listened to us necessarily, but either way we’re seeing some positive changes. It’s easy to be pessimistic, but it’s nice to see and recognize when things are actually moving in the right direction.

Michael Pettis: That’s really great. I would remind us of the Chinese problem, the institutional problem, which I think will also affect Germany and a number of other countries: it’s very hard to switch from an export-oriented economy, a trade-surplus-oriented economy, more correctly, to a domestic demand economy.

When you look at the historical precedents, it takes a very long time and a great deal of pain to do so. So it’ll be great if Germany is starting in the right direction, but I think we both would agree we’re going to have to wait and see.

I think we’ve gone on long enough, but I think we’ve only just started to explore some of the implications of the ideas we introduced in the book. And maybe on the next session we can start off by talking about Germany and South Korea and Japan, all of whom have seen their current account surpluses come down quite dramatically. And all of them, particularly in South Korea, are in a total panic about the implications.

I think it’ll be really interesting to consider why their surpluses have come down, whether that sustainable or a one-off impact of covid and continue along those lines.

Matt Klein: I think that’s a great idea. So I am looking forward to our next episode. I hope all of you listening are looking forward to our next episode next month. So thank you very much. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis.

Matt Klein: And that’s it for this episode, our very first one! Thank you for listening to UN/BALANCED, a podcast on the global economy with Matt Klein and Michael Pettis. Thanks very much to George Drake Jr., our producer, and thanks very much to White+, a Maybe Mars band for giving us that great music you heard. We look forward to having you come join us again next time. Your support is greatly appreciated. Thanks again!