Just three days after returning to Beijing from New York, I had to leave again, this time to a series of conferences in Torino, Italy, so it is hard to do much writing for my blog, especially since I won’t spend my free time in the hotel when there is so damned much food out here that urgently needs sampling. Still, I did want to write a hurried note about a topic of conversation that came up a lot while I was in the US and even more here in Italy.
For the next several years, as Keynes reminded us in the 1930s, savings is not going to be a virtue for the world economy. It is more likely to be a vice. In order to regain growth the world desperately needs less savings and more private consumption, but I think it is not going to get nearly enough to generate growth. Why? Because in all the major economies the banking systems are largely insolvent, or about to become so, and desperately need to rebuild capital. For reasons I discuss below, this will have a large adverse impact on private consumption.
Let’s go through the major banking systems. First, the crisis started in the US and, perhaps as a consequence, US banks have already identified a lot of their problem loans and have been the most diligent about rebuilding their capital bases. They nonetheless still have a long ways to go, even though a large part of the bad loan problem was directly or indirectly transferred to the US government. By the way, transferring bad loans to the government may be good for the banks but will have the same adverse impact on consumption. I try to explain why below.
Second, in Japan, during the past twenty years the Japanese government and the beleaguered Japanese household have been tasked with keeping the banking system alive. I don’t know whether or not the banking system has finally been cleaned up, but for the purpose of my calculations it doesn’t really matter. The Japanese government has been saddled with a huge nominal debt burden, which is only bearable because interest rates are kept artificially low. Forcing down the interest that depositors and bondholders receive means that borrowers are getting (albeit not visibly) substantial amounts of hidden debt forgiveness funded by household depositors.
Third, in China, even if you believe that all the NPLs currently in the banking system have been correctly identified (a claim which few Chinese bankers believe), no one doubts we are about to see a surge in NPLs thanks to the out-of-control lending expansion of the past two years. But things are even worse than the nominal numbers imply. As I discussed in my April 6 entry, when we are trying to estimate the cost of a banking crisis we need to think about more than simply the ability of borrowers to meet current obligations.
This is because, as in the case of the Japanese government obligations, when borrowers are able to benefit from artificially low interest rates, the effect is of hidden debt forgiveness which must be paid for by the net lenders, who are, as in the case of Japan, the beleaguered households. In other words, if you want to know how much real bad debt there is out there that must be cleaned up, you need to calculate what share of the loans would go bad if interest rates were raised by at least 300-400 basis points, the minimum needed to bring Chinese interest rates in line with an appropriate rate. This suggests that the Chinese banks, if obligations were correctly counted, might have much larger amounts of bad debt than any of us realize, and this needs directly or indirectly to be cleaned up.
Finally, Europe probably has the biggest banking problem of all. European banks are stuffed with bonds issued by Greece, Spain, Portugal, Italy and a number of countries that are either insolvent for all practical purposes or dangerously close to becoming so. The numbers are so big that the only reason we are likely to pretend that these countries aren’t insolvent is because recognizing the obvious would mean throwing the banks of Germany, France, Spain, and most of the rest of Europe into the trash can.
Who will clean up the mess?
So what does this have to do with consumption? A whole lot, unfortunately. Like it or not we are going to spend the next several years cleaning up the major banking systems of the world, and guess who gets to pay to clean them up? Let’s go through the clean-up options:
1. In order to prevent a collapse of the banking system, the government can effectively assume the bad debt and take it on the government balance sheet. They can do this by buying the debt at well above their true market value, or by giving the banks gifts of capital, or by a number of other mechanisms the net effect of which is the same: these bad loans now become the obligations of the government. How are these obligations serviced? Basically there are three ways governments can treat the cost of the debt.
- Governments can default or restructure their debt, and receive significant debt forgiveness. This does not resolve the debt problem so much as pass the burden on (in the form of losses) to banks and investors. In the case of countries like Greece, much of the burden will go abroad to German and other European banks.
- Governments can raise taxes to repay their debt. In this case the burden of cleaning up the banking system goes directly to taxpayers, who are ultimately households (corporate taxpayers of course pass the cost on to households). Raising household taxes reduces disposable income, and so will directly reduce future household consumption.
- Governments can hide the taxes by forcing down the borrowing rate. This effectively grants the government debt forgiveness and passes on the cost to net lenders. This doesn’t work in market economies in which investors have savings and investment alternatives to bank deposits, like the US, but it is the preferred way that countries like China and Japan use to cover the cost of government borrowing. This just means that the cost of the government debt is passed on to net savers – of course the household sector – and so reduces their wealth. As I discussed in an April 20 post, the wealth effect in China of a reduction in interest rates means that Chinese consume less and save more.
2. They can force the banks to recapitalize. Again there are a few ways they can do this:
- The can force the banks to raise money in the capital markets, but this is only a partial solution at best since investors are not willingly going to provide the capital needed to clean up the NPLs. They will only invest to the extent that the true losses are borne by others.
- The most powerful way of raising bank capital is for the monetary authorities to set interest rates so that banks can make money easily. In the US and Europe, the typical way is to engineer a steep yield curve, with very low short-term rates. Since commercial banks are in the business of mismatching maturities, they can profit from an artificially steep yield curve at the expense, of course, of depositors. This is basically how US money center banks regained solvency during the LDC Debt Crisis of the 1980s. Of course the cost of this policy is borne by net short-term lenders, who for the most part are household depositors.
- In countries like China and Japan, there is a much more powerful way to do the same thing. Since the monetary authorities set both the lending and deposit rates, they can very simply set the minimum spread between the two. In China, the maximum deposit rate is 300 basis points or more below the minimum lending rate. Combine this with an upward sloping yield curve, and Chinese banks make a huge profit on the back of their suffering household depositors, who have few alternatives to bank deposits.
Households, of course
Astute readers will have noticed that every solution to a banking crisis eventually boils down to the same solution: force households to clean up the banking system, either in the form of explicit taxes or in the form of hidden taxes. Before we get too cynical about this, it is worth remembering that there are huge benefits to having a functioning banking system, so that the high costs of cleaning the banks up are probably worth paying.
But one way or the other, banking crises lead to increased claims on future household income and wealth. By reducing future disposable income, this also automatically leads to downward pressure on future household consumption.
So here is the problem. Surplus countries like Germany, Japan and China save too much and already have significantly deficient domestic consumption. They rely heavily on foreign net demand to absorb their excess capacity and, for reasons I have discussed many times, they are going to find it very difficult to change the structure of their economies to rebalance demand. On the other hand, as I explain in my May 19 entry, deficit Europe will see a collapse in its net consumption as it struggles to maintain positive net capital inflows. This means that the US remains as the only large economy that is providing net demand, but high unemployment will ensure that it attempts tor reduce the amount of demand it provides to the rest of the world.
One way to think about this excess savings is to think about the pressure for exporting capital. China, Germany and Japan export huge amounts of capital and desperately need to continue to do so or else they will see their export industries collapse. Deficit Europe used to import huge amounts of capital, but these capital imports are set to collapse and may soon even become capital exports. The US is the only large importer of capital left, and it wants desperately to reduce these capital imports. So even before we worry about the impact of the banking crises, we have to wonder who is going to absorb all these savings?
But the banking crises make matters much worse. With all of the major economies facing banking crises, they must clean up the banks by forcing the household sector to pay the bill. This will put downward pressure on household disposable income and wealth for many years. But we are all betting on the consumer – and inexplicably enough (to me, anyway) many of us are betting most heavily on the hapless Chinese consumer – to come surging back and bring us the growth that we so desperately need.
I am pretty skeptical that this will happen. There is an awful lot of banking mess that households are going to need to deal with first, and only after the mess is cleaned up will consumption come roaring back. Look at Japan. For twenty years Japanese consumption growth has limped along at well under 2% on average while Japanese households dealt with (i.e. paid for) the consequences of their banking crisis. China too provides a worrying story. Chinese consumption dropped from a very-low 45% of GDP ten years ago to an astonishing 36% last year just as — no coincidence — Chinese households were forced to clean up the last banking crisis.
Why should the future be any different? Until the banking messes are cleaned up, I think we shouldn’t count on household consumption to save us. The only solution I can think of for this problem is if governments — especially China, Germany and Japan — use their resources of wealth to clean up the banking mess without forcing households to do it. How? they need to privatize their vast holdings of assets and use the proceeds either to clean up the banks or to prop up household wealth. This will require a major political reform, especially in countries like China, but I have no doubt that eventually we will get there.
Privatization is sort of a bad word today, especially in places like China, but I bet it will become eminently respectable again in a few years. But until then, and as long as the banks are in such bad shape, do not expect consumers to ride to the rescue.