Michael Pettis is Professor of Finance, Guanghua School of Management, Peking University, author of The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, Avoiding the Fall: China’s Economic Restructuring and The Volatility Machine: Emerging Economics and the Threat of Financial Collapse. Pettis is out with his latest missive on China’s three options regarding its rebalancing. Below is a small excerpt from Pettis.
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China: Transfer of wealth
Regarding China as far as I can work out there are really only three logical ways a transfer of wealth is consistent with no change in the total savings and consumption shares of GDP.
- The wealthy or the state consume as much as ordinary households.
- Ordinary households increase their consumption rate and reduce their savings rate.
- Unemployment rises.
Again, let us consider each of the three so that we can list the possible outcomes.
1. The wealthy or the state consume as much as ordinary households
Clearly this hasn’t happened and is unlikely to happen in the future. Both common sense and all historical precedent suggest that except perhaps over very, very long time periods, consumption does not rise linearly with income and households consume a far greater share of their income than the state sector can.
2. Ordinary households increase their consumption rate and reduce their savings rate
This, which is what happened in the United States and peripheral Europe, is one of those brutally obvious points that so many commentators and economists have failed to grasp. I think the mechanism is fairly easy to understand and has already been much discussed, for example well over 100 years ago by John Hobson who showed how rising income inequality can cause both higher savings and lower opportunities for productive investment. The difference, he argued, poured into speculative stock, bond and real estate markets or was exported abroad to finance foreign demand for home products.
As money poured into stock, bond and real estate markets, either at home or abroad, it caused these markets to soar, making everyone feel richer. The consequence was that although ordinary households saw their share of total GDP decline, rising asset prices nonetheless made them feel wealthier, and encouraged them to maintain or increase their consumption.
Higher savings generated by the rich or the state, in other words, were matched by lower savings (or rising debt, which is the same thing) among ordinary households. Of course this can only be sustained if asset prices rise forever, but assets are locked into a circular process in which rising asset prices cause rising demand and rising demand justifies higher asset prices.
It takes rising debt to combine the two processes, so it is only a question of time before we reach debt capacity constraints, in which the system has to reverse itself, which it did in the developed word as a consequence of the 2007-08 crisis. This process, in other words, is the default reaction to a forced increase in the savings rate in one part of the economy, but it is not sustainable because it requires a permanent rise in consumer debt.
3. Unemployment rises
There is another way you can force down the savings rate, and this is by closing down factories and firing workers. As workers are fired, their income drops to zero. Their consumption, however, cannot drop to zero, and so they dip into their savings, borrow from friends and relatives, receive unemployment compensation, or otherwise find ways to maintain at least some minimum level of consumption (crime, perhaps, or remittances).
Of course savings is just GDP minus consumption, and so as their production of goods and services drops relative to their consumption, by definition the national savings rate declines. This balances out the higher savings generated by rising income inequality.
If the savings rate in one part of the economy rises, without an equivalent rise in investment the only way for the economy to balance is for savings elsewhere to decline, and this can happen either in the form of a (usually credit-backed) consumption binge, or in the form of rising unemployment. The first is unsustainable.
Once we understand this it is pretty easy to explain much of what has happened in the global economy over the past decade or two.