Balance of Payments

Explaining Slow Growth: Turning Away from the Stale “Lessons from Japan”

For the past 3 years, macroeconomists and central bankers have grappled fiercely over the topic of developed market economic stagnation, pending a true recovery from the financial implosions of 2008. Many influential “macro guys” and financial analysts now see stark similarities with the Japanese post 1990 experience and the current forecasts given for much of the developed world. Paul Krugman in a recent Op—Ed piece in his New York Times Blog for example stated emphatically that “Nowadays, we are all Japan”, whilst Richard Koo’s (highly informative) “The Holy Grail of Macroeconomics: Lessons from Japan” attempted to empirically relate the current financial position of the US to that of Japan during the lost decade. Nevertheless, I see a number of structural differences between the Japanese economy leading up to 1990 and the other indebted developed markets of today.

Essentially, if China’s economic model is a mirror of Japan’s, and thus awaits an equally daunting “Long Landing” as is expected (See Pettis, China Financial Markets), then surely the U.S and Europe who run a functionally obverse economic model shouldn’t intuitively be in the midst of a Japanese styled slump. To my mind, much of the debate amongst the macroeconomists misses this point and is therefore muddled and wonky. To my mind, a viable opponent to the Japanese analysis, is one based upon the international Balance of Payments (BoP).

I have long found it curious and odd, that even at the height of sub-prime lending in the U.S combined with excessively low interest rates after 2001, that the U.S economy remained on its long term average growth path. Surely the asset bubble and leveraging cycle should have propelled growth. Similarly, the 3 rounds of QE in the post-crisis era should have also stimulated growth and investment. (I share the opinion of Richard Koo in the idea that the US financial sector, contrary to popular sentiment is indeed healthy) One explanation for lacklustre growth is that the US economy has lost much of its comparative advantage, and that without constant monetary pump priming growth would be even slower. Another idea is that of Richard Koo and those of the Japan school, who now believe that the U.S economy is caught in a fierce deleveraging cycle that may take decades to resolve. And yet both of these theories, as intuitive as they may be, are muddled by inconsistent empirical evidence and strange contradictions.

What if however, the U.S and European economies were plagued by a very different type of problem? One which monetary pump-priming and asset bubbles could not solve. What if, the U.S and peripheral European demand over the past 20 years had simply been bled out by distortions in the external account? In this case, the US crisis was driven by external trade policies, and not, by a statist investment orgy as in Japan.

This situation at first glance seems to be supported by simple facts and intuition. The persistent current account deficits of developed markets, specifically the US, to my mind have caused both the inflated asset prices leading up to 2008, and also the below trend equilibrium (rather than actual) growth rates experienced since roughly 1997.

The late nineties were indeed a tumultuous period, and can be seen hence, as crucial to the development of instability within the US financial system. In 1997-8 a few things happened:

  1. East-Asian financial markets, stunned by a sequence of currency devaluations, began to run targeted trade surpluses.
  2. The US capital inflows soared (functionally the equivalent of a rising trade deficit that balanced the East-Asian surpluses)
  3. Lending and credit within the US expanded, funnelled largely into real estate.
  4. Housing prices and volumes began their ominous ascent.

The East-Asian surpluses then, can be seen to have (either directly or indirectly) penetrated the American trade account. Consequently, East-Asian markets served to change the composition of the American economy. The U.S tradable sector, due to financial repression and increasing savings in East-Asia, was beaten to a pulp and workers quickly made redundant. With a contracting tradable sector, the only possible way to redeploy labour is through a surge in foreign-financed debt which expands domestic consumption and investment. In addition, when the economy is balancing away from the tradeable sector most investment becomes speculative and in this case was inevitably funnelled towards the increasingly liquid real estate sector.

Therefore, the capital inflows (functionally current account deficits) can be seen to have both slowed equilibrium growth, as productive workers were redeployed and fired, and simultaneously fuelling a speculative binge. (The impending crisis’ magnitude was of course also amplified by the irresponsible lending techniques rampant within US financial markets which increased the probability of insolvency).

Even to this day, East-Asian capital exports have continued to increase, with China probably consuming a mere 35% of production (GDP) in comparison to the US’ 72% and Europe’s 65% (Rough estimates). The effect of such Underconsumption on the national savings rate is immense and if the US is to bear the brunt of the resultant capital inflows and Chinese production overload (As the PBoC reserve account holdings of USD implies it does) then it means the U .S is being bled white through the gaping hole in the external account.

With the financial crisis having largely capped the private sector’s willingness to further leverage-up and accumulate debt, there thus remains only one natural way for the U.S economy to absorb foreign excess capacity- unemployment and slower growth. Of course also there are a few politically unlikely ways too though. The US could become competitive through devaluation, higher VAT tax or equivalent, labour market reforms, tariffs etc. But the point is that China and East-Asia have purposely pushed their surplus savings onto the US. The US must absorb this excess by either more consumption, more investment (both imply less savings) or by intervening in trade and stopping the central bank purchases of so many treasuries (remember for every net $1 of Treasuries that are bought by foreigners, that is by economic law $1 added to the trade deficit). Since debt financed consumption and investment is not really an option without significant fiscal stimulus from the public sector (the private sector seems unwilling to leverage up further) and intervening in trade is politically unlikely the only other way to reduce savings is to reduce production by an amount more than the reduction in consumption. ie unemployment. This is basically an accounting necessity

Spain is an exaggerated version and perhaps a better example to see why. Spain can’t devalue due to it’s Eurozone membership. It also has a very limited capacity to load up on leverage (Look at sovereign bond risk premiums and the imploding banking sector) and so if Germany’s surplus continues to be pushed onto it, what can the Spanish administration do? All it can do is lower domestic savings by jacking up unemployment or try to become competitive and push it’s own savings out onto the rest of the world. (Like a Vampire state, sucking away at foreign demand to keep employment high). Coincidentally, the quickest way to regain competitiveness without intervening in trade is to grind down wages via unemployment. This is referred to the “internal devaluation” mode of recovery.

It is in this context that the anomalous predicament of the U.S and other developed markets is neither surprising nor complex. Unemployment will remain high until the trade interventions in surplus nations are eliminated, and the deficit ones are allowed to compete on an equal basis. In a situation where demand is being haemorrhaged to foreigners, fiscal stimulus will also need to be focused on innovative investments and cannot be allowed to stimulate consumption as is optimal Japan. In this world we must draw very different conclusions from those of the 90s.

Understanding Sovereign Bonds- Foreign Financing of Fiscal Deficits

The rise of Neo-Mercantilism’s export-led growth in countries such as China and Japan has brought a host of Balance of Payments (BoP) and Sovereign Debt problems to the fore. These problems are paramount to the international economy, but experts and policymakers alike demonstrate ignorance of the mechanisms behind the BoP through counterproductive proposals.

Sovereign Debt Markets and the Balance of Payments are one of the most counterintuitive and complex themes that policymakers face, fallacies are therefore riddled throughout the public debate. Not even the US Secretary of State Hillary Clinton is immune to frequent blunders when engaging in the sphere of international macroeconomics. In February, 2009 for example she made a famous imploration to China that they continue their purchases of US treasuries. This simple (and fallacious) request to the Jintao administration received almost no academic criticism; despite the detrimental effect that the Secretary of State’s policy goals would have on the US economy. An analysis of Chinese purchases of US dollar-assets is therefore required in order to address the unforeseen issues associated with foreign financing of sovereign bonds.

There are two main problems with Clinton’s imploration to the Chinese- namely the nondiscretionary nature the Bank of China’s treasury purchases, and the manner in which these purchases fail to alleviate fiscal deficit serviceability.

Firstly, the Bank of China (BoC), and Chinese Sovereign Wealth Funds do not simply decide to purchase huge quantities of US dollar-assets (in the form of bonds for now) based on whimsical choices of investment hubs. The decisions are not arbitrary; they are natural. The Bank of China’s decision to keep the RMB devalued means that they acquire huge foreign exchange reserves primarily in the form of US dollars. These dollars must be invested somewhere, and the only two markets large enough to absorb this influx of liquidity are the Eurozone and the US. Of these two options the US financial sector’s development and reputation of a safer investment location makes it the obvious choice.

Even if the Chinese decided to shift their exchange reserves to the Eurozone, they would have to undergo huge and costly transactions changing their accumulated dollars to Euros, in the process making huge losses in arbitrage as the dollars were devalued. It is clear with this in mind that Clinton’s beggary to the Chinese was completely ineffectual. The only way the Secretary of State could get her wish of increased foreign purchases of dollar-assets would be through the BoC devaluing the RMB even more, acquiring more reserves, before shoving them back into the bloated US treasuries market.

This leads us to the second (and far more important) fallacy underlying the Secretary of State’s understanding of foreign financing. The only way for China to unilaterally increase its purchase of US bonds would be to increase the volume of its capital exports to the US, thereby forcing a larger current account surplus as well (By definition the quantity of capital that is imported or exported is equal to the quantity of goods that are imported or exported respectively). The influx of demand for dollars would inflate the value of the currency, increasing the trade deficit by an even larger amount, and consumption on imports would boom leading to an even more indebted household sector.

In addition, interest rates on bonds would be largely unaffected and the government’s debt would become no more serviceable than before. This is due to the fact that with an appreciation of the dollar, many tradable sector firms would be adversely affected, and workers would be made redundant quite quickly. As a consequence, the US fiscal deficit would rise in a quantity roughly equal to the initial influx of Chinese bond purchases which caused the appreciation or by contrast the US would have endure higher levels of unemployment (The change in the capital deficit will be exactly equal to the trade deficit).

The point is that the Obama administration would have to issue an amount of bonds roughly equal to or in excess (A few economists have tried to calculate the exact relationship with little success) of the amount purchased by the Chinese. The influx of supply would equal the influx of demand, and the price (in the form of interest) would have no net effect. The difference for the American economy would be that both the current account deficit and the fiscal deficit would have grown. Americans, in essence, would be forced into an even larger imbalance between consumption and production.

Hillary Clinton’s imploration to the Chinese in this light is clearly opposed to American interests, and yet the entire economics profession remained largely apathetic to her announcements. Today, the profession continues to be mute when confronted by similar policies that flout textbook macroeconomics.