Anyone reading news reports about the Chinese economy a year ago might have thought the country was on the verge of financial collapse. There seemed at the time plenty of evidence supporting those who expected an economic breakdown: debt was surging at unprecedented rates, regulators were in disarray following a stock market collapse the previous summer, and liquidity panics periodically swept through the banking system. In addition, so much capital was fleeing the country that even a huge current account surplus couldn’t prevent central bank reserves from eventually declining by nearly a quarter from their June 2014 peak.
But, as I have been arguing for years, China was not on the verge of a financial collapse and was never likely to collapse as long as regulators were credible and able to restructure liabilities in the banking system with relative ease. Financial crises are caused not by insolvency or economic downturns, but rather by highly inverted asset-liability mismatches severe enough to cause a breakdown when evaporating liquidity prevents the rolling over of liabilities. On paper, the Chinese financial system seems plagued by such mismatches, but liabilities in a closed banking system with all-powerful regulators are much more stable than they seem because the regulators have many ways to restructure liabilities through the banking system.
Move forward a year and sentiments have changed dramatically. Reserve levels have stabilized, and economic growth is on track to meet Beijing’s 2011 promise to double China’s GDP between 2010 and 2020. There is now a growing consensus that the worst of China’s adjustment is behind it, and that once Beijing gets debt under control—something banking regulators have clearly set their sights on—China can enjoy another decade or more of 5–6 percent growth. In Tuesday’s Wall Street Journal, I explained why I think the new consensus is as wrong as the old, and the article got enough responses and comments that I thought it might make sense to expand on it in a longer blog post.
The new optimism is perhaps epitomized by the release two months ago of a Morgan Stanley Bluepaper tellingly entitled “Why We Are Bullish on China.” The report makes the most cogent version of the bull case for China and predicts that average GDP growth rates over the next ten years will exceed 5 percent, turning China into a high-income country by 2027.
This would be a truly extraordinary feat if China were to pull it off, and unprecedented in history. Excluding a few very small economies whose experiences are not relevant for China—mainly trading entrepôts and oil sheikdoms—if China did reach high-income status, it would be the only poor economy besides South Korea and Taiwan to have done this in the twentieth and twenty-first centuries. And it is hard to believe that the development of these other two cases was not substantially enhanced by their pivotal roles in the Cold War.
What’s more, as any mathematician can explain, in any dynamic process in which different entities experience a widely distributed range of outcomes, the smaller, more homogenous entities are far more likely to be outliers than are the larger, extremely varied ones. What was already an extremely unlikely achievement for homogenous economies with 20–40 million people, like South Korea and Taiwan, is even less likely for an economy like China, with a population forty to fifty times larger, represented by a huge variety of economic circumstances.
Recent Data Confirms the New Optimism
To return to this new, guardedly optimistic narrative—guarded because all of the optimists, including Morgan Stanley, stress that their forecasts require that Beijing get debt under control—the high expectations seem to have been confirmed by, or at least are consistent with, recent economic data published in the past week. China’s exports were reported last week to have increased in March by 16.4 percent, well above the consensus forecast of 5 percent. Imports were up too, by a stronger-than-expected 20.3 percent. This left China with a healthy trade surplus of $23.9 billion in March, compared with February’s $9.2 billion deficit, and more than twice what analysts had been expecting. The surplus for the first quarter was $65.6 billion, or 2.5 percent of GDP.
With global trade tensions still high—and, as I have been saying for years, I expect that they will not get better any time soon—there are reasons to worry about China’s vulnerability on trade. But Chinese President Xi Jinping’s recent meeting with U.S. President Donald Trump seems to have gone relatively well, and trade no longer seems to be as great a source of worry among analysts as it was even a few weeks ago. This may be a little shortsighted. Exports in the first quarter were equal to 18.4 percent of GDP, which is a little higher than their 16 percent share last year, and while they are well below the peak ten years ago of 32 percent, this is a high enough share to indicate that China is still vulnerable to trade conflict.
There also remains the nagging problem of underreported exports and overreported imports as wealthy Chinese take money illegally out of the country, so China’s real trade surplus could be as high as 3.0–3.5 percent of GDP. As I have written elsewhere, a forced contraction of the surplus means that more credit expansion is needed for China to meet its GDP growth target, with every one percentage point of GDP contraction requiring roughly one third more debt.
I find it very useful, by the way, to evaluate the impact of changes in trade or other important economic variables by converting them into credit-expansion equivalents. The way its debt burden is resolved is key to the Chinese adjustment, and debt dynamics set most of the relevant parameters, including how much time Beijing has to implement the most important reforms.
Credit Expanded
This means, of course, that we cannot discuss China’s outlook without discussing changes in debt; last week, credit and monetary data were also released by the People’s Bank of China (PBoC). These indicators were more mixed. The good news is that regulators seem to have tightened their grip on China’s banks and were able to restrain loan growth in March to 1.02 trillion renminbi—below February’s 1.17 trillion renminbi increase, and well below expectations of 1.25 trillion.
The wider and more accurate measure of credit used by the PBoC is known as total social financing (TSF), but it is important to note that TSF is not a complete measure and excludes much of the bond issuance that came out of the recent provincial debt swaps. The news here was a lot gloomier, with TSF—according to the PBoC release—up by 2.1 trillion in March. This came in substantially higher than the consensus forecast of 1.5 trillion.
Finally, on Monday, the National Bureau of Statistics announced that China’s real first-quarter GDP rose by a more-then-expected 6.9 percent, above the 6.8 percent achieved in the previous quarter and last matched in the third quarter of 2015. This was comfortably above the 2017 GDP growth target of 6.5 percent. Nominal GDP growth was even more impressive, at 11.8 percent, which is the highest level since the first quarter of 2012.
The data seem broadly consistent with the new optimistic consensus, with Bloomberg describing the Chinese economy as having “stormed back in the first quarter, clocking its first back-to-back acceleration in seven years and bolstering the global growth outlook.” After five years of decline, GDP growth seems to have bottomed out, and while debt continues to grow too quickly, regulators have successfully targeted credit growth in certain especially worrying sectors. With the right policies and, more importantly, the necessary resolve, the newly optimistic consensus assumes that Beijing can get debt under control. If it does, when growth has bottomed out, it follows that China will finally put its difficult economic adjustment behind it.
The Economy as a System
Unfortunately, there is an assumption implicit in this story which, in my opinion, is completely untrue. The assumption is that the underlying drivers of economic activity, that is GDP, are somehow independent of the process of credit expansion, so that it is possible to talk about reining in credit growth and maintaining GDP growth as if these were two separate things.
The new consensus misreads the Chinese economy just as badly as the old consensus did last year, when many analysts expected a crisis; in both cases, the misreading is the result of treating individual pieces of data as separate and discrete instead of as interlocking parts of a system. What looked like extremely fragile balance sheets last year were a lot less fragile than they seemed when we consider the relatively closed nature of the Chinese financial system and the ability of the regulators to shift liabilities among the banks. Similarly, what might look like a bottoming out of growth this year and, separately, an increasingly successful attack on financial irresponsibility, is in fact a single system in which stable GDP growth requires accelerating credit expansion.
It is important to recognize, however, that until now—and contrary to what the new optimistic consensus assumes—Beijing has not been able to control credit growth. It may have done so in targeted sectors, but only by forcing greater credit growth elsewhere within the financial system. That is why even as the growth in direct bank lending has moderated, the growth in TSF has continued to accelerate at a pace wholly unaffected by regulatory attempts to contain credit expansion. Here is how Morgan Stanley explains the process in their Bluepaper:
“In our view, the most recent and arguably the most significant development on the policy front is that policy makers are now signaling a willingness to accept slower rates of growth, and place more focus on preventing financial risks and asset bubbles, indicating that they would not protect growth at all costs, often with the use of investment of a low return nature. This gives us greater confidence that policy makers will be able to slow the pace of rise in debt to GDP and will focus their efforts on setting a more stable environment which will allow China's vibrant private sector and formidably resourced SOE to continue the move towards high value added economic activities.”
China’s reported GDP growth does not represent fundamental growth in the country’s productive capacity, but rather growth in certain accepted measures of economic activity, productive or not. Morgan Stanley seems to agree with me that at least part of this growth is driven by increases in debt. Without this credit expansion, growth must automatically fall to the sustainable growth rate that can be organically generated from rising household income and needed investment. At that rate, GDP growth would correspond with growth in the economy’s debt-servicing capacity, and debt would grow no faster than GDP.
How Much Lower is China’s Sustainable Growth Rate?
Where Morgan Stanley and I differ is that I would argue that this sustainable growth today is at least 50 percent lower than the current growth levels, and that over the next ten to fifteen years China is unlikely to manage growth rates above 3 percent on average, and probably much lower. Morgan Stanley, however, proposes that China can manage to grow at an average annual rate above 5 percent for the next ten years, which suggests that they think this sustainable growth rate today is around 6 percent or a little less.
We seem to agree that any GDP growth above this sustainable rate requires an acceleration in credit growth. This is the only way to generate the additional demand needed to boost economic activity to a level, the GDP growth target, that is politically acceptable. So how much debt is needed to generate how much additional growth above the sustainable growth rate?
March’s 2.1 trillion renminbi increase in debt was part of a 7.0 trillion renminbi increase in debt in the first quarter of 2017, an amount equal to an astonishing 39 percent of the country’s first quarter GDP. Part of this increased lending was used simply to roll over bad debt that is not being recognized. But most of it went to fund a 13.6 percent increase in public sector investment, much of it unproductive (adding to the future amount of bad debt that must be rolled over). It was this debt that drove economic activity in the first quarter above China’s sustainable growth rate. This increase in debt—equal to 39 percent of GDP plus credit growth not included in the TSF measure (perhaps an additional 5–10 percentage points)—is what was effectively required to roll over bad debt and boost growth above its sustainable growth rate to the 6.9 percent reported in the first quarter.
I find it worrying enough that this enormous increase in debt was needed to add the 3–4 percentage points that I assume is the minimum gap between China’s sustainable growth rate and its actual growth rate. But it seems to me that Morgan Stanley—and anyone else who believes that China can manage a decade or more of 5 percent growth—is claiming something that might be even more surprising: this explosion in debt boosts growth by only one percentage point above the rate China can achieve anyway without relying on debt. This is a mind-boggling amount of debt required to achieve very little benefit, and the only way to make it intelligible is to assume that the amount of bad debt that is rolled over each period is significantly larger than we think—which helps resolve the problem but only by assuming an even more worrying condition.
There is only one other possible explanation consistent with Morgan Stanley’s numbers. They might assume that the vast bulk of credit creation over the past few years has occurred purely as speculative froth, has not generated any demand in the Chinese economy, and so can be eliminated overnight without impacting growth at all. This explanation is in my opinion inconsistent with the events of the past five years, which saw the acceleration in credit that Hyman Minsky told us would be needed to maintain a constant growth rate during the late stages of an investment-driven economy. It makes it hard to understand why Beijing has failed so miserably at containing debt during the past five years.
Logically, however, we must accept one or the other of these two explanations. Either credit expansion is necessary to boost growth above China’s sustainable growth rate, or it isn’t. If it is, just how much extra growth has it contributed? If it isn’t, why has it been so hard to prevent what has become among the fastest credit expansions in history?
That’s Why Slower is Better
Whatever the current sustainable growth rate, it is dangerous to assume that it is stable. In finance theory, it is widely understood how a rising debt burden can automatically force down the growth rate of the borrowing entity through a process referred to as financial distress. In spite of overwhelming historical evidence that supports the extension of these finance theory insights to economies, there has been no corresponding understanding among economists about how rising debt itself forces down long-term economic growth.1
I have discussed elsewhere how this process works and why the supporting evidence is overwhelming, but the point is that as China’s debt burden rises, the accumulated effects of financial distress caused by the debt automatically forces down China’s sustainable growth rate. This process—which Hyman Minsky also explained is always present in the late stages of an investment bubble—has locked China into a vicious circle. Rising debt automatically forces down China’s sustainable growth rate, and as it declines, the gap between China’s sustainable growth rate and its GDP growth target rises. This requires even greater credit expansion to meet the growth target, which, of course, forces the sustainable growth rate even lower.
Long-term prospects for the Chinese economy, in other words, will deteriorate as long as the Chinese economy is forced into relying on debt to grow faster than it can manage organically. For now, China’s GDP growth is largely driven by the political calendar. President Xi must consolidate economic decisionmaking in the run-up to this year’s Party Congress if he is to implement the difficult reforms that will break China out of its debt cycle, and higher growth early in the year will make this politically easier to do.
If he is successful in overcoming the vested-interest opposition that has for nearly a decade prevented necessary adjustments in the Chinese economy, GDP growth will probably begin to drop sharply, declining to barely above 6 percent by year end, and will continue to decline sharply over the rest of this decade. If he is not successful, he may be forced to maintain overly high GDP growth targets for as long as necessary, or as long as the country has the debt capacity.
High growth today does not imply that the growth deceleration of the past five years has bottomed out. It only means that for political reasons Beijing cannot yet abandon its GDP growth target, and so it is willing to let credit expand however quickly it must expand—but the more rapidly GDP growth declines, the better for China in the medium and long term. Whatever path China eventually takes, far from bottoming out, growth still has a long way down to go.
Notes
1 I should mention that in their book This Time is Different, Carmen Reinhart and Ken Rogoff have in fact introduced into academic economics the idea that excessive debt reduces growth, but they have done so in a much less sophisticated form that ignores many finance theory insights and seem to have convinced very few economists.
Comments(37)
"or as long as the country has the debt capacity." 1. And what is indeed the debt capacity? How do you quantify it and time it? 2. Considering the banking structure as mentioned in the article's opening, what would be the impact of reaching the debt capacity? Thanks.
"Debt capacity limits are reached, as I have long maintained, when debt cannot grow fast enough to cover its two main functions: First, it must grow at a geometric rate to roll over old bad debt as well as new bad investments whose principle and interest cannot be met by increases in productivity, and second, it must grow at a linear rate to invest into new projects that generate the targeted growth in economic activity." - Rebalancing, Wealth Transfers, And The Growth Of Chinese Debt (June 22, 2016) "once debt capacity is exhausted, which will occur when new loans cannot grow fast enough both to roll over existing bad loans (by which I mean loans that funded projects whose returns were insufficient to liquidate the loans) and to generate economic activity." - How Might a China Slowdown Affect the World? (December 02, 2014) "...runs into debt capacity limits (i.e. the growth in debt cannot exceed the growth in the amount of bad debt that must continually be rolled over)." - How Might a China Slowdown Affect the World? (December 02, 2014) M. Pettis talks about what reaching debt capacity limits looks like in various posts. Going off the top of my head, reaching debt capacity limits would result in a disorderly / uncontrolled rebalancing of the economy with investment and exports falling (sharply) resulting in unemployment surging. Self-reinforcing spiral. Potential for social and political chaos.
...and, my favourite: "How do we know when debt levels have become “excessive”? Debt levels are excessive when the uncertainty associated with the resolution of the debt is high enough to change the behavior of stakeholders. To put it in terms guaranteed to infuriate policymakers, a country has too much debt whenever the market believes it has too much debt. Anyone who does not understand why it is as simple as this does not understand the economic impact of debt." (When Do We Decide That Europe Must Restructure Much of Its Debt? Feb 25, 2015)
Emil K., Thank you very much for your detailed reply and the time it must have taken you to write that. I guess I was hoping for a more quantitive answer. That is, on which actual numbers from the statistics can you base the estimated time left till debt capacity is breached? Previously both Soros and Pettis mentioned 2 or 3 years if I'm not mistaken. If the actual period is 5 or 10 years then it is be fully expected from analysts to say that all is good. You mentioned the increase in productivity and its impact on debt capacity. What if productivity increase in such a fast rate, outpacing the increase in debt and services costs and this increase is not reflected in the GDP? Pettis also has an article about the shortcomings of GDP, especially keeping in mind various technologies. Well, the past year has seen significant growth of productivity enhancing technologies in China. Some are just spectacular, and it's only the beginning. If it continues with the same trend, should we expect the debt capacity deadline to be pushed into a future date?
Thanks, Emil. John, there is no way to quantify the amount of time a country has before it reaches debt capacity because this depends on far too many moving parts. In China's case, for example, the amount of time they have increases directly with the speed with which they allow growth to slow , whereas if problems in Europe get worse, if trade tensions force a contraction in China's trade surplus, or if credibility begins to evaporate, the amount of time they have will decrease. I am guessing that they probably don't have much more than a year or two before debt capacity is reached, in which case the only way for debt to continue growing is if the PBoC massively monetizes credit expansion, which effectively means that the cost of the debt is being forced onto household savers, and this will begin sharply to depress consumption growth.
First, I highly recommend Michael's post on capital stock. I think it tackles the heart of the problem and possible disagreements- http://carnegieendowment.org/chinafinancialmarkets/52078 Second, I have no doubt that Morgan Stanley knows it is being disingenuous. I won't speculate as to the reasons, but I don't believe anyone could be blind to the problems. Lastly, I'm interested in the amount of productive assets abroad Chinese companies can buy before the flow of capital slows. Acquisitions seem to be slowing with increased capital controls, but the big players still have a lot of money to throw around.
It would be nice if it would only be China. But it is not. The entire world economy seems to be "growing" into its maximum debt / income limit compatible with ultra low interest rates. We are past the point where a bail-out of over-indebted entities is remotely feasible. For that, we need "good money" order of magnitude bigger than "bad debt" so that allocated losses remain tolerable. But today, "good money"' is a fraction of "bad debt" the world over. Is a global debt crisis at 0% worldwide interest rates the quintessence of the proverbial Minsky moment?
Wikipedia defines Minsky Moment as, "A sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money." Sounds dire. But if you watch the most recent financial media interview of your preferred central banker you'll hear them say, "You can't give up hope just because it's hopeless. You gotta hope even more, and cover your ears and go 'Bla bla bla bla bla bla...'" Don't worry DvD, they have it under control. (On a serious note, I find it difficult to bring this subject up with people and sustain a conversation. Don't be so 'doom and gloom' they say. Gosh, well aren't you concerned, I say. Bla bla bla la la, they say.)
It depends on the country. Cullen Roche released a chart which had the US private sector net worth at ~600% of GDP. Total debt (including financial sector debt, which is really double counting) is ~300% of GDP. Even if you had a 50% drop in the private sector's assets, you'd still be flat. That doesn't even include all of the stuff regarding federal lands or assets on federal land that's currently not even leased out. What matters more than just interest rates is the maturity structure of the debt and when it comes due. If it's all short-term, then a significant spike in interest rates would cause debt-servicing costs to jump. If the debt is on a longer time frame, I find that unlikely.
The ratio of Total Debt to Total Net Worth is typically a very pro-cyclical, not very helpful ratio, for the simple reason that the more you lend against asset classes, the more they will rise in value. You never can see a real estate crisis coming by looking at LTV even as real estate buyers become over-extended because lending will in itself push up the asset value so that LTV might be fairly stable or even decline even as trouble approaches. As a matter of fact, Total Net Worth to GDP correlates highly with Total Debt to GDP. Why do you think Net Worth is 600% of GDP today when its long term range is ~ 390% of GDP? The last time, Net Worth was that high relative to GDP which is the flow of production and income ultimately backing asset values was in early 1929. That is the opposite of reassuring. Financial Sector Debt is partly double counting, partly double leverage. If Fannie Mae buys mortgage loans already accounted for in household debt to refinance them in the MBS market, that's double counting and should be omitted from total debt. But margin debt on listed equity or holding companies financing on credit equity participations in companies, or insurance companies leveraging their assets portfolio by issuing debt themselves, that's double leverage on the same underlying asset base and should be counted in total debt.
This isn't like 1929. It's closer to the late 19th century. Almost all business sector financing in the US is done with equity, not debt. The lead-up to 1929 (in the US) was excess capacity fueled by debt, the accumulation of foreign loans in the financial sector, huge trade surpluses entering a global depression as global trade collapsed, and then inequality. Today, only one of those factors exist. The US comparisons to 1929 need to stop. They're absurd and historically inaccurate.
You're talking about margin debt? Do you know how much margin debt actually is? It's a tiny portion. Total NYSE margin debt is ~$600 billion. The entire economy is $20 trillion and the market capitalization for all listed equity is ~$30-40 trillion. This correlation stuff is largely BS. You can find all kinds of correlations when you've got tons of data--and the vast majority of correlations are spurious. It's very easy to show mathematically that as data increases, the amount of noise increases faster than signal. The approaches used by people like Steve Keen are complete BS.
I'm not discussing the debt-equity mix of corporate financing nor whether the Smiths were then and are now borrowing fixed or floating rate on their mortgage. What I'm saying is that aggregate asset valuation relative to GDP is at similar level now than in early 1929. I'm also saying that, not coincidently, total debt relative to GDP is similar now than in 1929. In fact, it's higher now (~ 350% of GDP) than early 1929 (~ 200%) with non-financial private debt ~ 50pts lower, public debt ~ 100pts higher and financial-sector debt ~ 100pts higher. The comparison between now and 1929 can not be dismissed easily for the simple reason that, since 1916 (i don't have data before), this ~ 600% of GDP level of aggregate asset valuation has only been reached twice, in early 1929 and now. The previous contemporaneous relative asset value peaks of 2000 and 2007 were lower. There are simply no other periods to compare it too over the past century. Whether you like it or not, it is an intriguing comparison. The relationship between total net worth to GDP and total debt to GDP can not possibly be spurious for the very simple reason that total debt is an important component of total net worth: the household sector ultimately owns public sector debt and corporate debt as an asset and it also owns the residential real estate asset that is financed by mortgage debt which is the vast majority of household debt. Finally, financial sector debt and asset values are directly connected: insurance companies, holding companies or private equity funds use proceeds of debt financing to buy financial or physical assets. So total debt is a large component of total net worth. As for the remaining component of aggregate net worth not accounted by total debt, that is mainly unlevered business equity, its relative valuation is higher when interest rates are lower, ie. when total relative debt is allowed to be higher. The relationship between high total debt and high total net worth is profound: it is the two sides of the same aggregated balance sheet. Your rush to pseudo mathematical sophistication to claim spurious relationship between the two sides of the same balance sheet was really quite hilarious.
Yes, margin debt is $400bn when US marketcap is $25 Tr. That's not the point, though. The point is that this is an exemple among others (and easier than other to understand) to show that financial sector debt is not necessarily double counting and can also be double leverage on the same asset base, hence needs to be added to non-financial sector debt to get to a correct total debt number. Your affirmation that all financial sector debt is double counting is erroneous. Let's get the numbers from the latest Flow of Funds Account from the US: in 2016, GDP was $18.5Tr, Total Non-Financial Debt $47.3Tr (255% of GDP), Total Credit Outstanding $66.1 Tr (356% of GDP) including $15.7Tr of Financial Sector Debt. Of Financial Sector Debt, only GSEs debt of $8.5Tr can be considered double counting and should be removed. The rest of Financial Sector Debt ($7.2Tr) is double leverage on the same underlying asset base and should be added to total debt. That leaves $57.6Tr total debt (66.1 - 8.5), equivalent to 310% of GDP.
As I said, the private sector net worth (according to Oracam Group, which's pretty close to my estimates) is ~600% of GDP. That doesn't include public assets ranging from federal buildings to federal land. Is it a good idea to sell these assets? No, but the US isn't underwater or anything close to it. You could see a 60% fall in the asset side of the private sector and we'd still have a positive net worth if you excluded federal assets from the calculation.
Please refer to the Flow of Funds Accounts of the US to see how household net worth is calculated. The household sector as consolidating entity owns public sector assets.
Let's discuss 1929. The problem in 1929 was the accumulation of foreign loans in the banking system. Those foreign loans ended up in default, which led to a collapse in the banking system. The second part is that there was an overinvestment boom in commodities. When commodity prices, (largely agricultural) crashed, it hit the real economy very hard ("Dust Bowl"). When international trade collapsed, the trade sector of the country in the global system with the largest surplus in history got whacked. Combine that with a credit driven consumer boom and surging inequality, you got that kinda crash. The combination of all 5 of those factors led to a depression. Today, the US is the world's largest deficit country in the world. The US is the largest net importer of commodities in the world. The US is a net debtor in the world today. Also add in that the US is largely undercapacity. The situation is completely different and not at all the same. The US needs more investment and to buildup its trade sector, especially after the deindustrialization and shift to finance. That means more growth while cutting the debt burden.
You mention household net worth, but household debt is ~80% of GDP in a time when the country is about to shrink its current account deficits and expand government deficits. That necessarily means a rapid increase in either the household or corporate surplus. No real problems here. Also, we don't have a global financial system backed by gold. So comparing raw increases in debt isn't really fair cuz it's a different system.
In the 1920´s or now, irrespective of whether monetary base is mostly, partly or not at all made up of gold, GDP is always the flow of total production and income out of which Total Debt is serviced. So, comparing Total Debt to GDP across periods is always fair.
It is never fair because large current account deficits under a gold standard create reserve flows out of your banking system. That effectively acts as a cap on the amount of debt (and assets) created by the financial system. That's the entire point of having a hard backing IMO: to impose discipline and make sure the system can't create as much debt. When you remove that constraint, you shift the assumptions of the economic model. By definition, shifting assumptions shifts the entire structure of the model. Saying that you can treat two models as the same when they rest on two very different assumptions is faulty reasoning.
The fact that the credit multiplier can be larger or lower doesn't change the fact that total debt is being serviced by the flows of total income. Nor that all asset values are ultimately backed by the flows of production generated by this asset base. The large stock of gold in the US in the 1920's or the large capital inflows to finance the external deficit today are of a very similar nature and have the same effect of inflating the asset bubble. Monetary policy is also similar.
But rates are only zero for sovereign borrowers. Private sector borrowers pay real rates, credit card rates are obscene. This means debtors will go to the wall on the usual schedule.
Michael, could you make a few comments about the debt situation in the U.S. How sustainable is the rate of borrowing being done by US consumers/governments? Thank you.
I am no an economist or in the finical sector. What I don't understand is the Chinese government prints its own money and it owns lots of SOE which represent a good portion of its economy. If a country prints its own money, wouldn't that means the SOE has no debt service limit? My intuition tells me there is a grow capacity limit that would not be helped much by throwing money at it. But keep throwing money at it would produce inflation which means to me is a form of value destroying activity. I am not sure I buy the idea that the problem is debt servicing limit of the government. In order for a domestic population to accumulate financial wealth, this population must hold financial claims against domestic and or foreign governments. Government must be in debt for its citizen to have money, and government can always pay its debt by printing more money. The problem it seems to me is what Michael Pettis described as the problem with demand. Allocate more money to the general population to boost domestic consumption to offset flatulation in foreign demands. But wait for a minute, if the Chinese government prints money and it owns SOEs, why would it have problem allocating more money to the general public? I guess the reason is keep inflation low, so it means pry the money out of the hands of the vested interests and give it to the hands of the rest of its citizens. But couldn't it offer government bounds to suck the money out of the system and reallocate that money into social safety nets without prying the money out of the vested interests? Anyway, I am having a hard time pining the problem on debt service problem on limit in growth capacity for China.
Things become unsustainable when your fixed capital formation is growing as a faster percentage of nominal GDP than NGDP growth. You run into real resources constraints that display themselves on cash flows; and eventually, capacity collapses as you go through a debt deflation. There's no way of really avoiding such a collapse unless you adjust accordingly and bring down growth ahead of time.
I agree that debt capacity is the only limit for China's economy. However, it seems like the enormous debt creation has created a housing price monster that is hard to tame. I read that housing prices in China went up 10% year over year. All this money printing has to go somewhere. Housing prices going up may be good for the asset holder though and overlooked by most of the populace. On other hand, pork prices are still pretty low from what I hear. Even Vietnam pork producers are getting low prices. This sounds like the debt creation train can keep on going as long as those pork chops and rice plates are cheap.
I think this is answered in one of Michael's earlier posts ("Thin Air's Money Isn't Created our of Thin Air") : http://carnegieendowment.org/chinafinancialmarkets/61679 The entire article is really worth reading but the answer to your question is under the "Creating demand “out of thin air” section about half-way down and the following appendix (I'd summarize it, but I can't do the argument justice--basically, the accounting identities have to hold whether the State prints a lot of money, a little money, or no money at all)
Thanks for writing all these blog entries. I don't know much about these issues but feel a lot more informed after reading each one of these blogs that you write. Thanks again.
Agreed. It's invaluable. And free! Nuts.
Professor Pettis has made the same prediction for 13 years straight, and has never been right once. His statements like ""High growth today does not imply that the growth deceleration of the past five years has bottomed out" are silly at best and dishonest at worst. China’s GDP Growth PPP, in constant dollars, constant workforce: In 2006 growth was reported as 12.7% (considered at the time ‘dangerously overheated and unsustainable’), meaning that added $1.03 trillion and lifted GDP to $7.6 trillion. In 2015 growth was reported as 6.9% (considered at the time 'slow') and it grew $1.4 trillion to reach $19.5 trillion. In other words, it grew 30% faster in 2015 than in 2005. Calling the rate of acceleration ‘growth’ is useless and, in fact, misleading because it tells us absolutely nothing. Perhaps that is why our media universally do it.
PPP assumes the same consumption basket between countries. In the US, the average family has two cars. In China, half the population lives off <$5/day. PPP is useless as a tool to compare developed economies and developing economies. The implies assumptions of the model simply don't hold. What I said about PPP is something that's taught in any intermediate macroeconomics classroom.
I have noticed that you do not differentiate between government and private debt. To me, and many others, they are very different beasts, not to be compared at all (at least in the case of when it is issued in ones own currency). Also, is not the true limit of debt issuance inflation? Eg when one unit of debt produces an equal amount of inflation, you can say you have truly met "debt capacity"??
Inflation is a tax. It's an awful tax and a regressive one. Secondly, you're not distinguishing between cost-push inflation and demand-pull inflation. This idea that developing countries can always structure themselves to demand-pull inflation and create a bias is laughable. A developed economy means that the economy is high up in the value-added chain. So all inflation and currency volatility that shows up must necessarily be cost-push unless you take up policies to incentivize extraction. Developing economies don't have sophistication in their financial systems to run persistent deficits without downside ramifications, like very high FX volatility or currencies spiraling down.
*this idea that developed economies. (it initially said developing on the first instance, which's false)
I have noticed that you do not differentiate between government and private debt. To me, and many others, they are very different beasts, not to be compared at all (at least in the case of when it is issued in ones own currency). Also, is not the true limit of debt issuance inflation? Eg when one unit of debt produces an equal amount of inflation, you can say you have truly met "debt capacity"??
North Korea is or soon will be in a state similar to Europe after WW2. China most likely will come up with something similar to the Truman plan that was implemented in Europe. South Korea, Russia and to a lesser extent the US and others will also get a piece of the action. China could come out quite well on this and is the best positioned in my opinion.
All the numbers everywhere are incorrect. This was pointed out for me the first time in a SF short story from the 1950's where everyone fessed up to faking the numbers after the war-with-the-alien-species was won. The Leader of the Human Forces fessed up that he knew the numbers were faked and that he used a coin toss to decide when he wasn't sure. If one is told things are going great economically in a city but a rental trailer to leave a city is much more than to move into a city then that is a signal. If shipping cost is less than the cost of fuel to power a ship that is a signal. A great economic theory fed incorrect numbers is worthless. The signals imply that the world is awash in debt that will mostly be canceled. One could go borrow money and buy stock in Chinese companies that are going to grow in the next 18 years like they did in the last 18 years.
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