Alphachat: Michael Pettis on current accounts and the Chinese economy

PART 1 Cardiff Garcia So here's where I want to start, and I'm taking a bit of a risk here that all of our listeners are going to flee, because we need to begin with accounting identities and why they matter so much to the framework that you talk about in The Great Rebalancing. So let's start here: When a country runs a current account surplus, at its most basic level, what exactly does that mean? Michael Pettis There are two ways of looking at it. One way is to look at it from the income side and a country's GDP is defined - this is in a closed system - is defined as a total consumption plus savings. From the other side, from the supply side, it's defined as consumption plus investments. So in a closed system savings is equal to investment. But of course the world is a closed system. But individual countries aren't, and so there are open systems within the global economy and if there's a mismatch between savings and investments, then they are either exporters or importers of capital. And because the balance of payments is an accounting identity, it must balance to zero, if there is a capital accounts surplus there must be a current account deficit. The basic rule is the current account surplus means that you have an excess of savings over investment; you save more than you invest. So you export the excess savings and you run a current account surplus. And of course if you run a deficit that means investment exceeds savings. Cardiff Garcia I want to actually get even more basic than that though. So to summarise what you've just said, a country's production minus its consumption equals its savings. I think that part is intuitive enough. If the businesses in a given country make, let's say, 100 basketballs and each basketball costs $1, but that country's own people only buy 80 basketballs and then sell the other 20 basketballs abroad, then that country has a savings of $20, right? I think that makes sense.

And a country's savings minus investment is the current account surplus. So let's say that same country's businesses had instead made 95 basketballs, again each one sold for $1, but these businesses also invested $5 in factory equipment or buildings or whatever to make basketballs for next year. So, its overall production was the same, $100, just as in the first example. And again its own citizens had bought only 80 basketballs. Well in this case the country's savings is again $20 because the country had overall production of $100 and its people only consumed or bought $80 worth of basketballs, but in this example, remember that its businesses invested $5, and so the $20 in savings minus the $5 invested leaves you with a current account surplus of $15, which, you will also notice, is also the difference between the value of the basketballs that were made in the country, which was $95, and the value of the basketballs it sold inside the country. So that's a very simple example stripped of a lot of complicating details obviously, but again the point is that if a country makes more than it consumes and invests, it has to do something with those extra goods and services that it makes, and typically what it does is it sells them abroad. In exchange for that it accepts money and it uses that money to buy either foreign financial assets, like government bonds, or in some cases real assets like foreign real estate or a foreign business or whatever. And again it does that because it has sold more than its own people have consumed or invested. Michael Pettis Exactly right. There is never a net inflow or net outflow of dollars into the US or of euros into Europe or renminbi into China; it always balances to exactly zero and that's what drives that process. Cardiff Garcia Okay, now that we have those mechanisms in place, let's make it a little bit more concrete, or make it concrete again. Let's take an example of an economy this time that primarily makes basketballs and shovels, so we can have an investment category, and it is running a current account surplus. How would that work? Michael Pettis If it's running a current account surplus that means, let's assume basketballs are 100% consumption and shovels are investment. If it's running a current account surplus, that means the total amount of shovels and basketballs that it uses, in the form of consumption or investment, is less than what it produces. So let's assume it produces $100 of both: $60 of basketballs and $40 worth of shovels. What would happen in that case is that Americans would consume $60 of basketballs but they might only invest $30 of shovels. So now they've got ten extra dollars of shovels they have to do something with, and that they either export, in an open economy, or they have to

stop producing shovels and they have to fire workers that make shovels. Those are the only options. In an open society. In a globalised economy, they'll export those shovels. Cardiff Garcia So they export those shovels and they are paid for those shovels in... Michael Pettis They are paid for those shovels in dollars, but they lent the dollars to the foreigners. So the money was exported, the excess American savings of $10 was exported to the foreigners who used those $10 to buy shovels. Cardiff Garcia Explain the mechanism by which they exported the $10. Michael Pettis What ends up happening is you export the shovel, your foreign client now has to pay you $10. Your foreign client isn't going to be able to pay you until he sells the shovels so he goes to his bank and his bank contacts your bank. His bank will then effectively have borrowed $10 from your bank with the agreement that when the shovels are sold, the importer will pay the equivalent of $10, let's say, in euros to his bank and his bank would then buy the dollars and repay the loan. So an American bank would have had to lend the European $10 in order to buy the shovels. Cardiff Garcia Got it. Okay, this is a mythical world in which America is running a current account surplus. We're unlikely to see that for some time. But the mechanism is what matters here. Here's what I want to follow that example with: types of trade interventions, and specifically ways that countries can manipulate their current accounts and in this case, since we're talking about current account surpluses, how they can drive up the balance to create a current account surplus. Now, there are obvious examples here that we don't have to get too much into, like tariffs and non-tariff barriers, import quotas or subsidies to specific sectors. There are some non-obvious ones that you also talk about. I want to start with currency manipulation because it sounds intuitively clear how that might work, but actually it works in ways that are not necessarily as obvious as people think. Tell us about that. Michael Pettis That's right. Most people think that if you artificially lower the value of your currency you run a trade surplus because your goods are now cheaper in the international markets and foreign goods are more expensive. That's not really how it works. The way it works is if you depreciate your currency, all households are net importers so you have reduced the real value of disposable income relative to GDP.

So the household share of GDP goes down and as the household share of GDP goes down, the consumption share typically goes down. And savings is simply GDP minus consumption. So if the consumption share goes down, the savings share goes up. And if there's been no change in investment then savings has risen relative to investment. So let's say you started with balanced trade and then you depreciated the currency. By doing so you forced up the savings rate and because savings now exceeds investment, you export your net savings and you run a current account or a trade surplus. Cardiff Garcia The reason I started with currency manipulation is also because we've often heard the argument from either economists or economic observers that even though China, for instance, has appreciated the value of the renminbi in the last decade or so, the trade balance hasn't changed as much as you might have thought and so a lot of people have concluded therefore that the exchange rate simply doesn't matter. What you've said is that's not right. It's just that it's not the only thing that matters. Michael Pettis Exactly. From July 2005 the currency, the renminbi has appreciated quite a lot but the trade surplus has grown instead of shrink, which is what a lot of people would have expected. This is the same thing that happened by the way in Japan after the Plaza Accords. Both the Japanese yen and the deutschmark went up. They were forced to appreciate. And the Japanese current account surplus grew; it didn't shrink. Germany's shrank. And the point there is it's not true that the currency doesn't matter. The currency matters a great deal but it's not the only thing that matters. So to go through the Chinese or the Japanese case, because they both did the same thing, the currency appreciated. That increased the real value of household income, of disposable household income because it lowered the cost of foreign imports. That caused the savings rate in China or in Japan to go down because consumption grew as a share of GDP, so by definition savings contracted. If that had been the end of the story then we would have seen a decline in both countries' current account surpluses, and that's in fact what happened in Germany. But both Japan and China did something else. They expanded credit at very low, in the case of China, at negative real interest rates. Why does that matter? Because when you have negative real interest rates you're basically transferring wealth from net savers, and the net savers in a country like China were depositors, householders putting most of their money in the bank and the bank does all the lending, net savers of the

household sector. So you transferred money from households to borrowers, which in China were producers of GDP. So that counter-affected the change in the value of the currency. It reduced the household share of GDP by more than the appreciation increased the household share of GDP. So the net result was that the savings rate actually went up, not down, in both countries, and so their current account surpluses went up, not down. Cardiff Garcia Right. Let me take the next two, financial repression, and this usually takes the shape of mandatory low interest rates for household savings, so for instance if you cap, if you put a maximum cap on the interest rate that you can get for your deposits at the bank, that would be financial repression, and then the other one is wage growth repression. You can take those in either order. Michael Pettis Well financial repression was what I discussed last time which is the transfer of wealth from households to producers of GDP. Slow wage growth has exactly the same impact. If wages grow more slowly than productivity or more slowly than GDP, that means households as workers are getting a smaller share of what they produce. So the household share of GDP once again is contracting, and as the household share of GDP contracts, the consumption share contracts and the savings share goes up. So if wages lag GDP growth there's a tendency to force up the savings rate and to run a trade surplus or a current account surplus. Now, a lot of people say that's intuitive because as you lower wages you make your goods cheaper in the international markets. And it's true; both of those statements are true. Cardiff Garcia And then I want to give you one final actually unintuitive one, until you start thinking about it but it's an example that I think very few people bring up, which is environmental degradation and specifically the idea that if a country has very weak environmental standards, it's similar to a subsidy to the companies that operate in that country relative to the companies that operate abroad. Michael Pettis Right. That's why it's so useful to think in these terms because when you think in terms of the savings/investment balance it becomes much clearer. Environmental degradation is also a transfer of wealth from households to businesses. Why? Because if you can dump your chemicals in the river that lowers your cost. However, it raises healthcare costs for the household sector so they have to save more for future health purposes. So it's a straight transfer and once again you get an increase in the savings rate driven by a reduction in the household share of GDP. Eminent domain works the same way. In China if you want to build an airport you just throw

everybody off the land. That's another transfer of wealth from households to producers of airports. Cardiff Garcia Right, and that transfer from one part of the economy to the other is the most fundamental part of what we're discussing here I think. There is something interesting included in the paper that you sent me recently which is that a lot of people frequently like to say that a country's current account, whether it runs a deficit or a surplus, is the result of that country's savings or investment decisions. But that's only true as a kind of tautology because actually savings and investment changes because of these other, what you might call, exogenous decisions or shocks, not because a country collectively decides to save more money. Michael Pettis Right. Again, one of the big problems in this discussion is that we tend to think of savings as something that households do and households are one of three groups that save. And we tend to think of changes of saving as reflecting changes in thriftiness or all that stuff, prudence etc. Cardiff Garcia The other two groups by the way in addition to households are the corporate sector and the government. Michael Pettis Yes, exactly. So if you look for example at Germany, Germany was running current account deficits in the 1990s, quite large. And then after the labour reforms of 2003-2004, they started running huge current account surpluses, the largest in the world. Many people said that was because German households, seeing an uncertain world, became thriftier, more prudent etc, but if you look at the numbers that's not the case. Their household savings rate was unchanged. What happened was that the labour reforms, which is usually a euphemism for reducing wages, caused, and you can see it clearly in the numbers, the household share of German GDP contracted. And because the household share contracted, consumption contracted and savings went up. Who was responsibility for the higher savings? German corporates, because their profitability went up as wages went down, so it was business savings that went up and business savings went up simply because wages went down. Cardiff Garcia Okay, so now that we understand the technical aspects of how a country's current account surplus actually operates, let's talk about some of the reasons why countries do this deliberately and when they do it deliberately and not as an accident or because it was responding to the way other countries function, right?

So traditionally there are three possibilities. I'll give the first two and then I'll let you explain the third one which is in fact what your dominant theory is. So the first possibility is mercantilism. Traditionally this just meant that a country wanted to have a lot of savings so that it had enough money to raise an army, to pay soldiers, to build equipment, in case it had to go to war. More recently mercantilism might be as a precautionary measure in order to potentially fight off a financial crisis that's caused by currency mismatches. So a country might want to have a lot of foreign currency in case its private sector starts to have serious problems because of a rapid depreciation in the domestic currency. That's one possibility. A second possibility is known as the infant industry argument which is when a country effectively wants to have a very strong manufacturing sector and so effectively what it does is it transfers resources, as you've just discussed, from the household sector to the manufacturing sector so that it can build the technological capacity to compete with other countries, and also because it tends to work well as a rapid employment mechanism. It lets you hire a lot of people really fast. That's the second argument, and I think there is quite a lot to that in some cases, but your argument is that actually the countries right now that have been running large current account surpluses, primarily Germany and China, are doing so because of the under-consumptionist theory, right, so tell us what that is please. Michael Pettis Under-consumption is something that we've known about for a while. It really began probably in the late 19th century and the British economist, John Hobson, and the American economist, less well-known, Charles Arthur Conant, explained it extremely well. The way Hobson explained it is because there was significant income inequality in England at the end of the 19th century, one of the impacts of income inequality is to reduce consumption. Why? Because if you transfer $100 from an ordinary household to a rich household, you get a net reduction in consumption because rich people consume a much smaller share of their income. If you've got everything and you get additional money, you're probably not going to buy much more. So what does that mean? That means that you can find yourself in a position where you are producing far more than local households can afford to consume and that's usually worsened, and we saw this clearly in Germany after 2003, that's worsened by a reduction in private sector investment because if households cannot consume

everything that you're producing, then you're not going to invest. You're going to reduce your investment. So you get a reduction in consumption and a reduction in investment. Now, what are the options there? There are two things you can do. If you were in a closed economy there would be only one thing and that is you would have to find some way of reducing the savings rate, and the typical way of doing that is firing workers. So you produce more than can be consumed; that's not sustainable. At some point you fire workers, and the savings rate goes down. So you have a new equilibrium but at a much lower GDP. In a globalised world you have an alternative and that is you can export the excess production, and that's typically what happens. That's what happened in Germany, that's what happened in China. In other words, because of problems with the distribution of income, partly a result of income inequality but also because of policies that have increased the government share in China or the business share in Germany, those have reduced the consumption share of GDP. In that case you're running current account surpluses because the alternative is to fire workers, which of course they don't want to do. Cardiff Garcia Now this is where I want to transition into talking about the impact of these deliberate policy decisions of current account surplus countries on their corresponding current account deficit countries and how it affects them. Michael Pettis Right, but before that let me just remind what I said because this is the key point; when you run large current account surpluses it's not because households have become prudent. It is almost always because of distortions in the distribution of income. Cardiff Garcia It's not a cultural thing in other words. It's not a morality play. Michael Pettis Exactly. Cardiff Garcia And to recap a bit of what you just said also, for the household sector it tends to pressure consumption down when a country runs a current account surplus. Obviously it puts upward pressure on the country's overall savings. On investment the pressures can be a little bit tricky but typically it raises the pressure for investment on the corporate sector because it's had resources transferred to it and because it has the ability to borrow a lot of money and therefore to invest a lot of money

which it then can make goods that it will sell abroad in particular, especially in the cases where the currency is depressed for instance. Michael Pettis That's right. Cardiff Garcia Now, let's talk about what happens to current account deficit countries when they have, let's say, a neutral policy stance and these other countries are deliberately running up their current account surpluses. I would imagine that the mechanism works in exactly the opposite way. Michael Pettis Yes. Let's talk about two states of the world; one state which characterises really the middle of the 19th century is when you have a big difference between desired investment and actual investment. And there the main player was the United States; it was a rapidly growing economy, it had huge investment needs and it had a very low savings rate. So because of its low savings rate, American investment was constrained by the low savings rate plus whatever capital it could import from England or any other capital exporting country in Europe, mostly England and the Netherlands. In that case the world had a trade imbalance that was positive for growth because excess British savings were exported to the US and because the investment needs of the US were much greater than the actual investment in the US, because of lack of domestic savings, that import of savings caused American investment to go up. So the US grew more quickly and the British grew more quickly. Great. But what happens when you are in a world in which there is no longer a significant excess of desired investment over actual investment? And that was basically the world of the end of the 19th century. For most of economic history we've operated under a regime of savings scarcity. For the first time there was not a problem of savings scarcity and the result is that if, and this is the case today, if, it's not England but if Germany exports savings to the US, remember that if Germany is running a current account surplus that means savings is greater than investment, and it is exporting that excess savings, which funds the German trade surplus or current account surplus, it goes to the US. Now, because the US has completely opened capital markets, if there are excess savings in Germany or anywhere else and you don't have a place to put them, you put them in the US. Now, there are many countries that need investment, developing

countries, but they have very low credibility so we don't put money there. So a lot of that ends up in the US. So the US runs automatically a capital accounts surplus, not because of anything that happens in the US but simply because there is excess savings in Germany and very open and liquid capital markets, so the money goes to the US. If the US runs a capital accounts surplus it must run a current account deficit. Now, that means that in the US investment must be greater than savings. So let's pretend that the US has balanced trade, investment is equal to savings, and then we shift to a period in which German money flows into the US and the US now runs a current account deficit and a capital accounts surplus. By definition that means American investment is higher than American savings. The way most economists think, and it made sense 150 years ago in a regime of savings scarcity, is that as foreign savings entered the US, American investment goes up because the implicit assumption is that America suffers from a savings scarcity. But as soon as you say that most economists know it's not true. American companies that want to invest have unlimited access to cheap savings. In fact American corporations are sitting on huge piles of cash which they refuse to invest. What does that mean? That means that desired investment in the US is equal to actual investment. What the private sector wants to do it can do in terms of investment. So when foreign money comes into the US, American investment does not go up. It didn't need that foreign money. It has unlimited access to cheap savings. So you still need that gap between investment and savings. So if investment doesn't go up, by definition savings went down. A lot of people are really shocked by that. We all know that the US has a low savings rate because Americans are spendthrift. Not true. If the investment rate doesn't go up, the savings rate must go down and there are several mechanisms that force it to go down. One way is it could strengthen the US dollar, and remember we discussed earlier that as the currency strengthens that reduced savings and it increase consumption because it increases the household share of GDP. But there are other things that could happen. One thing that could happen, which we're most worried about, is that because we are importing foreign goods that used to be produced in the US, you have to fire the American workers. Remember, firing workers reduces the savings rate because when you work you consume out of your income. When you're fired you still consume but your income is now zero, so you have a negative savings rate. What else could happen?

Well, when tons of money pour into your country, and this is very typical of peripheral Europe, the banks have to respond and the way they respond is by lowering credit standards.

Now, if you assume that in the US or in any country in the world you have households with a wide range of risk appetites, you have prudent households, you have imprudent households, you have optimists, you have pessimists, if you lower the lending standards it is iron law that you are going to see more borrowing from households that are more willing to take on debt. Whether they're optimists or just foolish, who knows? But that's what causes the savings rate to go down. By lowering credit standards you increase household borrowing which is negative savings. Other things could happen. As money comes into the country, and we see this over and over again, you typically get real estate booms and stock market booms. That's when you have the so-called wealth effect. As the stock market goes up, as real estate prices go up, households feel richer. And when you feel richer you tend to save less for your retirement, so you increase your consumption and you reduce your savings. These are all fairly mechanistic processes that occur when you run a capital account surplus and your investment doesn't go up. One way or the other savings must go down and it's usually in a bad way. Cardiff Garcia Although there is one other option which advanced economies chose not to pursue. In order to make up for that arithmetic gap, that necessary arithmetic gap between investment and savings, if private sector investment didn't go up and you don't want household savings to plummet, the government could raise its investment rate. And by the way, the signals were all there with long term interest rates being held down extremely low by something called the savings glut, which we can get into; the signals were all there that the government should have been investing in things that would have raised the productivity potential of the economy. It chose not to, maybe because it misread the signs or because there's a kind of stigma against running large fiscal deficits, but in any case it didn't do that, did not enough to raise interest rates back to having a healthy looking yield curve, and by choosing not to do that, the gap ended up being accounted for by plummeting savings. Michael Pettis Exactly right. You're absolutely right. Now, we've had an old debate in American history, we've had really two debates about this issue. One is should the government be involved in investing, and then the second debate is if the government is involved in investing, should it be the federal government or the state government?

These are really old debates in American history. My personal prejudice is that the government does have a role to play in investing in needed infrastructure but I want to keep this discussion politics free in that sense. Let's make no assumptions about whether it's right for the government to invest or not. The point is that if the government responds to a capital account surplus by increasing investment then you won't have the problem of a reduction in savings through unemployment or through debt. The question though is should the investment program of the US government be driven by the inability of foreigners to consume everything they produce; in other words should we invest because we're running capital account surpluses or should we invest because it makes sense? And in the US the decision about government spending is independent of the capital flows. We don't spend; we don't invest because money is coming in. Now, what I would argue here is if you believe that there ever is a time for the government, whether at the state level or the federal level, to invest in infrastructure, presumably you want to do it at a time when global demand is weak and when capital is being given away almost for free. Those are the conditions today. So there's a very strong argument, if you believe there is a role for government investment, there is a very strong argument for the government doing it now. Cardiff Garcia Matt Klein, welcome to the conversation my friend. Matt Klein Thanks. Cardiff Garcia You heard everything that Michael just said. I want to now turn the conversation to what's happening in Europe. You've written a lot about Germany, I think often embracing the same or a similar framework that Michael uses. Can you tell us what the mechanisms are by which German deliberate policies have affected what's happened in the peripheral countries of Europe? Matt Klein Sure. So to be clear, the deliberate policies weren't to deliberately create large current account deficits in the periphery but they were deliberately, I think, in their perspective, to make Germany what they would call competitive in global markets. As far as I can tell from reading about this and looking at the data and reading what German analysts have said, the two big things they're reacting to are, on the one hand how you deal with reunification after communist East Germany is brought into the federal republic in the early 1990s, and at the same time, very much related to this, how you deal with the integration of Central and Eastern Europe, the other communist

states, into what you could think of as a broader European supply chain while maintaining employment. And what they essentially decided to come up with is a system of we will help people get jobs but they won't necessarily pay very well and they won't necessarily involve a lot of raises, but there's this social compact of we'll boost employment. And so what you see is that basically the total number of hours worked in Germany has been more or less flat for the past 20-plus years but the number of people with a job has gone up by something like 15%. That's intimately tied with the labour market reforms that Michael was talking about but it's also part of, it goes back a little bit further I think to the mid-1990s as well where you have massive outsourcing of German auto parts and other manufacturing components to places like the Czech Republic and Slovakia and Hungary and Poland, and you move that supply chain out and essentially it improves the competitiveness of companies based in Germany but it also means obviously that people who are working in Germany have no leverage for getting pay rises, so they didn't. And at the same time you have a whole lot of workers coming into the German economy initially at essentially excessively high wages but who weren't necessarily as productive as the people who are already in West Germany, so you have a long period of adjustment there. And so you deal with those twin forces and you can understand those are big challenges they had to deal with. They imposed a solidarity tax to help deal with the cost of adjustment and transfers to East Germany that is still ongoing, they are still much poorer almost 30 years later, and that I think can lead to a lot of the phenomena that Michael is describing. It doesn't fully explain however a key point which is that the profitability of the German corporate sector has actually gone up tremendously in the past 15-20 years in a way that you haven't seen in other parts of Europe. There was a really interesting analysis done I believe by the Bruegel think tank a few months ago that was essentially saying that the real difference between places like Germany and Italy, in terms of competitiveness, had nothing to do with what we think of as labour costs but it was about the share of national income going to the corporate sector and to profits. Where in Italy essentially you had actually workers more or less were paid in line with productivity or maybe a little more than productivity. France, they were paid in line with productivity. In Germany they were paid way less than productivity, and that is the thing that they attributed as the source of these imbalances.

Cardiff Garcia Yes, what's interesting about this, Michael, is that it's a pretty stark example of your point that morality should not be brought into this, that this is not about Germans preferring to save more and Italians preferring, or Spaniards preferring, to save a lot less. These were decisions that were taken by the German government, in some cases for understandable reasons, but that over time their effects ended up accumulating both inside of Germany but, crucially from the standpoint of the last half decade, other countries in Europe as well. Michael Pettis Yes, in a way it's hard to know what else Germany might have done because Germany did have a problem after unification. The consensus is that they unified at an excessively high exchange rate which caused the labour costs of low productivity Eastern Germans to be too high. So they had to make an adjustment. Now, there are two ways you can become competitive in the international markets. The high road is to invest in productivity increases and the low road is to reduce wages or to reduce the value of your currency which is the same thing. Clearly Germany should have done the former but there's an argument to be made that in a globalised world it is very difficult to improve productivity because much of the benefits of the greater demand bleed abroad. It's very difficult to raise wages because the benefits bleed abroad. So what Germany did was effectively lower wages through the Hartz reforms. Now, everyone I think was surprised by how powerfully effective that was and I would argue the reason it was so effective was probably because of the creation of the euro, because normally what should have happened is that the deutschmark should have strengthened and the currencies of the rest of Europe should have weakened, partially to offset the reduction in German wages, but thanks to the euro that couldn't happen. Countries that entered the euro with higher inflation compared to Germany, which had no inflation, ended up seeing a real appreciation in their currency rather than a real depreciation which would have been the normal result. So the German wage policies had enormous traction. And there's one other thing that we should consider and that is what happened to all of that excess German savings? Why did, if the Spanish and the Italians weren't being spendthrift, why did they take it all and consume it? Well once again inflation differentials matter because this German savings was offered to German companies and German households at more or less the same interest rates as was offered in the rest of Europe as interest rates converged. But since peripheral

Europe entered the euro with much higher inflation and it continued, that meant that that capital had a negative real cost in peripheral Europe and a very high positive real cost in Germany. So not surprisingly the capital flew into the rest of Europe. Cardiff Garcia And Matt, this is where I want to transition to talking about the example of Spain, and there's a reason I'm choosing Spain instead of Greece. In the case of Greece everything tends to get a little bit confused in part because the government really did lie about what was going on there for many, many years, and because Greece has legitimate structural problems in addition to these imbalances that Michael's talking about. Spain, you can't say that about them, and as you've written, before the crisis Spain ran by all accounts what would be considered a, and I'm putting in air quotes, responsible macroeconomic policy. Give us the example of what happened in Spain and tell us essentially what has been happening since. Matt Klein Yes, I think Spain is a fantastic example because when we look at the debates that have happened since the crisis and people who talk about how the euro isn't really the issue because there are a lot of things that countries can do, even within the framework of a single currency, if you look at the policies they suggest, they're all things that Spain actually did at the time. They say oh, if you have too much private capital inflows from abroad, you need to have the government offset that with budget surpluses. Well the Spanish government did do that. They were running surpluses on the order of 3% of GDP on the eve of the crisis; their government debt to GDP I think fell by something like 40 percentage points during the boom years. They say oh, you need to offset it with tighter regulation; you have to have higher capital requirements for banks. Spain again innovated on that front. You could argue they could have done more but they had this idea of the counter-cyclical provisioning which is basically, nowadays people talk about macro-prudential capital requirements for banks where you essentially say banks should be relatively less indebted when asset prices are going up. Spain innovated on that front. They were doing that. Clearly it wasn't enough but then it leads to the question of if they were already doing those two key things that people were saying they should have been doing more so at the time than what any other country was doing, what are the kinds of things that would have been necessary to actually offset this? I don't know. Maybe, sometimes there are economists who do models and they say in theory you should have a 10% budget surplus or something. That's not something that you see as being realistic. The only countries that do that are generally oil exporters.

Since the crisis, [Spain] and other countries are very limited in terms of the size of the budget deficits they can run. Those limits are not symmetrical. So in theory they [could have run before the crisis] a bigger surplus if they want, which is a separate problem, but the fascinating thing is the government was doing, I think within the limits of what we would consider reasonable, what it could to offset it, but the flows of private capital were just enormous. And so what happened was they basically, in the 1990s the Spanish current account balance was something like negative 1% of GDP, so it was a slight deficit but it wasn't crazy. Spain was growing faster than other European countries. They probably did have legitimate investment needs so it's not particularly unreasonable. That grew as you get closer to the creation of the euro. Again, it's not necessarily unreasonable; the population was growing, you had millions of people coming in from Latin America for jobs, there was a housing boom, some of it was, construction was probably legitimate because again you had millions of people coming into the country. However, then it gets pretty wild as you get into the mid to late 2000s. On the eve of the crisis I think their current account balance was something in the order of negative 10% of GDP which is almost without precedent in terms of a developed economy that... the investments that they're doing, again you start getting these beautiful airports that are in the middle of nowhere. The FT has written some great stories about this, and they're being sold for I think €1 a now because no-one wants to run them. So that's clearly an excess of savings that were being available to invest in anything. You can argue that there were some levels of mismanagement in some local regional banks or whatever but it wasn't fundamentally a case of nefarious local governments and businesses abusing the rules. It was a function of the fact that there was just this inflow of capital and if you have that much money coming in, what are you supposed to do with it? Michael Pettis When you look at the flows from Germany to Spain there are two possible explanations. One explanation is that capital was pushed from Germany to Spain. Why? Because of excess savings driven by income inequality and the inability to use it domestically for consumption or investment. The other explanation, which is the preferred explanation in many places, including among many of my friends in Spain, is to blame an explosion in just the siesta mentality; everyone in Spain went out and had a

big party and because of this consumption boom they forced Germany to provide the capital to supply this big consumption boom. The difficulty with those arguments are two things; if Germany, or if money is being pushed from Germany into Spain, you would expect the way that would happen is through lower interest rates. And if it was being pulled, you would expect that through higher interest rates. Clearly interest rates went down. But there's also a timing problem because the big capital exports began roughly after the Hartz reforms and then we had a case in which Spain, Italy, Portugal, Greece, France and several other countries all simultaneously decided to go on a party. And it's possible; it's just very hard to believe that that's the way it happened. It would be an amazing coincidence. So to me it's much easier to think of money being pushed into these countries, and the amounts were huge, 20-30% of GDP in a short period of time. I cannot find a single case in history of a country that received anywhere near that level of inflows without, including Germany, without having stock market bubbles, consumption booms and crises. Cardiff Garcia Michael, this brings up another issue which is what can current account deficit countries do to defend themselves when some of their counterparts abroad start deliberately running current account surpluses? In the case of Europe this is complicated by the fact that they share a currency but let's say the example of the US, the UK which have their own currency and also run large deficits; what can they do the next time or actually even in the present moment with China and Germany still running very large surpluses? What do they do in order to have some kind of a healthy adjustment? Michael Pettis If you listen to the Trump administration, and in fact I think if you listen to a lot of traditional economists, the way you fix the US current account deficit problem is you look at the countries with whom the US is running large deficits, so that's China, Japan, Germany and Mexico, those are the big four, and you intervene directly in trade by changing relative prices, maybe through tariffs or whatever you like. That was an approach that made sense again 150 years ago when trade was done bilaterally and capital flows responded to trade. Most capital flows in those days, something like 90%, were simply trade finance. So in that case what happened is that you had a trade imbalance driven by price differentials and trading was mostly in finished goods, and the capital imbalance was simply the financing of the trade

imbalance. But that's clearly not the case today. Today, because of the collapse in transportation costs, most trade is in intermediate goods. So the US has a bilateral deficit with Mexico that could originate in Mexico but it's just as likely to originate somewhere else. The way to find out is to look at the overall Mexican balance. But more importantly, remember I said that if you run a capital account surplus, you must run a current account deficit. So the problem at the level of the US on the capital account, not on the current account, let's say that the US impose tariffs on everybody; would the US current account deficit decline? Well it depends on what happens to the capital account. And I would argue that if the US were to impose tariffs we would see more money coming into the US rather than less because the assumption would be that you would see an increase in American production and so therefore the profitability of American investment would go up. If more money comes into the US, if the US capital account surplus is bigger, then its current account deficit must be bigger. Now, I can't tell you, I can't predict exactly how that will occur. It could occur in many, many different ways. But I can predict with absolute certainty that it must occur. If the capital account surplus rises, the current account deficit must rise.

So if you really want to address the problem, if the problem is, if it originates on the capital side by the need of a world of excess savings to invest that money in some place that is safe, deep and liquid, then you have to intervene on the capital side. So I can't really give you specifics because it depends on a whole bunch of legal structures but they're not covered under WTO. But if the US were to intervene in the ability of foreigners to dump excess savings in the US, the US current account deficit would automatically decline. Matt Klein Just to follow up on this question, because I'm struck by the difference between your estimates of the impact of a broad tariff versus currency suppression because it sounds like... I mean obviously there are a lot of different effects that go in both directions but one impact I would think of higher tariffs across the board is that, as with the currency depreciation, it hits household real incomes and so from that perspective it would boost the savings rate in the same extent we've seen in China. Can you give a sense of how you see those things offsetting or, put another way, why the cheaper exchange rate in China doesn't lead to an increase in investment that offsets the increase in savings?

Michael Pettis Right. Let's say the US impose tariffs across the board, and you're absolutely right, if you impose tariffs across the board you raise the price of foreign goods, so you reduce the household income share of GDP because you reduce the real disposable income of American households. So if you do that shouldn't the savings rate go up? It depends. If investment goes up the savings rate will go up. Investment will probably go up. Let's assume that more foreign money comes into the US after it erects all of these tariffs. You're in the funny position where the tariffs itself forced up the savings rate but there are more inflows into the US which means the gap between investment and savings is greater than ever. There are two ways you can explain that. One is because the tariffs are going to cause Americans to buy more goods, American factories need to produce more so there will be more investment in American factories and that will probably occur.

It's hard to imagine it would occur to a significant extent if there was a significant increase in inflows, in which case some mechanism has to drive the savings rate down. Again, there are many mechanisms that can do so but the most obvious mechanism is a raise in the value of the dollar, an increase in the value of the dollar. So the benefits generated by the tariff, or rather the effect of the tariffs on household income is not simply the tariffs; it's the tariffs minus the strength in the dollar that's a result of increased inflows into the US.

There are so many moving parts it's hard to figure out exactly what would happen, but the point that I would make is that if capital inflows into the US increase, the US current account deficit must increase and it could increase for good reasons, it could increase for bad reasons. -------------------------------------------- Part 2 Cardiff Garcia Michael, here's what I thought we would do this 30 minutes: we're going to give you a break to start and I'm going to ask Matt to bring us up to speed on the Chinese economy, just to give us a little bit of a breakdown. So Matt, you recently wrote this post that essentially explained what was happening in the years up to the end of 2015, which was a time when there were a lot of really

gloomy predictions about what would happen to the Chinese economy in 2016. Those predictions have not yet panned out, but why don't you just give us a sense of what's been going on in the last five years or so? Matt Klein Sure. I'm going to start the clock basically right after the financial crisis. China, unlike many other countries, really goes gung-ho on the idea of reflationary stimulus. The way they choose to do that is by having the government-controlled big banks lend to state-owned enterprises that then go on a really big investment spending -- you can call it binge -- you can call it bonanza, whatever it is... Cardiff Garcia ... there's a lot of it. Matt Klein There was a lot of it, right. Some of that spending clearly led to excess capacity in things like steel and there were airports in places that didn’t need them, but there was also spending on things that maybe people will look down the line and say it was useful. Either way, there was a lot of it. And in that period from, say, 2008-2009-2010, you have a lot of people outside of China who react to that and think that is going to be a baseline for the foreseeable future, both in terms of the growth rate of Chinese GDP and in particular the growth of Chinese demand for raw materials, because in order to do all this spending you need a lot of coal, you need a lot of iron, and you need a lot of copper. That forecast turned out not to be right. So basically we get to 2011 or so and China's begun switching gears, for a variety of reasons, and you start seeing the prices of these industrial commodities turn down. They all peak sometime around the first half of 2011. And there's a very long and, for some places, a very painful adjustment as China begins to retrench. The growth rate of China's GDP, if you take the official numbers at face value, basically halves between then and the next few years. The prices of things like iron ore and coal and such, they fall by well over half. Cardiff Garcia Specifically because Chinese demand for these goods has started to fall quite precipitously.

Matt Klein Right. Another way of looking at it... Michael Pettis And China used to consume 63% which no country in history has done. Matt Klein They were by far the biggest consumer and I believe, if you look at, say, since 2000, I think all the extra consumption -- or more than all of it -- came from China. So the shifts in their behaviour really do drive these things. I have a friend who does commodities research at a hedge fund and he goes to China it seems like all the time to check on what’s going on, because that's what drives demand and prices. This Chinese slowdown spills over in a variety of ways. Places like South Africa, which export a lot of raw materials, Australia is another big one, they really feel these big shifts. One way of seeing it -- that is one of my personal favourites -- is the exchange rate between the New Zealand dollar and the Australian dollar. They both export a lot to China and they have very similar economic models, but New Zealand is based on milk and meat while Australia is dirt and rocks. You have this big shift starting around 2011-2012 where there's like a 25% move in the relative value of their exchange rates because of this shift in the Chinese government's priorities from building steel capacity to trying to, at the margin, improve the welfare of households and getting them to eat better. Then you get to a period where you can say maybe this went too far, or what have you, starting around 2013-2014. There were a lot of things going on in this period in terms of the consolidation of political power under Xi Jinping and going after perceived threats in terms of corruption and so forth. That led to a lot of capital outflows from the Chinese private sector, which hadn't really been as much of a phenomenon up to that point. Cardiff Garcia Nervousness that their money would be confiscated, is that what you're talking about? Matt Klein That could be, I mean that's certainly I think one contributing factor. Some people say it's more a function of China liberalising. They wanted to give more

opportunities for investment to their citizens because up until then you basically only had the domestic property market or bank accounts. The mix between those two things is difficult to determine, but there clearly is a situation in China where people are relatively under-invested in foreign assets. Some of those capital outflows you could therefore say are legitimate versus the fearful outflows, but I think there's clearly a mix of both. Whatever the reason, there were suddenly huge outflows and the government's initial response was to tighten domestic monetary policy to offset that. That didn't fully work and so the next response was: “what if we let the currency drop?” when it hadn't really done that before. Cardiff Garcia Just to clarify, when you say tighten monetary policy, you mean raise interest rates to make China more attractive for the money already there so then not as much of it would flow out? Matt Klein Right. That's correct. And it comes to a head in August 2015 when they have the currency drop. It wasn't even by that much, I think it was like 2%, but relative to the perception of it being something that was very tightly managed and completely under the central government's control, it spooked a lot of people. So then you start getting into a conversation of “oh, we're going to have a global recession.” By the time you get to the end of 2015 people were really worried about the shift in Chinese behaviour, in terms of what it had done to commodity prices and what that in turn had done to credit conditions. Those forces flowed through to the rest of the world because a lot of emerging market countries had depended upon Chinese demand for commodities to boost their own economies, and you also had things like what was going on with oil in terms of US credit conditions. There were a whole lot of things happening all at once. When you get to the beginning of 2016 there are a lot of people who are saying we might actually have some global recession risk. And when I say “recession” I don't necessarily mean literally that GDP is going to be falling, but there's a reasonable definition there for it which is you have the global economy growing at least 2 percentage points slower than what its normal trend would be. I think that certainly could have been something that was in the cards. At least that’s what the market was

pricing based on commodity prices and credit spreads and what was going on with stock markets. That didn't happen and so a lot of people now are saying “oh, clearly this was just overdone, markets were silly”. But I think what makes more sense is to realize there was actually a big shift in Chinese policymaking in 2016. Essentially, after a year or so of trying to restrain growth and what they call total social financing, or credit growth, they decided to completely reverse course. You can see an incredibly rapid increase in credit growth and that led to higher prices for commodities which flowed through to lower credit spreads, which led to a pick-up in Chinese demand. That also helped, along with other things that they did, to curtail the net capital outflows, which supported the currency. Now you're in a situation where people have weirdly forgotten about what was going on a year and a half ago. The post that I wrote that you mentioned at the beginning was based on a research note that I saw that I think illustrated this beautifully. They had made a chart of Chinese inventory accumulation in renminbi terms. It started in 2011 and basically was at a very, very high level, I think there was something like a trillion renminbi of inventory accumulation on an annual basis that was slowly churning downward until you get to 2013-2014. It sharply falls when you get to 2015-2016 and at the point that you actually have net inventory liquidation. By 2016 it's something like they were selling 200 billion renminbi a year worth of inventories. There was a cumulative 1.2 trillion shift over those few years. And then what was really remarkable was that by the time you get to, I think May 2017 and the latest data they had, China was back to accumulating a trillion renminbi worth of inventory. So you have a swing of something like 1.2 trillion renminbi in the course of a year, back to where it was in 2011. There are a lot of ways to represent this policy shift; I think that chart very clearly illustrates what changed and I think it explains a lot of what we saw with commodity prices and so forth. The open-ended question is: can they keep doing this? Presumably all you have to do is lower that rate of inventory accumulation and that impulse that was helping commodities earlier in the year, last year, goes away.

So there's an open question of whether they can sustain this. Do they even want to sustain this? Michael has certainly written a lot about the Chinese government's investment policies and how it's been too much and unproductive, so I think that leaves some interesting questions for the future. But that's the basic narrative that I would give of the past five, six years. Cardiff Garcia Michael, by the contours of the conversation that we had in part one, when China was ramping up its current account surplus, it effectively amounted to a big transfer of resources from the household sector to the corporate sector which also, by the way, has a lot of overlap with the state sector obviously, right? Michael Pettis Mostly through the interest rate. Cardiff Garcia Mostly through the interest rate mechanism, and because of that you're in a situation where these companies could produce things at a loss because they were being subsidised. And they could basically do it forever -- not forever but for as long as these mechanisms were in place. And the extension of that, as you've written, is that what matters for China now, as it has tried to rebalance and shift resources back to the household sector, is not overall GDP growth but rather household income as a share of GDP growth. And by the narrative that Matt just gave us, it sounds like they were trying to rebalance for a few years, and then last year or early last year, at the end of 2015, they changed their minds and went back to doing things the way they were doing them before. Michael Pettis Before I answer that, can I talk a little bit about what happened with the contraction in China's current account surplus? The savings/investment framework, which you can use or not use depending on whether it's useful, the savings/investment framework makes it very easy to understand that. Before the crisis China was running a current account surplus of something like 10% of GDP, something absurd. Because of the crisis that contracted to 3%, not because of anything that happened in China but because of the crisis abroad. Foreigners could

simply no longer purchase the same amount of Chinese goods. Now, if the current account surplus contracts from 10% to 3%, by definition the excess of investment over savings also contracted from 10% of GDP to 3% of GDP. Now how does that contraction occur? There are two ways it can occur with some combination. One is with an increase in investment and the other is with the reduction in savings, by definition. The right way, the best way would have been a reduction in savings. But in fact savings actually went up. How do you reduce savings? There are two ways. One way you reduce savings is massive transfers of wealth very quickly from the state sector to the household sector so that the households are much richer. And then you hope they immediately begin spending that greater wealth. Now, that's politically impossible to do quickly. It's difficult to do in the best of cases but to do it quickly is impossible. So there's the other way savings can go down and that's very simple: fire all the workers. That brings the savings rate down. Beijing couldn't do the first quickly enough and clearly it didn't want to do the second, so it had to increase investment. It had no choice. If it did not increase investment unemployment would have surged. And that explains the Chinese reaction to the 2008-2010 crisis. There was a very simple tradeoff between higher unemployment and higher investment. So even though they knew they didn't need to increase investment, they did it anyway to save jobs. Cardiff Garcia Okay. This is where I want to start talking about whether or not the path ahead for China resembles the path for Japan post 1990 more or less. This is a parallel that I think you've written about in the past as well, but because of all of these astonishing events that have happened in China in the last two years especially, it's a narrative that I think is now gaining increasing attention. So tell us what the similarities might be and maybe even a few of the differences that could actually alter the path for China. Michael Pettis The similarities are pretty substantial. The differences are either irrelevant or they make things look worse for China. For example, a lot of people will tell

you Japan is much richer than China, but that has nothing to do with how the economy rebalances. The Japanese imbalances were pretty bad and the increase in debt was quite rapid. But the imbalances in China are much worse, perhaps the worst we've ever seen, and the increase in debt is the most rapid we've seen. So the differences are not good ones. But let me step back and be as logical as possible here. You have these unbalanced economies -- including the US in the 1920s -- many of the same imbalances, and they have to rebalance. Rebalancing by definition means the household share of income must go up. Now, in principle there are three ways you can do it. One way is what China said it was going to do, which no country in history has done and it's, I think, impossible to do. That is to keep GDP growing at the same rate while having a surge in household income. So for many years GDP was growing at ten and household income was growing at seven; somehow we were going to keep GDP growth at ten or maybe nine and household income would grow at 12 or 13. Now, no country has ever done that in history and it's not clear what the mechanism is that does that. I think we can reject that. There are two other ways of rebalancing. The way the US rebalanced in the 1930s was that, from 1930 to 1933, American GDP fell by something like 35% and household income was down roughly half that. So the US rebalanced. It was very painful, very brutal, and very quick, but it rebalanced. The other way we've seen rebalancing take place is the Japanese way: from 1990 until the next 20-25 years GDP grew at 0.5% while household income grew at roughly 1.5%. So Japan rebalanced. Cardiff Garcia Household income growth still outpaced GDP growth, in other words. Michael Pettis Yes. Household consumption in Japan went from 52% of GDP to 57. It wasn't a major rebalancing; it was a partial rebalancing. But basically those are the two ways history gives us and my guess is that in China we're either going to see a crisis, which I think is very unlikely, I've always thought that was unlikely...

Cardiff Garcia Unlikely? Michael Pettis Unlikely. I'll explain why but banking crises are not caused by insolvencies. So we will either get a crisis -- it's a rising possibility but I still think it's very unlikely -- or we'll get a Japanese-style rebalancing which, in the absolute best case in China that I can think of, would be maybe 3% GDP growth and 4.5% household income growth, which would be pretty good. The problem is a political problem. After 30 years in which households did well but their income grew more slowly than GDP, someone else did really well. We now must move to a system where GDP growth slows significantly and household income growth doesn't. So their share grows and somebody's share must contract. We know who that somebody is: it's the elite and the local and provincial governments, which is why it's politically so difficult. Logically those are the three ways you rebalance. One way has never been done, so we are probably looking at the other two ways. Cardiff Garcia In a second, Michael, I'm going to ask you about why you think that a financial crisis is unlikely despite everything that you said. But first, Matt, you like writing about Japan and I think what Michael just said is an underappreciated story when people talk about what's happened in Japan for the last two and a half decades. Usually it's one of a couple of lost decades, usually it's one of flat real growth, but from what Michael's saying, this rebalancing was necessary and actually for domestic Japanese households it hasn't been as bad as the numbers might indicate. Matt Klein That's right. One of the mistakes that a lot of people make when they talk about Japan is they compare it to a baseline that was based on the bubble in the 1980s. Another is they forget to divide by the population. There has been much slower population growth in Japan than in the West, which makes for bad comparisons. Or they look at total GDP as opposed to what I think is a more relevant measure of living standards, which is household consumption.

So if you actually look at household consumption per person adjusted for changes in prices in Japan against all the major western countries, what you see is they've actually done reasonably well since 1990. They haven't done the absolute best, but they're in the top third of countries. Only the US, the UK and Sweden have consistently, since 1990, outperformed Japan on a per capita basis over that long period. I don't know enough about Sweden, quite frankly, but in the case of the US and the UK, it's not clear how sustainable those consumption patterns are going forward, especially given what we've already seen in terms of the post-crisis change in consumption behaviour. In Japan by contrast consumption growth has been remarkably stable. Part of that, admittedly, has come from a big drop in the Japanese household savings rate from like 12% to essentially 0%, so how sustainable is that? But I think the common narrative of lost decades, if you look at it compared to the US and Europe, it's really unfair I think. Cardiff Garcia Michael, you wrote recently in the Wall Street Journal that a few years ago everybody thought that China was going to have a financial crisis. You said that wasn't the case. You recently wrote that now everybody is saying that China might even be able to manage 6% or 7% GDP growth into the future for the next ten, 15 years and you said that's wrong also. Let's take the first bit: why is it that China will be able to avoid a financial crisis despite this necessary and very difficult rebalancing for its corporate sector? Michael Pettis A financial crisis or debt crisis or banking crisis is effectively a kind of bank run. You don't get bank runs because the banks are insolvent. When I started my career I worked for one of the nine of the top ten American banks that were insolvent -- in other words every one of the top ten American banks except JP Morgan was insolvent. But you didn't get bank runs and you didn't have a crisis because there was a credible guarantee of deposits by the central government. And that's really the key. Crises are caused by what economists refer to as sudden stops. That is when you have a significant mismatch between assets and liabilities and some event prevents you from

rolling over the liabilities. That's when you have a crisis. Now, if you look at the Chinese balance sheets, they look terrible, particularly the small banks. Not only do they have really awful assets but their funding base is terrible. It's all purchased money, very little retail deposits. So you would think with these kinds of balance sheets, China should have a crisis. But as long as the banking system is closed and most of the money remains within the banking system and the regulators are credible, then that mismatch disappears because the liabilities can easily be restructured by the regulators. They can force banks to lend among themselves if there's a run on any one bank. So to me, as long as the regulators are credible, you're not going to get a sudden stop. Credibility is still quite high -- they've taken some steps to undermine it but it's still quite high -- and without that I don't see how you can have a run on the banks. It's something worth keeping an eye on but it's unlikely. Cardiff Garcia Yes, our colleagues at the FT recently produced this statistic which is that two-thirds of Chinese corporate debt is owed by state-owned enterprises to state-owned banks. Michael Pettis Right. Matt Klein Just following up on that, you made a point recently in one of your notes to clients which I found very interesting, which is that it's possible that a deliberate tightening of domestic Chinese monetary conditions by the People's Bank of China could effectively shift money from these smaller fragile banks to the larger state-owned banks that Cardiff was talking about and actually, whatever the economic merits, actually serve a political function of centralising the control of credit allocation. Can you elaborate more on that? Michael Pettis This is a very political economy point of view. In the 1980s there seemed to develop a consensus among the leadership, among Deng Xiaoping and the people around him, that the tremendous centralisation of the economic policymaking process under Mao had been a big mistake for a country like China, a huge country with an enormous amount of variety.

So there was a very explicit plan to decentralise the decision making, particularly economic decision making. Maybe it's because of my many years on Wall Street but to me the key point there is decentralising the credit allocation process. Remember that until the reforms began there was only one bank in China, The People's Bank, and that was run out of Beijing. During the reforms in the 1980s, the big four and several other banks were created. They were mostly controlled by Beijing. Even as late as the late 1990s, something like 90% of all lending occurred through the big four banks. But there was a real goal in decentralising that process and we saw the emergence of a huge number of local banks. In fact China today has way too many banks, to the point now where I think the big four account for only 40% of total lending. A portion of the rest is by Beijing-controlled banks but much of that is by local banks. So we saw this process where the credit allocation process was decentralised significantly. To me that's the heart of the decentralisation of the whole economic policymaking process. But that's changed because the reforms that President Xi must implement. I think there's a consensus on this now, they know what the reforms are, and they involve a transfer of wealth from local governments -- from governments, but because of political centralisation it will be local governments -- to the household sector. That's the only way to increase consumption and reduce savings. So can they do this? Historically the types of reforms that Beijing has to implement are so difficult that very few countries have been able to do it successfully without a political crisis. There are exceptions, and the exceptions tend to be democracies. The classic case could be the United States in the 1930s where we saw a real decentralisation of wealth. It also happens in highly centralised autocracies, and the classic case could be China itself in the 1980s. We forget how ferociously opposed the Communist Party elite were to many of Deng Xiaoping's policies, but power was very centralised then so he was able to implement them -- with difficulty, but he implemented them. So if you're going to advise the President on the implementation of these reforms you'll probably say, based on the historical precedents, either you must become a democracy within three years or you must re-centralise power. I think it's pretty clear what the

possible route is, and they've been doing that since 2011-2012. The main purpose of the anti-corruption campaign is widely perceived to be Now, again wearing my banker's hat, that means among other things you want to re-centralise the credit allocation process. So what I'm expecting to see, what I have been speaking to my students about for a couple of years, is that one of the indications that the President is being successful in his attempts to implement the necessary reforms is we should start to see a change in the credit allocation away from the local governments back towards Beijing. There are many ways this can happen. For example we all know there are too many banks in China so there are going to be a lot of mergers. The big question is, do you have all of these local banks merged into the big Beijing banks, so you create these huge zombies but run by Beijing, or do they merge among themselves and create alternatives to the Beijing banks? If my model is right it's going to be the former. That's what the President will have to do. And what I suggested is that this is related to the fact that interbank interest rates have been extremely high recently. You know how the interbank lending works in China: it's basically the big four lend to the local provincial and local banks because of their huge retail branch system. So what happens if you raise the interbank rate? Well if you raise the interest rates it's a transfer of wealth from net borrowers to net lenders. Who are the net borrowers? They're the small local provincial banks. Who are the net lenders? They're the big Beijing banks. So I don't know if this was their plan but to me it's very consistent with this whole process of the re-centralisation of power. Basically high interbank rates weaken the local banks tremendously at the expense of the big Beijing banks and that's what I would want to see if Xi Jinping is going to be successful. Cardiff Garcia That's fascinating. There is something I want to focus on here which is a simple, but I think radical, point from the standpoint of the way that monetary policy is traditionally understood. Usually the mechanisms seem simple enough. If interest rates go down, then people, including households, are incentivised to borrow

money to then either spend or invest in buying a house through low mortgage rates etc, etc. In China it works a little bit differently, in part because households tend to only have access to their domestic deposits. And so what ends up happening is if you keep interest rates low, but they have to save for something in the future because they don't have access to other kinds of sophisticated financial products, it means that their savings go up despite interest rates going down. In a country like the US where people have access to, for instance, buying a house and they have access to a pension and they have access to stocks, things like that, when interest rates go down, they're incentivised to spend more money because the value of their assets has gone up while their cost of funds has dropped. It's exactly the reverse of China. In both cases lower interest rates will incentivise the corporate sector to borrow and save more money, but in the US I guess you might say that the impact of lower rates is democratised whereas in China it works in reverse for those two sections, which means that if you raise interest rates households will feel like it will be easier for them to save for their future spending needs and that means that effectively consumption will go up instead. This to me is an intriguing insight. Michael Pettis Yes. It's surprising that it's so controversial because the IMF did a study and found exactly that: as the real deposit rate goes down, consumption goes down, not up. I won't get into a big discussion of why but in the US if you lower interest rates, you lower the cost of consumer credit, so households consume more, it's cheaper... Cardiff Garcia Yes, you could mention credit cards in there too. Michael Pettis Exactly right. And there's very little consumer credit in China so you don't have that effect. And then there's also the wealth effect. When American interest rates go down, typically real estate prices go up, Americans feel richer and they spend more, and the stock market goes up, Americans feel richer and they spend more. In

China the real estate market works very, very differently and it's not liquid so there isn't a wealth effect to the same extent and the stock market is just too small. When interest rates go down in China, the typical Chinese household feels poorer so he saves more or he consumes less, which is the same thing. So it works backwards there, and that creates a lot of confusion, I think. Cardiff Garcia Yes, I agree. Matt? Matt Klein Speaking of the political economy and financial regulation, another issue that you've been discussing that is on people's minds is that the long-time head of The People's Bank of China is finally going to be retiring. I believe he was supposed to retire a few years ago and he was kept on for a few years and now he's really going to be leaving. There is some interesting discussion about who his successor might be and what that might mean for policy. I know you've spent a lot of time thinking about this. What are your general thoughts here? Michael Pettis Well everything is still in the rumour stage. We don't know but if I had to bet I would bet pretty heavily that it's an unexpected name, the Party Secretary of Hubei province, who is a very interesting candidate if it's true, because he spent most of his career in banking but what's interesting is that he really cut his teeth on bad debt resolution. He was very heavily involved in the GITIC [Guangdong International Trust and Investment Corporation] crisis. Remember, that's when Wang Qishan [current member of Politburo Standing Committee and head of anticorruption campaign] was the Party Secretary of Guangdong province. They worked very closely together then, and he was very involved in cleaning up a bank which he was chairman. That was the first state-owned bank that did a foreign IPO and he had to clean up the bad debt before the IPO. So he's a roll-up-your-sleeves-and-fix-the-bad-debt-problem guy, and in my opinion that's probably what they would want, somebody close to Wang Qishan who understands bad debt.

Cardiff Garcia I want to ask a very general question about the politics of trade. Is the US getting this right vis-a-vis China or is there something else that it should be doing? Michael Pettis There are so many objectives that you have to define the objective first. But what I do want to suggest is that this is a really important issue for China because remember the problem that China suffers from is very weak domestic demand. That's why it must have a current account surplus. Without that it would have to increase unemployment and it doesn't want to do that. China has a growth rate now of roughly 6.5% and a lot of people ask if that's real or are they lying. I don't think there's a lot of lying going on. There may be some. But the important point to remember about GDP is that GDP isn't a measure of wealth or debt service capacity. It's a measure of economic activity. Now, if you invest in an airport that gets no airplanes, it shows up as an increase in GDP. Now, in the US what would end up happening is you would have to write that investment down to zero, which would reduce the profitability of the bank or the company that did it, and so it would reduce the value added component of GDP. So you would eliminate that bad investment from GDP. In China you don't do that, you don't write any of it down, and you're able to rollover the bad debt forever, effectively because of government guarantees. So GDP is significantly overstated by the amount of bad investment. I shouldn't say GDP is overstated, I should say the real increase in wealth is overstated by the GDP number because that includes a lot of non-productive activity. Now, what is the real growth in productive capacity and debt servicing capacity? I don't really know. I would be surprised if it were much above 1-2%. We are now in a situation where roughly every year debt has to increase by roughly 45% of GDP in order for China to hit its GDP growth target. That means going from the real number, which is maybe 2%, to the target of 6.5%. The way I think about the current account surplus or the trade surplus is in debt terms. I did a rough calculation and I calculated that for every 1% forced contraction in the trade surplus because of

anti-trade activity abroad, the amount by which Chinese debt would have to grow in order to achieve the GDP growth target goes up by one-third. So if somehow you could force the Chinese trade surplus to drop by 3% of GDP, to hit the growth target you would need -- instead of another 45% of GDP of additional debt -- you would need double that, which of course is impossible. So the current account surplus is very important for China. It's a way of moderating the difficulty of the adjustment. So I think they're very concerned about that. Cardiff Garcia I think that is all the time we have for part two's discussion on China, but before we let you go, Michael, I want to ask what you're working on now. Do you have a new book in the works or any bigger projects other than what you're producing for your blog China Financial Markets? Michael Pettis I've been working for a while -- things have been so busy that I'm way behind schedule -- on a book. One of my big complaints about economics is that economists don't understand debt the way people in finance do, and what I want to do is create an equivalent of corporate finance looking at debt, financial distress costs etc at the sovereign level. So that's my really big project, but given all the talk about trade we may do a quick interruption and do a book on trade, on how trade works. Cardiff Garcia Who is “we”? Is this a joint project or is this...? Michael Pettis Yes, it's with an academic from the University of Chicago. We haven't really agreed to go public so I'm not really sure I'm allowed to say his name. He's much more interesting than I am so people are going to read the book. Cardiff Garcia Michael Pettis, always a pleasure. Thanks so much for coming back on the show. Michael Pettis Thank you.