All But the Kitchen Sink?

As the rhetoric around trade continues to deteriorate and the incidence of name calling rises, it is getting harder and harder to discuss global trade and monetary conditions dispassionately and objectively. This should not come as a surprise, and is something I have been “predicting” for several years as part of the standard package of events that mark the end of a major liquidity cycle, but it is nonetheless frustrating.

However, at the same time that I am attacked for being a panda-hugging free-trade fundamentalist I am also regularly accused of being anti-trade or, even worse, anti-China, when I argue that Chinese policies aimed at promoting “competitivity” will, if they exacerbate global overcapacity, almost certainly lead to trade friction, and that both theory and historical evidence suggest that in a world of collapsing demand, trade friction is especially difficult for trade-surplus countries like China. These “anti-trade” and “anti-China” accusations I find especially idiotic: Examining and citing historical precedents to understand how trade frictions are likely to arise is certainly not the same thing as calling for trade war. On the contrary, it is an attempt precisely to reduce the likelihood of trade friction.

The debate over the underlying causes of the global monetary imbalance is often even more muddled. This almost always quickly degenerates into a profoundly silly argument over whether the current crisis is all China’s fault or all the fault of the US. In fact it has become fiendishly difficult to make what should be a very obvious point: that every major participant in the massive and wholly unprecedented distortions in the global balance of payments that characterized the past decade are necessarily implicated in the resulting imbalances, and any policy-making aimed at minimizing the cost of the adjustments are doomed to fail if the role of each major participant and the implications of its role are not understood.

Are both China and the US both responsible for the policies that exacerbated the monetary imbalances of the past decade? Of course they are (and many other countries too). After all the two participants in this system have between them run up the largest trade deficits in history, the largest trade surpluses in history, the largest accumulation of reserves in history, and in so doing stumbled into the first sustained period in history of massive (truly massive) capital flows from poor countries to rich countries. All of these things, and the numbers are huge even by global standards, must have mattered in some way, right? To say that China was merely the victim of US machinations must be as idiotic as saying that the US was merely the victim of Chinese machinations. Both countries locked themselves, for good or bad reasons, into monetary policies in which each reinforced the other’s imbalance and which together were at the heart of the mechanism that created the explosion in global liquidity. It was this excess liquidity that was at the root of the subsequent global asset and credit bubbles.

In the US there is very occasionally a real debate on monetary policies that doesn’t automatically degenerate into your-fault-my-fault. See for example a very interesting discussion on Econobrowser, in which the moderator largely disagrees with the claim that the Asian savings glut is the prime mover, but acknowledges the role of Chinese and Japanese (and OPEC) savings in the imbalances, and hosts a real debate. In China unfortunately except at the left- and right-wing academic fringes there is very little real debate as far as I can see on China’s role in the imbalances, although I can say that the Guanghua Students Monetary Policy Committee (a sort of PBoC shadow committee run by a dozen brilliant grad and undergrad students at Peking University) is ferociously debating the issue openly and intelligently.

Probably the main reason the discussion so easily takes this your-fault-my-fault turn is that most analysts and commentators seem to have only the vaguest grasp of balance of payments mechanisms and the role of central banks within that mechanism. In trying to understand why, I saw a very helpful recent blog entry by Paul Krugman in which he worries about the widespread argument that the identity between savings and investment indicates that fiscal expansion is useless. He says:

What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line.

I think something similar is happening in analyses of the balance of payments, in which the requirement that accounts balance is seen as implying a crude causality — the direction of which depends on your geopolitical predisposition — where none need exist. At any rate discussions about China and the US are destined forever to get mired in crude political grandstanding.

Anyway, enough whining. I should be honored that people take my musings seriously enough to accuse me of evil intent. On a very separate note I have been enjoying the amazing weather in southern Spain where I’ve spent most of the past three days sunbathing and reading Antony Beevor’s excellent (and profoundly depressing) book on the Spanish Civil War, so I haven’t been following global events too closely, and the pleasant daze in which I live when I am home in Spain should explain, I hope, the scarcity and thinness of recent blog entries. I was nonetheless awakened from my stupor by a report from Credit Suisse that projects an increase in January bank lending in China of RMB 1.3 trillion.This is a huge number — about one-quarter of last year’s total increase. According to Credit Suisse’s Dong Tao:

We observe that most of the expected lending is earmarked for infrastructure projects. Infrastructure lending is “politically correct”, backed by collateral, and should have steady cash flows. Lending to the industrial sector and export sector should see minor improvements, however, and banks remain cautious on the economic outlook. Large property developers should get some lending as well, but smaller and “weak” ones are still barred from receiving credit. The private sector seems to be experiencing greater trouble obtaining loans than the public sector and state-owned enterprises.

Dong Tao then goes on to make the point that worries me:

We are concerned about the quality of bank lending but the move to increased lending would be positive news for China’s GDP and global demand. We do wonder how banks conducted their due diligence to allow them to lend one-forth of last year’s lending within three weeks. The potential consequence to the health of the banking sector remains to be seen. Nevertheless, with this massive credit expansion, our upbeat 2009 growth forecast of 8% is more likely to be met.

China has to make an adjustment from an economy overly dependent on exports to one more focused on domestic consumption. This adjustment was never going to be easy and there will definitely be a significant cost. Every other country in history that I can think of that successfully made the adjustment only did so with great difficulty, in the throes of crisis, and over decades. My worry, which I started discussing a few months ago, is that in their desperation to reduce the combined cost of the transition and the global slowdown — instead of forcing the transition during good times they waited until they were forced into it during a crisis — policymakers are going to throw everything they have against the resulting slowdown, including out-of-control bank expansion. While this may reduce the extent of the slowdown this year, as Dong Tao points out, it does so at the risk of creating much deeper instability in the banking system.

If the global crisis lasts only a year, this all-but-the-kitchen-sink strategy will probably have turned out to be a good one, but if, as I suspect, the crisis is going to last two or three years or more, weakening the banking system so early in the process may create much greater risks for China in the future. Piling up loans in such an undisciplined way and having the banks bear most of the heavy lifting in the fiscal expansion plans is good only if it does not result in a sharp rise in non-performing loans. That, most of us would agree, and Victor Shih has been especially worried about this possibility, is unlikely. If it does result in surging NPLs, however, in the near future policymakers will be seriously constrained in their ability to fund more expansion and may even find themselves caught up in a monetary contraction as bank portfolios go bad. The monetary side of policy making in China continues to be, in my opinion, the most difficult and uncertain part of the process, and I think it pays to be cautious.

I know, I know, it sounds like I am warning that China’s growth will be much lower than expected (I still think well below 7% for 2009), which is a bad thing, but if I am wrong, and growth is higher, that is an even worse thing. That sounds a little mean spirited, doesn’t it, and possibly inconsistent?

Maybe, but not necessarily. I have been arguing for three years that an adjustment in China is very necessary and that this adjustment does not involve choosing policies that lead either to good or bad outcomes but rather that lead to bad or worse outcomes. In other words Chinese overcapacity was based on excess investment and massive capital misallocation. There will be a significant cost to reorienting capital and resolving the earlier misallocation. This necessarily entails a slowing of the economy — reallocation of capital typically takes place disruptively and via bankruptcies.

If adjustment policies had been put into place during periods when the global economy was booming — always easier said then done, politically — the adjustment would have been more easily absorbed, but clearly that is no longer an option. There is however still a chance to postpone the adjustment by accelerating the misallocation process, but this only postpones the adjustment and, of course, increases its magnitude. This strategy may be politically necessary but ultimately represents a gamble on the duration of the global slowdown. If the duration is short and the slowdown light, it will have been a winning gamble, and once the world takes off again China can get serious about resolving the internal imbalances.

Of course if the global slowdown is long and deep, the gamble will have failed. That means, dear readers, that if Chinese GDP growth in 2009 is higher than I projected — say 8% – I will not whip out the party hats and favors. Instead I will immediately begin whining about the state of the banking system. Perhaps that indicates intellectual rigidity on my part, but I have been working with and studying developing economies long enough to know that problems that we identify may take longer to emerge than we expected, and often emerge differently from what we projected, but they almost always do emerge in the end.

By the way recent growth numbers from Japan suggest just why we shouldn’t expect the global crisis to be a one-year problem. Fourth quarter Japanese GDP numbers will be released later in February and will show a double-digit decline in GDP and, according to CNBC, that “Japanese industrial production fell a record 9.6 percent in December, while core annual inflation almost evaporated, reinforcing expectations of a record economic contraction as the global financial crisis worsens.” If true, these are staggering numbers. It is hard to imagine a contraction of this magnitude not having ugly implications for the rest of Asia and the world. If it were only Japan, that would be bad enough, but I don’t need to tell anyone who reads newspapers that other large economies aren’t following radically different paths.

Finally, I see that Wen Jiabao and Angel Merkel had a good meeting yesterday. Following their meeting China and Germany have vowed to make joint efforts to stabilize the global economy amid the ongoing financial and economic crisis. As the two leading trade surplus countries I think both of them are going to be subject to the same kinds of very sharp criticism from their trading partners concerning their failures to boost domestic demand and their undermining of fiscal expansion in trade deficit countries. According to , “the two sides agreed to strengthen dialogue on economic and trade, currency and fiscal policies and pledged to support each other on their economic stimulus plans based on their own situations…The two sides also stressed the importance of curbing trade protectionism, saying they will oppose trade and investment protectionism in whatever forms. “

I am sure they will. Unfortunately nearly all the trade-protection cards are in the hands of the trade deficit countries.

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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.

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1 Comment on All But the Kitchen Sink?

  1. Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9 trillion. What will happen when those assets are depleted? Today’s recession may be just a preview of what’s to come.

    Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

    Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?

    At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.

    Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at or where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It’s also available at

    Please forgive me for the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

    Pete Murphy
    Author, “Five Short Blasts”

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