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The Great Rebalancing – Michael Pettis

Trade, Conflict, and the Perilous Road Ahead for the World Economy, Princeton University Press, 2013

Michael Pettis has gained a reputation for his forthright articles on the Chinese economy and financial markets, which he publishes in his blog (some of which are reproduced on The World in Crisis, with his kind permission) and in international media like The Wall Street Journal. He is a professor of finance and economics at Peking University, and has lived in China for a number of years.

The Great Rebalancing has a simple message, the underlying problem the global economy faces today is due to the unbalanced nature of international trade, with a number of countries, like China and Germany, holding large credit balances and a number of countries, like the United States, having large deficits in their balance of trade. He maintains that the primary cause of the 2008 crisis lay in the imbalances of trade, not in the behaviour of Wall Street, although that does not absolve banks of responsibility for their actions.

The problem that Michael Pettis has is that this message differs from so much of what passes for expert opinion, and for most it is counter-intuitive. This book focuses on the unprecedented Chinese trade surplus, and the balancing US trade deficit, but it also provides clarity on the problems of the Euro. He sees German intransigence over the problem of its own huge trade surplus as the main driver of the Euro crisis. Germany’s trade surplus has created the mirroring problem of southern European trade deficits, held by countries locked in the straight-jacket of the single currency.

Pettis says, “The global crisis is a financial crisis driven primarily by global trade and capital imbalances, and it has unfolded in almost a textbook fashion.” He adds. “There is nonetheless a tendency, especially among Continental European policymakers and the nonspecialized Western media, to see the crisis as caused by either the systemic deregulation of the financial services industry or the use and abuse of derivatives. When the crisis is viewed, however, from a historical perspective it is almost impossible to agree with either of these claims.” [pp 2-3]

Pettis also argues that under-consumption in the surplus countries is “the most likely cause of global trade distortions.” [p 9] He states that, “Large and persistent trade imbalances … are almost always caused by distortions in financial, industrial, or trade policies.” [p 10] He says that trade imbalances will be eventually reversed despite policy constraints, but when the change is forced the adjustment is “often violent and can come in the form of a financial crisis.” [p 11] Pettis identifies the main imbalances as the very large trade surpluses during the past decade of China, Germany, and Japan and the very large trade deficits of the United States and peripheral Europe.” [p 11] He describes how large deficits in trade lead to unsustainable increases in debt and, ultimately, to the deleveraging process necessary to restore balance, as he says, “It is this deleveraging process that is at the heart of the global financial crisis.” [p 11]

There is one insight which is at the heart of this book: “We know for example the relationship among savings, investment, and current account imbalances in any particular country, but we fail to apply this knowledge logically to the full range of policies and institutions that affect the components of the global trade and capital balances. We fail to think in terms of the overall system.” [p 12]. These words should be engraved over the doors of the treasuries and central banks of the world – particularly, “We fail to think in terms of the overall system”. Pettis makes it clear that the world economy is now a single system, problems in any one part automatically create effects in the other parts of the global system. Government investment policies in China, for example, which increase Chinese manufacturing output, in an economy with low rates of consumption and high rates of savings, are one of the causes of the increasing trading surplus built up by China, which is a capital flow from China to the United States. The US deficit is the inevitable consequence of China’s policies.

I strongly recommend this book to anyone who is interested in an authoritative overview of how the global system actually works.

Pettis also makes three other points:

Firstly, he believes that the Euro will break up unless Germany reverses its current policies and increases its consumption and reduces its saving rates, moving to deficit from surplus.

Secondly, he also makes it clear that China’s position is extremely difficult, China’s policies have caused it waste capital on an unprecedented scale, investment has been as high as 50% of GNP, a level which is a record in any large economy. Pettis says, “China now needs urgently to abandon the development model because debt is rising furiously and at an unsustainable pace, and once China reaches its debt capability limits, perhaps in four or five years, growth will come crashing down.” [p 93] He adds that China is massively under-consuming, and it has concentrated its wealth in the state sector, at the expense of Chinese households, which currently consume only about 34% of GDP (roughly half the global average). He says that, “China must change its growth model. Until it does so it will be excessively vulnerable to changes in the trade surplus or in domestic investment.” [p 94] The adjustment required of China is massive, virtually unprecedented. Pettis argues that the global system is desperate for demand, not production or capital, and that this will push much of the pressure to rebalance on those countries running large trade surpluses.

The third point, which Pettis makes forcibly, is that the United States does not benefit from the use of the US Dollar as the world’s reserve currency, even though the US Government remains strongly opposed to any change to the current situation. He says that this makes it very difficult for the Federal Reserve to manage domestic monetary policy, and that the policies of countries like China have forced the United States to provide reserves which was created large and serious imbalances, including the US deficit.

In conclusion Pettis makes it clear that the imbalances which caused the 2008 crisis have still not been resolved, that these major imbalances are unsustainable and must eventually be reversed. He states that, “Any policy that does not clearly result in a reversal of the deep debt, trade, and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing required and then to design and implement the least painful way of getting there. International cooperation, of course, will reduce the pain.” [p 194]

So the present crisis is far from over and the next stages will see major adjustments, planned or not, particularly in the German and Chinese economies.

“It ain’t over till the fat lady sings”.

© Andrew Palmer, 2014

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