By Michael Pettis. Cross posted from Michael Pettis’ China Financial Markets
One of the reasons that it is been so hard for a lot of analysts, even trained economists, to understand the imbalances that were at the root of the current crisis is that we too easily confuse national savings with household savings. By coincidence there was recently a very interesting debate on the subject involving several economists, and it is pretty clear from the debate that even accounting identities can lead to confusion.
The difference between household and national savings matters because of the impact of national savings on a country’s current account, as I discuss in a recent piece in Foreign Policy. In it I argue that we often and mistakenly think of nations as if they were simply very large households. Because we know that the more a household saves out of current income, the better prepared it is for the future and the more likely to get rich, we assume the same must be true for a country. Or as Mr. Micawber famously insisted:
Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.
But countries are not households. What a country needs to get wealthier is not more savings but rather more productive investment. Domestic savings matter, of course, but only because they are one of the ways, and probably the safest, to fund domestic investment (although perhaps because they are the safest, investment funded by domestic savings can also be misallocated for much longer periods of time than investment funded by external financing).
Saving in itself, however, does not create wealth. It is productive investment that creates wealth. Domestic savings simply represent a postponement of consumption.
In a closed economy, total savings is equal to total investment or, to put it differently, whatever we don’t consume we invest (if we produce something that we neither consume nor invest, we effectively write its value down to zero, so the balance remains). In an open economy, if a country saves more than it invests it must export the excess savings. It must also export the excess production.
Notice that by definition if a country saves more than it invests, total consumption plus total savings must be greater than total consumption plus total investment. The former is the sum of the goods and services it creates, whereas the latter is the sum of goods and services it absorbs. That country, in other words, supplies more goods and services than it absorbs, and so it must export the excess.
What is more, by exporting excess savings, the country is providing the funding to foreigners to purchase its excess production. This is why the current account and the capital account for any country must always add up to zero.
In the late 19th Century, as I discuss in my most recent book, economists like John Hobson in the UK and Charles Arthur Conant in the US noticed that the rich countries of the west were exporting large amounts of savings abroad – mostly to what were later called by the dependencia theorists of the 1960s the peripheral nations. Hobson and Conant argued that the reason for this excess savings had to do with income inequality. As more and more wealth is concentrated into the hands of fewer people, consumption rises more slowly than production, largely because the wealthier a person gets, the smaller the share he consumes out of his income. Notice that because savings is simply total production of goods and services minus total consumption, this forces up the national savings rate.
This was a very important insight. Excess savings, they pointed out, was not a result of old-fashioned thrift but rather a consequence of structural distortions in the economy. The consequence of this “thrift”, furthermore, was not greater wealth but rather structural imbalances in the global economy.
In a closed economy there are four ways of resolving the imbalances caused by an increase in the savings rate. First, and most obviously, investment can rise by the same amount.
The private sector, however, may be reluctant to increase investment if it believes the consumption share is declining over the long term, in which case the government can sponsor the increase in investment, for example in infrastructure, so that savings and investment balance at a higher rate. This is sustainable only as long as there are productive investments that can be made, but as consumption declines, the reason for investing should decline too. The purpose of investment today after all is to create consumption tomorrow.
The second way to resolve the imbalance is if the government or the labor unions take steps to redistribute income downwards. As middle class and poor households retain a greater share of total GDP, consumption will automatically rise relative to production (the savings rate declines), even if middle class and poor households save a greater share of their higher income. The savings rate declines to the point at which savings and investment are once again balanced domestically and everything a country makes it consumes or invests.
The third way to resolve this in a closed economy – albeit only temporarily – is to fund a consumption boom among the not-so-rich. How would this work? One way might be, as Conant discusses extensively, that as savings grow faster than opportunities for productive investment in infrastructure and production capacity, more and more of the savings of the wealthy go into speculative investments that drive up asset prices – homes, stocks and bonds. As asset prices rise, households feel richer and they begin to take advantage of the abundance of savings to borrow for consumption, and borrowing is just negative savings.
As home prices or the value of investment portfolios rise there is likely to be not just an increase in consumption but also an increase in investment in new housing. As both of these happen, the reduction in consumption caused by rising income inequality is matched by the increase in consumption caused by credit-fueled purchasing and an increase in housing investment, and once again savings and investment can balance domestically. We saw this happen in the US and in the peripheral countries of Europe in the run-up to the 2007-09 crisis.
The fourth way to resolve the savings imbalance in a closed economy is to force up unemployment (this is what Karl Marx said would eventually happen). As income inequality grows, and so consumption grows more slowly than production, companies are forced to cut production and fire workers. Fired workers of course produce nothing, but they still consume, either out of savings, welfare payments, or handouts from friends and families. This causes total savings to drop so that once again it balances investment, but of course in an economy with rising unemployment, profits are likely to drop, and with lower profits comes reduced investment, so more workers need to be fired and the process can become self-reinforcing.
Open economies have another option
In a closed economy there really aren’t many other ways to balance savings and investment if structural factors force up the savings rate. But we do not live in closed economies. Most of us live in open economies (although the world itself is a closed economy), so there is actually a fifth way to resolve domestic savings imbalances, and this is what Hobson and Conant described as the root source of late 19th Century imperialism.
If domestic savings rates are so high that the country cannot invest it all profitably, it can export those savings, which means automatically that it imports foreign demand for its excess production. Its net export of savings (less net returns on earlier investment) is exactly equal to its net export of goods and services.
In an open economy, in other words, a country’s total savings matters because to the extent that it exceeds investment, it must be exported, and it must result in a current account surplus. Here is where the confusion so many analysts, including economists, have about the difference between national and household savings. Household savings represent the amount out of household income that a household chooses not to consume, and so can be affected by cultural or demographic factors, the existence and credibility of a social safety net, the sophistication of consumer finance, and so on.
The national savings rate, on the other hand, includes not just household savings but also the savings of governments and businesses. It is defined simply as a country’s GDP less its total consumption. While the household savings rate may be determined primarily by the cultural and demographic preferences of ordinary households, the national savings rate is not. Indeed in some cases the household share of all the goods and services a country produces, which is primarily a function of policies and economic institutions, is the main factor affecting the national savings rate.
National savings, in other words, may have very little to do with household preferences and a lot to do with policy distortions. In China, which has by far the highest savings rate in the world, part of the reason for the high national savings rate of course is that Chinese households save a relatively high proportion of their income.
But while China’s savings rate is extraordinarily high, the Chinese household savings rate is merely in line with those of similar countries in the region, and in fact lower than some. Chinese households are not nearly as thrifty as their national savings rate implies. Why, then, is China’s savings rate so extraordinarily high?
The main reason, as I have discussed many times and which now has pretty much become accepted as the consensus among China specialists, is not so much income inequality (although this is certainly a problem in China) but rather the very low household income share of GDP. At roughly 50% of GDP, Chinese households retain a lower share of all the goods and services the country produces than households in any other country in the world.
This is a consequence of policies Beijing put into place many years ago that goose GDP growth by constraining the growth in household income. As a result of these policies, the household share of China’s total production of goods and services has been falling for thirty years, and fell especially sharply in the past decade. It isn’t surprising, consequently, that as households earn a declining share of what China produces, they also consume a declining share. Because savings is simply GDP less total consumption, and most consumption is household consumption, the fall in the household income share of GDP is the obverse of the rise in China’s extraordinarily high savings rate.
Many factors explain this very low household income share in China, including most importantly financial repression, whose characteristics typically include artificially low deposit rates, which, by reducing the amount of money that a saver should earn on his bank deposit, transfers part of his income to borrowers, who are able to borrow very cheaply. In China, this implicit transfer is extremely high, perhaps 5 percent of China’s GDP or more.
Of course the more money that is transferred in this way, the less disposable income the household depositor has, and so he is forced to reduce both his nominal savings and his nominal consumption. We cannot easily predict how this reduced interest rate will affect the household savings rate, but it is pretty easy to figure out how it will affect the national savings rate. If the transfer is substantial, it will reduce the share of GDP retained by households. Unless households reduce their savings rate by more than the reduction in the household share of GDP, it must automatically force up the national savings rate.
Confusing thrift with inequality
China’s extraordinarily high national savings rate, in short, is a function primarily of the extraordinarily low household share of GDP. Even economists who really should know better manage to make some fairly impressive mistakes when they discuss Chinese and other savings imbalances, mostly because their understanding of savings can be hopelessly confused. For a typical example, consider a piece Raman Ahmed and Helen Mees, published last year called, “Why do Chinese households save so much?”
In the article the authors try to address the causes of China’s high savings rate, but they do so by thoroughly confusing national savings with household savings. For example they set out trying to prove that financial repression has no impact on China’s savings rate, but because they fail to understand that financial repression does this by reducing the household share of income, and not necessarily by reducing the household savings rate, they find:
China’s monumental savings rate is a popular topic of for policy discussion. It has been blamed for the global financial crisis, currency wars, and the ensuing Great Recession. But what explains the high savings rate?
…Although the savings rate varies significantly per income group, with the lowest income group’s savings rate in urban areas in the single digits and the highest income group’s savings rate at almost 40% of disposable income, we do not find evidence that income inequality as such is a motive for households to save a larger portion of their income, as Jin et al. (2010) have suggested. It would have been the Chinese version of ‘keeping up with the Joneses’, albeit that ‘keeping up with the Wangs’ would not have involved conspicuous consumption but rather conspicuous saving. This would have instigated higher savings rates across the board of deciles of savings rates, with the strongest effect on low-income households. However, using urban data on household savings rates and income inequality from 1985-2009, we do not find this effect present.
There is no evidence that the household savings rate in China is high because of low deposit rates, as Michael Pettis (2012) has asserted time and again, which would indicate that the income effect of lower deposit rates trumps the substitution effect of lower deposit rates. The coefficient of the deposit rate has alternating signs, but is insignificant in every single estimate.
The article purports to discuss what they refer to as China’s “monumental savings rate”, which, according to the authors, has been blamed for the global financial crisis, currency wars, and the ensuing Great Recession, but it focuses on the wrong savings rate. Chinese household savings are not by any definition “monumental”, and they most certainly did not cause the global financial crisis, nor does anyone seriously claim that they did. Chinese household savings rates are high, but not exceptionally high, and because household income is such a low share of GDP, Chinese household savings as a share of GDP, which is what really matters, are even lower than the household savings rate would imply. Chinese household savings are not the problem.
It is China’s national savings rate which is “monumental” and which drives China’s current and capital account imbalances, and the national savings rate is monumentally high because the national consumption rate (which consists mostly of the household consumption rate) is extraordinarily low. The authors have either confused national and household savings rates or they have failed to see that what matters is not the household savings rate but rather total savings. Aside from the fact that there is indeed evidence that Chinese savings are negatively correlated with interest rates, for example a 2011 study done by the IMF, the relationship is one of pure logic.
The important lesson from this article, aside from suggesting just how confused many economists are when it comes to understanding the source of global imbalances, is that national savings represent a lot more than the thriftiness of local households, and as such it has a lot less to do with household or cultural preferences than we think. In fact many factors affect the savings rate of a country, including demographics, the extent of wealth inequality, and the sophistication of consumer credit networks, but when a country has an abnormally high savings rate it is usually because of policies or institutions that restrain the household share of GDP.
This has happened not just in China but also in Germany. In the 1990s Germany could be described as saving too little. It often ran current account deficits during the decade, which means that the country imported capital to fund domestic investment. A country’s current account deficit is simply the difference between how much it invests and how much it saves, and Germans in the 1990s did not always save enough to fund local investment.
But this changed in the first years of the last decade. An agreement among labor unions, businesses and the government to restrain wage growth in Germany (which dropped from 3.2 percent in the decade before 2000 to 1.1 percent in the decade after) caused the household income share of GDP to drop and, with it, the household consumption share. Because the relative decline in German household consumption powered a relative decline in overall German consumption, German saving rates automatically rose.
Notice that German savings rate did not rise because German households decided that they should prepare for a difficult future in the eurozone by saving more. German household preferences had almost nothing to do with it. The German savings rate rose because policies aimed at restraining wage growth and generating employment at home reduced household consumption as a share of GDP.
As national saving soared, the German economy shifted from not having enough savings to cover domestic investment needs to having, after 2001, such high savings that not only could it finance all of its domestic investment needs but it had to invest abroad by exporting large and growing amounts of savings. As it did so its current account surplus soared, to 7.5 percent of GDP in 2007. Martin Wolf, in an excellent Financial Times article on Wednesday on the subject, points out that
between 2000 and 2007, Germany’s current account balance moved from a deficit of 1.7 per cent of gross domestic product to a surplus of 7.5 per cent. Meanwhile, offsetting deficits emerged elsewhere in the eurozone. By 2007, the current account deficit was 15 per cent of GDP in Greece, 10 per cent in Portugal and Spain, and 5 per cent in Ireland.
Employment policies and the savings rate
It is tempting to interpret Germany’s actions as the kind of far-sighted and prudent actions that every country should have followed in order to keep growth rates high and workers employed, but it turns out that these policies did not solve unemployment pressures in Europe, and this is implied in the second sentence of Martin Wolf’s piece. Germany merely shifted unemployment from Germany to elsewhere. How? Because Germany’s export of surplus savings was simply the flip side of policies that forced the country into running a current account surplus.
To explain, let us pretend that Europe consists of only two countries, Spain and Germany. As we have already shown, forcing down the growth rate of German wages relative to GDP caused the household income share of GDP to drop. Unless this was matched by a decision among German households to become much less thrifty, or a decision by Berlin to increase government consumption sharply, the inevitable consequence had to be a reduction in the overall consumption share of GDP, which is just another way of saying that the German national savings rate had to rise. During this period, by the way, and perhaps as a consequence of restraining wages, Germany’s Gini coefficient seems to have risen quite markedly, and the resulting increase in income inequality also affected savings adversely.
As German savings rose, eventually exceeding German investment by a wide margin, Germany had to export the difference, which its banks did largely by making loans into the rest of Europe, and especially those countries that were financially “shallower”. Declining consumption left Germany producing more goods and services than it could absorb domestically, and it exported excess production as the automatic corollary to its export of savings.
Of course the rest of the world had to absorb excess German savings and run the current account deficits that corresponded to Germany’s surpluses. This was always likely to be those eurozone countries that joined the monetary union with a history of higher inflation and currency depreciation than Germany – countries which we are here calling “Spain”. As monetary policy across Europe was made to fit German needs, which was looser than that required by Spain, and as German savings were intermediated by German banks into Spain, the result was likely to be higher wage growth, higher inflation, and soaring asset prices in Spain.
In fact this is exactly what happened. Spain and the other peripheral European countries all saw their trade deficits expand dramatically or their surpluses (many were running large surpluses in the 1990s) turn into large deficits shortly after the creation of the single currency as their savings rates shifted to accommodate German exports of its excess savings.
The way in which the German exports of savings were absorbed by Spain is at the heart of the subsequent crisis. As long as Spain could not use interest rates, trade intervention, or currency depreciation to block German exports, it had no choice but to balance the excess of German savings over investment. This meant that either its investment would have to rise or its savings would have to fall (or both).
Both occurred. Spain increased investment in infrastructure and in real estate (and less so in manufacturing, probably because German growth occurred at the expense of the manufacturing sectors in the rest of Europe), but it seems to have done both to excess, perhaps because of the sheer amount of capital inflows. After nearly a decade of inflows larger than any it had ever absorbed before, Spain, like nearly every country in history under similar circumstances, ended up with massive amounts of misallocated investment.
But this was not all. If the savings that Germany exported into Spain could not be fully absorbed by the increase in Spanish investment, the only other way to balance was with a sharp fall in Spanish savings. There are two ways Spanish savings could have fallen. First, as the Spanish tradable goods sector lost out to German competition, Spanish unemployment could rise and so force down the Spanish savings rate (unemployed workers still must consume).
Second, Spain could have reduced household savings voluntarily by increasing consumption relative to income. Higher Spanish consumption would cause enough employment growth in the services and real estate sectors to make up for declining employment in the tradable goods sector.
Not surprisingly, given the enormous optimism that accompanied the creation of the euro, the latter happened. As German money poured into Spain, helping ignite a stock and real estate boom, ordinary Spaniards began to feel wealthier than they ever had before, especially those who owned their own homes. Thanks to this apparent increase in wealth, they reduced the amount they saved out of current income, as households around the world always do when they feel wealthier. Together the reduction in Spanish savings and the increase in Spanish investment (in infrastructure and real estate) was enough to absorb the full extent of Germany’s export of excess savings.
But at what cost? The imbalance created within Europe by German policies to constrain consumption forced Spain into increasing consumption and boosting investment, much of the latter in wasted real estate projects (as happened in every one of the deficit countries that faced massive capital inflows). There are of course no shortage of moralizers who insist that greed was the driving factor and that Spain wasn’t forced into a consumption boom. “No one put a gun to their heads and forced them to buy flat-screen TVs”, they will say,
But this completely misses the point. Because Germany had to export its excess savings, Spain had no choice except to increase investment or to allow its savings to collapse, with the latter either in the form of a consumption boom or a surge in unemployment. No other option was possible.
To insist that the Spanish crisis is the consequence of venality, stupidity, greed, moral obtuseness and/or political short-sightedness, which has become the preferred explanation of moralizers across Europe begs the question as to why these unflattering qualities only manifested themselves after Spain joined the euro. Were the Spanish people notably more virtuous in the 20th century than in the 21st? It also begs the question as to why vice suddenly trumped virtue in every one of the countries that entered the euro with a history of relatively higher inflation, while those eastern European countries with a history of relatively higher inflation that did not join the euro managed to remain virtuous.
The European crisis, in other words, had almost nothing to do with thrifty Germans and spendthrift Spaniards. It had to do with policies aimed at boosting German employment, the secondary impact of which was to force up German national savings rates excessively. These excess savings had to be absorbed within Europe, and the subsequent imbalances were so large (because German’s savings imbalance was so large) that they led almost inevitably to the circumstances in which we are today.
For this reason the European crisis cannot be resolved except by forcing down the German savings rate. And not only must German savings rates drop, they must drop substantially, enough to give Germany a large current account deficit. This is the only way the rest of Europe can unwind the imbalances forced upon the region in a way that is least damaging to Europe as a whole. Only in this way can countries like Spain stay within the euro while bringing down unemployment.
But lower German savings don’t mean that German families should become less thrifty, only that the average German household should be allowed to retain a much larger share of what Germany produces. If Berlin were to cut consumption taxes, or cut income taxes for the lower and middle classes, or force up wages, total German consumption would rise relative to GDP and so national savings would fall – without requiring any change in the prudent behavior of German households.
To ask Spanish households to be more “German” by saving more is not only impractical in an economy with 25 percent unemployment (it is hard for unemployed workers to increase their savings), it is counterproductive. Lower Spanish consumption can only cause even higher Spanish unemployment, until eventually Spain will be forced to abandon the euro and so regain control of its ability to absorb or reject German imbalances. This abandonment of the euro will be driven by the political process, as those in the leadership (of both main parties) who refuse to countenance talk of leaving the euro lose voters to more radical parties until they, too, come around:
The latest opinion polls show the PP has lost 10 percentage points of support since Rajoy’s election in November 2011. Support for the main opposition group, the Socialists remains unchanged, while backing has been growing for smaller, more radical, parties. More than 68 per cent of Spaniards say the government is doing a bad or very bad job, while the latest official forecast shows that a quarter of the workforce will still be out of work three years from now.
An article in this week’s Economist suggests that Spain is indeed becoming more “German” and so that this is reason for hope:
Is Spain the next Germany? It may not feel like that to the 26% of Spaniards who are unemployed. GDP shrank by 0.8% in the fourth quarter of 2012. Yet in some ways, Spain resembles the Germany of a decade ago, when Gerhard Schröder brought in reforms to turn the sick man of Europe into its strongest economy. The efforts by Mariano Rajoy’s government to loosen labour laws and cut public spending are aimed at a German-style miracle.
…Joachim Fels, chief economist at Morgan Stanley, is one of several backers of the Germany theory. “Spain is doing a lot of the things Germany did ten years ago, but in a much shorter time span and tougher global conditions,” he says, pointing to falling labour costs, rising exports and booming Spanish car factories. But, he adds, “Spain becoming Germany is really a two- to four-year story.”
The global constraints
The problem with this argument may be, however, that the global conditions that allowed Germany to grow by exporting savings to Spain cannot be replicated. If Spain were to make its workers more competitive by reducing wage growth relative to GDP growth, it would implicitly be forcing up its savings rate to generate employment. To whom would Spain export those savings? The world is awash in excess savings, and unlike in pre-crisis days, there are no countries with booming stock and real estate markets willing to fund another consumption binge. This means that Spain and Europe are expecting to recover by exporting unemployment, but to whom?
In fact this is the great worry that Martin Wolf expresses n the conclusion to his article:
A big adverse shock risks turning low inflation into deflation. That would aggravate the pressure on countries in crisis. Even if deflation is avoided, the hope that they will grow their way out of their difficulties, via eurozone demand and internal rebalancing, is a fantasy, in the current macroeconomic context.
That leaves external adjustment. According to the IMF, France will be the only large eurozone member country to run a current account deficit this year. It forecasts that, by 2018, every current eurozone member, except Finland, will be a net capital exporter. The eurozone as a whole is forecast to run a current account surplus of 2.5 per cent of GDP. Such reliance on balancing via external demand is what one would expect of a Germanic eurozone.
If one wants to understand how far the folly goes, one must study the European Commission’s work on macroeconomic imbalances. Its features are revealing. Thus, it takes a current account deficit of 4 per cent of GDP as a sign of imbalance. Yet, for surpluses, the criterion is 6 per cent. Is it an accident that this happens to be Germany’s? Above all, no account is taken of a country’s size in assessing its contribution to imbalances. In this way, Germany’s role is brushed out. Yet its surplus savings create huge difficulties when interest rates are close to zero. Its omission makes this analysis of “imbalances” close to indefensible.
The implications of the attempt to force the eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, highly likely. Moreover, if it starts to work, the euro is likely to move upwards, so increasing risks of deflation. Not least, the shift of the eurozone into surplus is a contractionary shock for the world economy. Who will be both able and willing to offset it?
The eurozone is not a small and open economy, but the second-largest in the world. It is too big and the external competitiveness of its weaker countries too frail to make big shifts in the external accounts a workable post-crisis strategy for economic adjustment and growth. The eurozone cannot hope to build a solid recovery on this, as Germany did in the buoyant 2000s. Once this is understood, the internal political pressures for a change in approach will surely become overwhelming.
As long as it is part of the euro Spain has no choice but to respond to changes in German savings rates. There is nothing mysterious about this process. It is simply the way the balance of payments works, and thrift has nothing to do with it. If Germany does not take steps to force down its savings rate by increasing the household share of GDP, then either all of Europe becomes like Germany, in which case growth slows to a crawl and some other country – maybe the US? – will be forced to resolve Europe’s demand deficiency either through higher unemployment or through higher debt, or Europe must break apart to free Spain and the other peripheral countries from German savings imbalances.
I don’t imagine the rest of the world can absorb demand deficiency from a Germanic Europe, and if Europe tries to force it the result will almost certainly be an eventual collapse in trade relations, so either Germany rebalances or Europe breaks apart. It is hard for me to see many other options.
Lambert, I’ve been angsting over the nature of (self managed) superannuation in Australia very recently wondering what the hell I’m dealing with.
In effect this is giant bucket of savings for Australian retirement – currently 1.4 trillion $ and predicted to rise with changes etc. to 6 trillion later this decade. But most seems unproductive because of its very conservative investment constraints. So buckets of money go into cash to earn interest, extortion cash vehicles to get even more interest, property which locally has long been largely about a bubble that is deflating now if not bursting – and finally ‘securities’. These include productive shares but the most profitable are bank and finance and insurance shares which aren’t what I would call productive in the old sense. The Canadian system is the same.
This feels like the same issue but I’m no formal economist.
More and more money kicking the same old tires. There is too much money for the investment opportunities out there.
Everyone wants their portfolio to grow so they don’t have to work. Markets are too big for the GDP.
One day, they’ll understand that fully funded pensions for a demographic bulge is utopia.
You can condense this piece down to one sentence:
When Germany shredded the growth and stability pact (wages linked to productivity) the stage was set for systemic imbalances across the Eurozone.
It all began when the German oligarchs, for whatever reason, were allowed to murder German labor.
Immensly interesting article.
1. Couldn’t ‘Spain’ have used regulatory measures like min 50% downpayment for home morgage instead of say 0-10% – thus decreasing the hype on the market by decreasing the demnad for credit (not a lot of people have 50% of downpayment for a house). I understand in the yeras were ‘free’ ‘non-regulatory’ neo-libs were prevailing theory it couldn’t have happend as well as politicaly it would be a shot in the foot. I just ask out if this was possible if one wanted to.
2. Wouldn’t it be that firms from ‘Germany’ to win the market share in the future say with better pricing in the ‘Germany’ or ‘Spain’ would have to relocate part of the manufacturing to ‘Spain’ where unemployment and austerity has driven the wages down. ANd the rest will follow to keep their shares and defend.
Point 2 takes of course very, very long time.
coobek: Spanish government could have refrained borrowing for real estate investment. If so, excess savings pouring from the eurocore should then have been spent in more infrastructures or manufacturing investments or simply, borrowing for higher consumption. Nevertheless, housing, and rising housing prices, was one of the investmente offering less resistance for various reasons. One of the reasons was the creation of debt instruments, (I believe they were originated in the US and UK), that easily, and massively diverted money to real estate investments. How much money poured german banks in spanish mortgage backed securities (spanish “cedulas” and other MBSs) in search of higher interest rates?
Regarding the point of spain using regulatory measures like min 50% to limit excessing investment in housing, I think its much harder than it looks. For example, there is so much vested interest that benefits from a housing bubble in Canada that it was difficult for the government to stump on the boom. Canadian government only try to clamp down on the mortgage requirement after the boom has gone on for a long while even as they have clear example of aftermath of the housing crisis in other countries. Spain didn’t have the advantage of seeing other countries fail so its much much harder to have the foresight to do the right thing.
” if a country saves more than it invests it must export the excess savings”
why must it export excess savings? Can’t money just get parked in the banking system for example?
I don’t think it can, LXDR1F7. What will the bank do with it? It could lend it to a consumer, which brings down the savings rate, or to an investor, which brings up the investment rate, or to a foreigner. Banks don’t just take your cash and throw it is a big drawer, and I think if they did, the government would be able to lower its borrowing (cash is just an interest free loan to the government), so it wouldn’t matter anyway.
if people deposit money into the banking system and banks dont increase lending savings will not equal investment
If the banks don’t increase lending they will buy government bonds and push down interest rates, which will either reduce savings or increase investment. . The idea that banks will just sit on drawers full of cash is nonsense. If you want to understand why they are accounting identities you have to think of the whole system, not of a single transaction.
Wow you’ll get in trouble making that assumption in the 21st century. It sounds too sensible, too stable. Banks take excess funds and sit on them, knowing they have assets to keep them solvent through any financial downturn. They wouldn’t even take every DM and pretend it was 10 DM then lend it out over and over again until there wasn’t a pfennig in the vaults covering their liabilities.
Instead we live in a modern economy which is nothing more than a spinning top. We must spin it faster and faster because the moment it slows down it will topple over. In such an economy every DM, every pfennig must be put to work to keep the top spinning. Banks lend all their funds out and are one hiccup from insolvency because endless growth is all that matters. It is an incredibly fluid and unstable economic system.
If a nation (the government sector plus the domestic private sector of households and businesses) saves more money out of income flows than it invests, profits fall (as the business sector fails to recapture enough of its wage outlays as revenues from consumer spending) UNLESS exports (sales to foreigners) exceed imports (purchases from foreign producers). The business sector has to force a net cash flow in its favor to earn profits. It will not be able to do so if say the household sector tries to save more money than the business sector is willing to invest in new tangible capital unless the government is deficit spending, or foreigners are deficit spending (that is, the nation is running a trade surplus).
I think it’s called vendor financing.
No vendor financing to Spain, no sales to Spain.
Look, no. Just no alright.
Now I am one for laying a substantial, even the majority, of the blame for the euro crisis at Germany’s feet. But saying that it was the fault of German savers is just wrong, wrong, wrong.
It was the fault of the lenders, the lenders, the lenders.
The German banks took those savings and misallocated the wealth. The incompetence of the bankers meant that the savers money was lost on unproductive, and speculative investments all over the world. It was wasted fuelling bubbles and rewarding failure instead of being invested in productive companies and long term investments.
The essential problem of the euro crisis is that this lost wealth is not being realised. The German saver is still being protected from his bankers mistakes, even as the (poor in the) peripheral countries are being flogged for their bankers misdeeds. The German saver may regard his right to his deposit back as absolute, but he should tell that to Herr Schauble and the Cypriots.
When the article points to German savings as a problem, the article isn’t talking about the people taking their excess income and putting it into a bank. Those people are entirely blameless and have no control over what’s happening.
What the article is talking about how Germans aren’t consuming/investing enough of their own production. (The article attributes this to a number of factors and offers a number of solutions, none of which involve shaming Germans for making bank deposits.)
What Germans don’t consume/invest domestically needs to be consumed/invested by someone else. The existence of the single currency makes it especially hard for other countries in the EU to refuse that excess German investment.
I must say that I like Pettis and his rationale rings true for me (albeit that I find myself mentally wrestling to get my head around what he is saying).
My take (for what it is worth) is that he provides in the article a coherent (and for me believable) analysis … but at a technical level. What is missing is the human dimension – meaning that overlaying all the ‘structural imbalances’ and ‘policy errors’ are people, who generously, are trying to do their best for mankind, or perhaps more cynically, act out of their own narrow self interest.
Policy, it seems to me, favours in-groups and does so for votes, power, money (all connected). It has suited the German banks who were happy to lend to the hapless Spanish ‘investors’ in housing – so perhaps a lesson through massive default on Spanish loans and the collapse of German banks would be a better adjustment as the pain falls on those who benefited.
Politically….. wont happen.
Don’t bet on it. You must remember that Spain and Portugal, speaking of culture and communications, are linked very closely to South America.
Brazil and Argentina have already given neoliberalism a thumbs down, so don’t be surprised if Spain and Portugal learn from Brazil and Argentina’s nightmarish experiences with neoliberalism, and join the anti-neoliberal club in short order. This would mean leaving the Euro and telling Germany to cram its 1.5 trillion euros of loans up where the sun don’t shine.
Will there be musicals? And dancing?
I completely agree with the main conclusion: unless Germany reduces it’s national savings rate (and does it fast) there is no other operative way to resolve internal imbalances without breaking the euro. Since, apparently, the main political parties in Germany oppose to this rebalancing process, it seems that a euro breakage is the most probable scenario. A copernican turn is needed in EU fiscal policies to readdress internal imbalances or the euro is doomed.
This is a great analysis of the situation. However, we don’t need to go so deep into details to get to the reasoning that austerity in high unemployment and low interest rates situation is very very stupid.
Austerity in the current climate is a violation of simple mathematics. Refusing to see that is akin to refusing that 2 + 2 = 4.
The current situation is global as it affects a large part the worlds interconnected economies. The larger or the more global the economy we are discussing, the more impossible austerity is.
The reasoning: When talking about the economy as a whole including people, businesses and governments:
Debt = Paper savings
Every piece of debt is owed to someone and to this someone it is savings. This even applies to money. When someone has money, it simply means the rest of society collectively owes him a certain amount of goods.
Austerians think that we can solve the economy’s problems by reducing debt and increasing savings. THIS IS A MATHEMATICAL IMPOSSIBILITY. It can only happen if large amount of money is printed which creates at least a perception of saving.
If you try, through austerity, to force the reduction of debt without reducing people’s savings or without printing lots of money, you are pushing against immovable mathematical limits. You create huge economic gridlocks that lead to unemployment and reduction in the real amount of value the economy is generating. A population not in full production is not only in a bad position to pay back individual’s debt, but when they get back to full production they will have accumulated less wealth and be forever poorer because of it.
This is a simplification of the situation described in the article. I, for example, didn’t mention saving through stocks instead of paper, but there are similar mechanisms when it comes to stocks that make it mathematically impossible to save through them on a global scale without printing money.
To summarize, when you take the economy as a whole, there is no debt to some external fictitious entity. There is no such thing as paying down the debt for a while to get on a better footing. If governments pay off their debt, people or businesses’ savings will be reduced or money will need to be printed. Mathematically, there is no other way. Debt and savings are equal and between parties inside the economy. Austerity without increasing quickly the money supply through stimulus is as stupid and futile as trying to make 2+2=5.
To say it is all the Germans fault is a mistake.
The Sterling zone is part of the EU remember ?
People seen to forget this important fact just because of the Sterling currency but it is very much integrated in almost all other fields.
For example the UK through its London & Edinburgh operations was earning income from Europe during the credit hyperinflation
The Scottish banks were very active in Ireland for example.
This income was realized as it eventually became consumption somewhere.
If you look at UK balance of payments data income from the rest of the world peaked at Q1 2008 at over £18 billion sterling and now is only a few billion a quarter.
Londons big bang and the euro experiment is the same event.
By design or default London created the “services” excuse to absorb German & later Norwegian & Chinese physical surplus goods & energy.
Post crash it has chosen real goods over income.
This is very profound.
It means the current system has no settlement in Europe.
All countries are being driven into surplus so that the UK and to a lesser extent France can consume.
The answer is to go back to national currencies as even during the gold standard era countries could print to sustain domestic commerce.
In the euro system there can be no rational domestic commerce.
Its the ultimate market state experiment.
Just to repeat
“In the euro system there can be no rational domestic commerce.”
There is simply not enough fiat to pay local debt.
So you will get a breakdown of local demand & commerce.
This was always the case in Euroland at a extreme level.
The credit hyperinflation disguised this until implosion.
The credit hyperinflation was the method of extraction.
Need I remind you this happened in Ireland in 1980 !!!! creating a mini depression.
This is a 33 year ongoing monetary crisis !!!!
There is another important connection between savings and unemployment. In each currency area, actual savings must be equal to actual borrowing, even if there is an excess desire for savings. One way this excess is accommodated is by unemployment, because the unemployed can no longer save and, furthermore, must borrow or absorb potential savings (directly or indirectly) just to survive.
Thus, as the unemployment rate goes up, actual savings go down and actual borrowing goes up, until the excess savings demand of the remaining savers is balanced by the borrowing of the unemployed. This is why we can have a stable economic equilibrium where, say, 10% of the population is unemployed while the other 90% carry on more or less as normal.
I agree these issues were discussed long ago and would add that the underlying comparative advantage stuff is so flawed as to be useless. I remember discussions in the 1970’s with the same ring – UK failing to get productive investment because of high home ownership type stuff.
What makes no sense is using unemployment (really not to do with jobs but rather making 10% of people skint) as an economic tool and pretending financialisation is anything but a control fraud. Frankly this is playing with the deck chairs – we need a radical new practice. Massive assumptions underlie this kind of economics and go largely unchallenged. I suspect they are immoral and racist. Why should I want or expect the UK (Germany or wherever)to be more successful than anywhere else? It’s hard to explain that without the kind of idiot xenophobia of Gordon Brown urging us to be proud of Britain (add your own nation’s clown here). We are the ones who can work harder and smarter? The chosen ones?
The analysis adds up, but we need something else to explain and change why we are still playing beggar thy neighbour and a sump population of your own. I think this is a denial of rationality and people’s ability to organise lives. Should add I am grateful for the analysis nontheless.
Also productive DOMESTIC investment is investment which does not require much external inputs (at least once the system is running)
There is a big difference between building a Dam which may provide domestic elec power for 100 years and a car which depreciates into rust within 15 years while also consuming external oil on a epic scale.
The euro system is clearly a failure of globalization where banking systems scaled up beyond national borders (causing huge economic & social externalties) creating another 1914 like event.
Netherlands, a Northern surplus country, had a housing bubble too, while Italy, a Southern deficit country, did not have a housing bubble.
Two examples that do not fit within the theory of Pettis.
I think the euro mess can be better explained as follows: there are two groups of euro countries that are in trouble, housing bubble countries (Netherlands, Ireland, Spain and others), and countries with too much government spending (Greece, Italy).
And the underlying theme for all eurozone countries was a huge debt cycle with overleveraged banks. This happened in non eurozone countries too. That’s why the current crisis can still be best described as a debt crisis, not a eurocrisis, balance of payments crisis or excess savings crisis. Without the excessive debt and risk taking, this crisis would not have happened. The countries that followed modest policies are the ones relatively in good shape. For example Germany.
The only reason they are in ‘good shape’ is because:
1) Financial system backstop by the ECB (ECB = Bundesbank = controlled by Germany; always.)
2) External demand financed by credit OR by other sovereigns fiat (what the EU is refusing to do btw).
There is no magic here, is basic maths, and if everybody did what Germany is trying to do the world would collapse.
Germany, sitting on 1.5 trillion euros in foreign investment that it has a snowball’s chance in hell of ever collecting on, is in “good shape”?
As Michael Hudson so wisely says: “Debts that can’t be repaid, won’t be repaid.”
Thanks for bringing this important piece into the light on this site.
As most of Michael Pettis long time readers on his blog , I find his new text thought-provoking.
What I dislike – to say the least – is how this kind of argument will be used by bankers, governments and more as a justification for some of their insane behaviours.
One can understand that households are not trained economists and financiers and may enter in over-40-years variable rates arrangements for massive amounts of hard money.
But I do not accept that educated bankers acting as brokers do make the “financial engineering” à la subprime on such a scale.
No more than for “Cedulas Hipotecarias” than for the subprime business on the other side of the Atlantic.
The macro-argumentation is certainly valid.
Should it be a “safe-conduct” for the most reckless intermediation that took place? No.
Sure some made some great money on this. Is that a justification? No.
Thank you Mr Pettis
Best economics article Ive ever read. Well argued and coherent/consistent with the facts on the ground. Need to read a couple more times to internalize it a little more but this really gets at the crux of what most economists are arguing about. The relationship of savings to investment is key. Getting the causality correct and differentiating between govt and households is equally important. There is way too much confusion out there.
Ive never taken an economics class in my life but I knew intuitively that using a household as the model for a govt was flawed. This article does the best job Ive ever seen of showing why.
Again, thank you
Pettis is describing events that we are all familiar with but in what I think is an unnecessarily complicated way. What Pettis alludes to as an “agreement among labor unions, businesses and the government to restrain wage growth in Germany” in the early 2000s is the notorious Hartz reforms. This amounted to an enormous transfer (or more accurately theft) of wealth from German workers to the benefit of Germany’s 1%. This is why German household savings declined (They had relatively less to save but also less to consume) and national savings (the loot the rich accrued from the Hartz reforms) increased. The German 1% used these savings to make dodgy loans and blow bubbles in Southern Europe.
The adoption of the euro also fueled this process. It made German goods relatively cheaper than if they had had to be paid for in marks, and made the corresponding Southern goods more expensive than they would have been with the lira or peseta. So German exports were advantaged and Southern exports were disadvantaged leading to large German trade account surpluses, that is savings. But as we saw above these surpluses did not go to German workers but to the German 1%. And they added these to what they were stealing from German workers to blow those Southern bubbles up even more and finance even more exports to the South.
The real masterstroke in all this is that when those bubbles went kerblooey, instead of the German 1% getting hit with the losses from their bad investments, they used the troika to pressure Southern governments into assuming their losses, something the corrupt Southern elites of all parties who ran these countries were more than willing to do. Why? Because these losses didn’t affect them and the resulting austerity could be used by the local 1%s to whom they were beholden to loot the commons, i.e.the countries’ infrastructure and patrimony.
I think you misunderstand, Hugh. You say this is too compkicated an explanation of what happened in Germany, but it seems to me that Pettis is not explaining what happened in Germany. He is explaining why what happened in Germany had to lead to what happened in peripheral Europe, and why you cannot solve the latter without changing the former. I see this article as being more about “Spain” than about Germany.
It’s a step by step process.
Step #1 was when the German oligarchs screwed the German workers.
Without Step #1, the German 1% would not have had the savings to make dodgy loans and blow bubbles in Southern Europe. Stopping Step #1 would have stopped the whole process in its tracks.
Pettis asserts early on that the only way to create wealth is via productive investment of “savings”. That thought is lost the moment it saw daylight. The fundamental problem globally has for decades been massive mal-investment in an orgy of ever-more short-sighted consumptive stupidity in “devloped countries” while multinationals exported significant portions of the means of production of that wealth. Far worse, the US, deliberately, forcefully extended (rather than “exported”) the American State’s financial/trade neoliberal regulatory framework it had drawn up specifically for the benefit of those huge corporations, including the global imperative to keep inflation in check via the steady demolition of workers bargaining positions.
That framework, which essentially constitutes “globalization”, generated a new and immediate race-to-the-bottom dynamic, one wherein non-US capitalist elites across the board threw their own peoples’ interests under the bus in order to capture larger gains through the “economies of scale” gained through large “trading blocs” and uber-concentration of corporate power. During the course of the creation of this globalized version of the US State’s vision of “capitalism” the fortunes of competitors have been subjected to wild swngs in response to the serial financial crises which attended neoliberal globalization.
For decades, the economists who matter, i.e., those at Treasury and the Fed, argued that the US must run very high deficits if their “project for globalization” was to work at all, as countries deemed “important” had to run surpluses in order to become strong enough to be useful as regional “managers”. And this, it was often argued (Summers, Rubin, Krugman, for instance) was not a serious problem so long as the US attracted mammoth flows of foreign investment due to both the size and perceived “safety” of US markets and/or Treasuries. Note this chart depicting US current account balances, which had been essentially “flat” from 1960 to 1980, dropped into deficit through the ’80’s, sniffed surplus territory in a sliver- window of peace between the end of the Iraq/Iran War and Gulf War I, and has since become so large both most mainstream private and Government actors sound the alarm on a regular basis.
Confronted with this neoliberal framework, countries that either lacked substantial raw materials, a large-enough, organized, industrial production base, a global financial presence or some combination were doomed from the outset. The strong now had a legal lock not only on “markets” but through “markets” on any policy options to become stronger: absent a lengthy, tough program that sacrificed current consumption or borrowed only for productive investment, the classic route taken by independent countries in the past, OR an Imperial decision to strengthen particular countries for “strategic” reasons (Germany, Japan, South Korea etc.) by imposing that forced-savings regime but with huge amounts of US money poured in to speed up the process, the only other choice is to exit the system.
This just to say that it was utter folly for weaker States to enter into any of these larger “blocs” absent specific, iron-clad committments by stronger players to disperse either the multinational production facilities and employment of the stronger members evenly throughout the “bloc” or fiscal arrangements that specifically recognized an ongoing requirement to re-balance gains and burdens on a continuing basis. And as we’ve seen, it was also folly for the majorities of peoples in developed countries as well – though in many instances, most people rejected this path at every opportunity, only to be undone by some political dysfunction or other – for instance, the original US/Canada Free Trade Agreement would not have taken place had all those opposed voted strategically, rather than throw away votes in blind partisan loyalty. In Mexico, of course, NAFTA was essentially imposed, creating a social disaster of monumental proportions.
But back to “excess savings” in the form of exports. Germany, because it alone acted in anticipation of accelerating global competition via the WTO and changes within the EU and actually developed a broadly consensual industrial policy (did German workers revolt? No.) is blamed for its export success, or as Pettis would have it, “its excess savings export success”, which I hasten to distinguish from Pettis’ other “excess savings exports” in the form of German bank loans – loans which are levered by absurd amounts, enormously inflating the perceived size of those presumed national savings “excess”. France gets a pass for not doing the first “excess” (serious productive investment) but engaging big time in the second. Italy gets a pass for similar policy. Even the UK gets a pass, though the City of London is the most thoroughly corrupt place on the planet, a post-Imperial parasite of global financial extraction without which the UK could not even pretend solvency. Nope, not their fault. Germany’s fault.
Now Germany, it must be noted, has virtually no resources, as is true of most of the Eurozone, the UK and significantly Japan. It is dwarfed in this respect by the US and even China, its gigantic appetite for foreign resources a symptom of its own huge malinvestment boom. Yet only Germany and Japan are, from the early “economic miracle” days ALWAYS wrong in the eyes of pundits, economists, analysts, etc., with Japan always branded as incapable of taking tough decisions, while Germany is to this day portrayed as if the merest scratch will reveal a Nazi underneath.
Meanwhile Obama, puppet-in-chief of the country that created neoliberal globalization, and more than any individual European country pushed for the form of integration of the EU we see today, 2 years ago set the goal of doubling US exports within 5 years. A quick look at any chart listing major country exports totals reveals the size of the impact that will have on foreign exporters competing in high-end markets who do not respond in kind moving forward.
While the US has recently been surpassed by China in manufactured exports, the US dominates every high-tech sector by huge margins. Japan, which must export or die, has in response to recent trade deficits largely caused by US gains globally has recently adopted what most analysts regard as “radical” measures to hang on. Germany, of course, competes in the same sectors as the US, Japan, South Korea, as well as increasingly sophisticated emerging markets. A doubling of US exports over 5 years will seriously impact US competitors.
Exports by country:
Current account by country:
So Pettis, precisely by focusing on accounting identities, various meanings of “savings” points accusatory fingers at two seemingly “winning” players leaving aside who pursued as top priority to this day a renewed global capitalism, and who, when that capitalism was failing then proceeded, from a position of unmatched economic and financial power, to destroy any obligations previously encumbent on wealthy corporations or individuals. And who, if you did not follow suit as a nation, would, at the first sign of trouble, subject said nation to an IMF screwing the likes of which it had not before experienced outside of war or colonization.
Japan had its head handed to it when it threatened to become a challenger. Germany has been saddled with a political-economic Pandora’s Box it cannot possibly fix without exiting, EU in tow, this form of globalization entirely, which I can’t see happening short of a global uprising. And as we well know, China, if it does not radically change direction, is on course for a throttling mere year down the road.
Only the American people have the means to take power back from the global wrecking crew its State has loosed on ALL the world’s majorities. To throw darts at Germany or China, or Japan demanding more “maturity” or “generosity” or “common sense” while Kong, sitting atop his Tower, beats its chest, thumps anything that disagrees, and can be happy only in the new jungle of its own creation, is a bit much.
For now, in Spain and Greece and Portugal and elsewhere, my heart bleeds for your pain. But surely you can only do what is within your power to do, which means first and foremost, re-taking power in your own countries from elites who’ve for so long sold you out, then setting an arduous course to compete within the EU or for independence, or a Southern European or Mediterranean Union of some sort, because within an EU itself entirely embedded in US global corporate capitalism, there just isn’t much of a future for countries that are small, or weak, or lack resources – just like in Alabama or on Canadian aboriginal “reserves” or the urban hells all over the world.
Countries are not households and planets are not countries. At the planet level there are no savings, no resources put aside, no consumption deferred. It is leveraged consumption, a huge drawdown in resources. It will be interesting when wealth,the shorthand abstraction, has to meet reality. It is difficult to think of a more hubristic term than “wealth creation.” Belongs on a grave marker.
Can you comment on the likelihood of this? http://www.telegraph.co.uk/finance/financialcrisis/10108010/German-court-case-could-force-euro-exit-warns-key-judge.html