A Deficit Driven by Excess Consumption Must Eventually Reverse

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In The Media

A Deficit Driven by Excess Consumption Must Eventually Reverse

Trade deficits generated by credit-fueled consumption are unsustainable, and can be reversed by either shifts in the policies of surplus-producing countries abroad or by crippling austerity at home.

By Michael Pettis

Published on Dec 16, 2011

Source: Economist

A Deficit Driven by Excess Consumption Must EventuTrade deficits, or more concretely current account deficits, have to be financed by net capital inflows, and it is really the cause of the deficit and the nature of the financing that determines whether or not persistent trade deficits are harmful. If a country is running a trade deficit mainly because domestic investment levels are very high, the high investment levels should generate enough growth in the economy that the costs of servicing the foreign capital inflow can easily be covered. In that case many years of trade deficits are unlikely to be a problem.

If a country is running large and persistent trade deficits, however, because a surge in domestic credit has boosted consumption levels excessively and so reduced savings levels, then the resulting increase in debt is clearly unsustainable and will have eventually to be resolved by a reversal in the trade deficit. This is the problem countries like Spain are facing. What is often not recognised is that the credit-fueled consumer boom in Spain was actually caused as much by consumption-repressing policies in Germany as by domestic distortions, and so without a reversal in German polices (and surplus countries historically never accept their responsibility for having created trade distortions), the only way Spain can resolve the persistent trade deficits is via default, devaluation, or very high levels of unemployment for many years. This is a classic kind of "bad" persistent trade deficit.

About the Author

Michael Pettis

Nonresident Senior Fellow, Carnegie China

Michael Pettis is a nonresident senior fellow at the Carnegie Endowment for International Peace. An expert on China’s economy, Pettis is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.

Recent Work

Commentary
The Plaza Accord and Its Relevance for China
- Michael Pettis
Commentary
Who Paid for China’s Last Debt Cleanup, and Who Will Pay for the Next?
- Michael Pettis

Economy Trade Western Europe

Carnegie does not take institutional positions on public policy issues; the views represented herein are those of the author(s) and do not necessarily reflect the views of Carnegie, its staff, or its trustees.

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