Why is the Balance of Payments Constraint Such a Mystery?

Fareed Zakaria usually writes very interesting pieces on international policy issues, but it seems to me that there is so much mystery about how the global balance of payments works that he, like so many others, makes simplifying assumptions that don’t take the balance into account, and for that reason just don’t make sense. In his latest piece for the current issue of Newsweek, for example, he says the following:

There is a consensus forming that Washington needs to spend its way out of this recession, to ensure that it doesn’t turn into a depression. Economists of both the left and right agree that a massive fiscal stimulus is needed and that for now, we shouldn’t be worrying about deficits. But in order to run up these deficits-which could total somewhere between $1 trillion and $1.5 trillion, or between 7 and 11 percent of GDP-someone has to buy American debt. And the only country that has the cash to do so is China.

In September, Beijing became America’s largest foreign creditor, surpassing Japan, which no longer buys large amounts of American Treasury notes. In fact, though the Treasury Department does not keep records of American bondholders, it is virtually certain that, holding 10 percent of all U.S. public debt, the government of the People’s Republic of China has become Washington’s largest creditor, foreign or domestic. It is America’s banker.

But will the Chinese continue to play this role? They certainly have the means to do so. China’s foreign-exchange reserves stand at about $2 trillion (compared with America’s at a relatively puny $73 billion). But the Chinese government is worried that its own economy is slowing down sharply, as Americans and Europeans stop buying Chinese exports. They hope to revive growth in China (to levels around 6 or 7 percent rather than last year’s 12 percent) with a massive stimulus program of their own.

The spending initiatives that Beijing announced a few weeks ago would total almost $600 billion (some of which include existing projects), a staggering 15 percent of China’s GDP. Given their focus on keeping people employed and minimizing strikes and protests, Beijing will not hesitate to add tens of billions more to that package if need be.

At the same time, Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus. In effect, we’re asking China to finance simultaneously the two largest fiscal expansions in human history-theirs and ours. They will probably try to accommodate us, because it’s in their interest to jump-start the American economy. But naturally their priority is likely to be their own growth.

While I agree strongly with the thrust of Zakaria’s piece (cooperation between China and the US is extremely important to both countries), I disagree with his claim that “someone has to buy American debt, and the only country that has the cash to do so is China.” I was hoping that Brad Setser had already killed this argument, but apparently not.

Zakaria argues that the US needs a plan of massive deficit-financed fiscal expenditure in order to pull the US out of recession. This may or may not be true, but if it is true, the reason for the recession is that US households and businesses have found themselves overleveraged after years of excessive consumption, and must now cut back sharply on their spending as they increase savings. US fiscal expansion, in other words, will occur to offset the economic impact of a rise in US savings.

But if there is a rise in US household savings, don’t these increased savings need to be invested? Where will Americans put their savings? In fact almost all of it is likely to be invested in the US, and therefore the increase in savings is going to offset the need to finance a higher deficit (by the way, even if Americans decide to invest their incremental savings abroad instead of in the US, the net impact is the same). This is just another way of saying that the money that used to go towards financing private US consumption will now go to finance public US consumption, and by the way we all hope (I think) and expect that overall US consumption declines from its clearly excessive levels of recent years, so the total financing will be smaller.

The net impact is that the US doesn’t need foreign savings to finance the fiscal expansion unless the expansion is so great that the US economy surges and Americans (private and public) spend more than ever, in which case the problem is not a recession but a boom.

There is more to it. The $2 trillion in reserves that China has is already invested, so it cannot be used for additional investment. If the US really needs larges amounts of Chinese financing in the future, that is simply another way of saying that China must run significant trade surpluses with the US in order to accumulate the dollars necessary to lend to the US government (remember, China doesn’t finance the fiscal deficit, it finances the trade deficit).

Basically what Zakaria is implicitly saying is that in order to boost the US economy – which means boosting US production of goods and surpluses – the US must run very large trade deficits with China so that fiscal deficits can be financed by the Chinese. But a trade deficit, by definition, is consumption supplied by foreign production, not domestic production, so insisting on a large trade deficit with China cannot be the way to boost US production. And of course if the US does not run a large trade deficit with China, then China simply cannot fund the US fiscal deficit.

Zakaria continues:

“People often say that China and America are equally dependent on each other,” says Joseph Stiglitz, winner of the 2001 Nobel Prize in Economics. “But that’s no longer true. China has two ways to keep its economy growing. One way is to finance the American consumer. But another way is to finance its own citizens, who are increasingly able to consume in large enough quantities to stimulate economic growth in China. They have options, we don’t. There isn’t really any other country that could finance the American deficit.”

I have a huge amount of respect for Stiglitz but I also wonder about the logic of this claim. He says that China can either finance its own consumption or American consumption, and we should somehow hope they are kind enough to finance American consumption. As I have tried to argue in several previous posts, we should actually hope for the opposite. If China boosts domestic demand sufficiently, that will go a long way towards adjusting the global imbalance between excess US consumption and excess Chinese production. The main purposes of US fiscal expansion, I think, would be a)to slow down the US adjustment process so that it does not fall into a downward spiral, and b)to give the Chinese fiscal boost more traction – program of coordinated fiscal expansion by the world’s major economies would be better, I think, than leaving any one country to try to bear the brunt alone.

By the way the view that the Chinese authorities will have an easier time in this crisis than the US because “They have options, we don’t” is not, fortunately in my opinion, universally held among Chinese authorities. It is increasingly obvious that policy-makers here are very worried. Yesterday’s Bloomberg pointed out that the RMB is depreciating:

The yuan headed for the biggest weekly decline in almost two months on speculation China is seeking to protect exporters and prevent a recession in the world’s fourth-largest economy. Bonds fell. …”There is some pressure for depreciation as the dollar is strong and other Asian currencies are softening,” said Patrick Bennett, a foreign-exchange strategist with Societe Generale SA in Hong Kong. “Still, record trade surpluses and strong investment flows suggest appreciation pressure is intact.”

The currency declined 0.17 percent this week to 6.8356 a dollar as of 11:44 a.m. in Shanghai, according to the China Foreign Exchange Trade System. The yuan is allowed to trade by up to 0.5 percent against the dollar either side of the so- called central parity rate, which was set at 6.8317 today.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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