The great political challenge of the moment is how to update the 20th century entitlement state so that it is affordable. This challenge manifests itself in two main forms. The primary problem is the cost, or growth in cost, of health care in our country. The second problem is the current excess of spending over and above revenue in both discretionary and non discretionary spending.
Republican's like to say that "this country has a spending problem." In actuality, this country has a revenue and a spending problem, and addressing one without the other offers an overly simple and incomplete solution to this challenge.
In the recent past, both Mr. Ryan and President Obama have offered largely partisan proposals on how to solve this challenge. They are both drastically lacking in a comprehensive solution to this challenge. Mr Ryan health care proposals are incomplete and the rest of his budget is laughable in bad assumptions. Mr. Obama's health care proposal is enlarged government largesse, and the rest of his budget depends on politically favorable tax hikes which will result in sub optimum outcomes.
Mr. Ryan's health care proposal is to increase competition by giving "consumers" more control.
Friday, April 22, 2011
Wednesday, April 20, 2011
The Great Depression
This post draws significantly on M. Pettis
Countries that left the gold standard quickest, and thus were able loosen credit sufficiently to counteract the banking collapse, had the mildest economic contraction. Countries with the largest balance of payment surpluses (the U.S.) were in the strongest position to hang onto gold, and thus the last to leave the gold standard, and suffered the most painful economic contraction (it took 18 year for SP500 earnings to reach their pre-great depression peak, by comparison, it took the SP500 to 19 months to reach its pre-credit crisis peak). Countries with the strongest balance of payments were also those with the largest trade surpluses, and thus most exposed to collapse of net demand.
Besides the standard impact of the stock market crash of 1929 on consumer confidence, consumption, and cost of capital, economist agree that:
1. Significant industrial overcapacity in the United States was exported abroad, financed through massive foreign borrowing in the U.S. The 1929 crash not only crushed domestic demand, but eliminated the ability of foreign borrowers to finance imports from the U.S.
As international trade collapsed (and US tried to force the adjustment abroad through import tariffs), domestic demand was not nearly enough to absorb what U.S. factories produced. Government did not respond by spending, so so overcapacity was resolved through unemployment and factory closings. Government action (Smoot Hawley, mercantilism) invited retaliation and made the process more difficult.
2. Excess monetary creation caused by massive expansion of gold reserves in the 1920s lead to over investment and risky lending. The stock market crash set off the de-leveraging cycle, bank assets collapsed, and a sudden collapse in the money supply. The Fed failed to intervene with liquidity and the sharp contraction in economic activity became a depression. This is widely believed (Friedman, others) to be the biggest policy blunder that ensured the contraction turned into a depression.
Some comparison's to China:
China's trade surplus is about the same size in terms of Global GDP as the U.S. in 1929 - about .5% Though China's economy today is one fifth the relative size of the U.S. So, overcapacity, and domestic demand are likely to be much smaller than the U.S. in 1929.
Unlike in the 1920s, authorities recognize the importance of forceful monetary and fiscal response to sustain demand and provide liquidity. On the other hand, China most certainly has had excessively low interest rates, excessive monetary expansion (excess of savings), risky lending, and over investment.
A sharp reversal in China's trade surplus will result in a decline in foreign currency, and with it a decline in the money supply (effectively those savings leaving the country). This is because so long as the PBoC main job is to fix the value of its currency, it has limited ability to manage the money domestic money supply. In 2009, China did a fantastic job managing a contracting money supply with an explosion of loan growth.
Countries that left the gold standard quickest, and thus were able loosen credit sufficiently to counteract the banking collapse, had the mildest economic contraction. Countries with the largest balance of payment surpluses (the U.S.) were in the strongest position to hang onto gold, and thus the last to leave the gold standard, and suffered the most painful economic contraction (it took 18 year for SP500 earnings to reach their pre-great depression peak, by comparison, it took the SP500 to 19 months to reach its pre-credit crisis peak). Countries with the strongest balance of payments were also those with the largest trade surpluses, and thus most exposed to collapse of net demand.
Besides the standard impact of the stock market crash of 1929 on consumer confidence, consumption, and cost of capital, economist agree that:
1. Significant industrial overcapacity in the United States was exported abroad, financed through massive foreign borrowing in the U.S. The 1929 crash not only crushed domestic demand, but eliminated the ability of foreign borrowers to finance imports from the U.S.
As international trade collapsed (and US tried to force the adjustment abroad through import tariffs), domestic demand was not nearly enough to absorb what U.S. factories produced. Government did not respond by spending, so so overcapacity was resolved through unemployment and factory closings. Government action (Smoot Hawley, mercantilism) invited retaliation and made the process more difficult.
2. Excess monetary creation caused by massive expansion of gold reserves in the 1920s lead to over investment and risky lending. The stock market crash set off the de-leveraging cycle, bank assets collapsed, and a sudden collapse in the money supply. The Fed failed to intervene with liquidity and the sharp contraction in economic activity became a depression. This is widely believed (Friedman, others) to be the biggest policy blunder that ensured the contraction turned into a depression.
Some comparison's to China:
China's trade surplus is about the same size in terms of Global GDP as the U.S. in 1929 - about .5% Though China's economy today is one fifth the relative size of the U.S. So, overcapacity, and domestic demand are likely to be much smaller than the U.S. in 1929.
Unlike in the 1920s, authorities recognize the importance of forceful monetary and fiscal response to sustain demand and provide liquidity. On the other hand, China most certainly has had excessively low interest rates, excessive monetary expansion (excess of savings), risky lending, and over investment.
A sharp reversal in China's trade surplus will result in a decline in foreign currency, and with it a decline in the money supply (effectively those savings leaving the country). This is because so long as the PBoC main job is to fix the value of its currency, it has limited ability to manage the money domestic money supply. In 2009, China did a fantastic job managing a contracting money supply with an explosion of loan growth.
Factors Affect Trade
This post draws significantly on M. Pettis.
Any policy that explicitly or implicitly affects the balance of production and consumption.
So currency policy affects trade through diverting production and consumption (devalue = raise cost of imports, reduce real wages, opposite for production - which raises employment but does not improve living conditions). Tariffs work the same way.
Taxes - reduce income which reduces consumption (income and sales taxes) and corp taxes raise cost of production so reduces production. Taxes are transfer mechanism - so increasing income tax and reducing corp tax can have a bigger combined effect on trade balance.
Wages - low wages reduce household income, reduces consumption and increases production - relative to productivity.
Subsidies to producers - input costs, cost of capital (which is especially dangerous if the subsidy lowers the hurdle rate of an otherwise unprofitable enterprise)- subsidizing increases production relative to consumption, but also increases employment which has a slightly offsetting impact on consumption. Remember the net impact on trade surplus from rising production is offset by consumption through employment.
Costs to consumer - low deposit rates - which is the subsidy to producers in the form of cost of capital - reduces income, especially in economies where households do not own diversified portfolios of assets, i.e. dependent on savings rates. Wide lending margins (i.e. in China where there is a cap on deposit rates and a floor on lending rates) also reduce consumption.
Other Credit Intervention/Repressed Financial System: lending guarantees, directed lending, etc. This raises production (again, while raising consumption also through employment and increased wages, though longer term if that capital is misallocated the result is reduction of production, employment/wages and consumption. This is also tied to "regulated" interest rates - where interest rates are much lower than comparable growth equilibrium rates.
Any policy that explicitly or implicitly affects the balance of production and consumption.
So currency policy affects trade through diverting production and consumption (devalue = raise cost of imports, reduce real wages, opposite for production - which raises employment but does not improve living conditions). Tariffs work the same way.
Taxes - reduce income which reduces consumption (income and sales taxes) and corp taxes raise cost of production so reduces production. Taxes are transfer mechanism - so increasing income tax and reducing corp tax can have a bigger combined effect on trade balance.
Wages - low wages reduce household income, reduces consumption and increases production - relative to productivity.
Subsidies to producers - input costs, cost of capital (which is especially dangerous if the subsidy lowers the hurdle rate of an otherwise unprofitable enterprise)- subsidizing increases production relative to consumption, but also increases employment which has a slightly offsetting impact on consumption. Remember the net impact on trade surplus from rising production is offset by consumption through employment.
Costs to consumer - low deposit rates - which is the subsidy to producers in the form of cost of capital - reduces income, especially in economies where households do not own diversified portfolios of assets, i.e. dependent on savings rates. Wide lending margins (i.e. in China where there is a cap on deposit rates and a floor on lending rates) also reduce consumption.
Other Credit Intervention/Repressed Financial System: lending guarantees, directed lending, etc. This raises production (again, while raising consumption also through employment and increased wages, though longer term if that capital is misallocated the result is reduction of production, employment/wages and consumption. This is also tied to "regulated" interest rates - where interest rates are much lower than comparable growth equilibrium rates.
The Arithmatic of Chinese Consumption
This post draws heavily on M. Pettis.
First - Chinese consumption is not depressed by the "investment model" - which is an effect - it is depressed by trade policies, monetary policies, distorted credit allocation, and rigid financial system. Second, Chinese consumption in the 35% area in 2008 compares to 55%-65% in Europe, Latam 65%-70% and above 70% in the U.S. Other Asian consumption figures are mid 50% - India is an example at 57%.
The flip side is the savings rate in China. From 12-15% in early 1990s, the savings rate rose steadily to 25% in 1998 and only rose to 26% recently. The increase in national savings in the 2000s occurred at the corporate level - though this is due to transfer from households to producers.
China's last trade deficit was in 1996. After that trade surpluses grew to around 5% of GDP in 2003 and then surged to a high of 10% in 2007. Investment grew as a share of GDP, from 23% in 1990, jumped to 31% in 1992-94 where it stabilized, then grew at steadily to 40% by 2008.
The Asian growth model forces households to subsidize investment and production, which generates employment and growth which at the expense of household income and consumption.
In 1992 household income peaked at 72% of GDP, then erratically declined to 66% in 2002, and subsequently plunged to 55%.
Rebalancing is not just a rise in consumption, it is a expansion in Chinese net demand so that China can adjust to dropping net demand in the US in a way that doesn't harm trade partners and escalate trade tensions. Rebalancing is not consumption growing (which is the critical mistake analysts make everywhere), it is consumption growing relative to GDP. In fact, this can occur by GDP dropping below current consumption rates, which would be the worst outcome. The best outcome is for GDP to grow and for consumption to grow more quickly.
If consumption continues to grow more slowly than GDP imbalances get worse, while the trade numbers can be temporarily disguised by surging investment. This only makes rebalancing more difficult and increases the cost if capital is missallocated.
The arithmetic is very difficult. If China grows at 8%, consumption must grow at 11% to raise consumption as a share of GDP from 35% to 36% in a year. To return consumption to 40% of GDP in the next five years (40% is still well below any global consumption rate), at 8% GDP rate, consumption has to grow at 11%; at 7% GDP, consumption growth is 10%. To bring consumption to 50% of GDP in twenty years (the low end of other Asian high savings economies) if GDP grows at 7%, consumption must grow at 9%.
So, if Chinese GDP slows from 14% over the past decade, consumption none the less must surge in excess of 8-9% growth rates of recent years for any rebalancing to take place.
First - Chinese consumption is not depressed by the "investment model" - which is an effect - it is depressed by trade policies, monetary policies, distorted credit allocation, and rigid financial system. Second, Chinese consumption in the 35% area in 2008 compares to 55%-65% in Europe, Latam 65%-70% and above 70% in the U.S. Other Asian consumption figures are mid 50% - India is an example at 57%.
The flip side is the savings rate in China. From 12-15% in early 1990s, the savings rate rose steadily to 25% in 1998 and only rose to 26% recently. The increase in national savings in the 2000s occurred at the corporate level - though this is due to transfer from households to producers.
China's last trade deficit was in 1996. After that trade surpluses grew to around 5% of GDP in 2003 and then surged to a high of 10% in 2007. Investment grew as a share of GDP, from 23% in 1990, jumped to 31% in 1992-94 where it stabilized, then grew at steadily to 40% by 2008.
The Asian growth model forces households to subsidize investment and production, which generates employment and growth which at the expense of household income and consumption.
In 1992 household income peaked at 72% of GDP, then erratically declined to 66% in 2002, and subsequently plunged to 55%.
Rebalancing is not just a rise in consumption, it is a expansion in Chinese net demand so that China can adjust to dropping net demand in the US in a way that doesn't harm trade partners and escalate trade tensions. Rebalancing is not consumption growing (which is the critical mistake analysts make everywhere), it is consumption growing relative to GDP. In fact, this can occur by GDP dropping below current consumption rates, which would be the worst outcome. The best outcome is for GDP to grow and for consumption to grow more quickly.
If consumption continues to grow more slowly than GDP imbalances get worse, while the trade numbers can be temporarily disguised by surging investment. This only makes rebalancing more difficult and increases the cost if capital is missallocated.
The arithmetic is very difficult. If China grows at 8%, consumption must grow at 11% to raise consumption as a share of GDP from 35% to 36% in a year. To return consumption to 40% of GDP in the next five years (40% is still well below any global consumption rate), at 8% GDP rate, consumption has to grow at 11%; at 7% GDP, consumption growth is 10%. To bring consumption to 50% of GDP in twenty years (the low end of other Asian high savings economies) if GDP grows at 7%, consumption must grow at 9%.
So, if Chinese GDP slows from 14% over the past decade, consumption none the less must surge in excess of 8-9% growth rates of recent years for any rebalancing to take place.
Asian Developement Model
This post draws significantly from M. Pettis
Beginning in 2009 - the massive expansion of credit and investment is an extension of the same policies observed in China since 2004 - driven by the Ministry of Commerce, export constituencies, and provincial and municipal leaders focused on short term growth targets and unemployment.
In late 2009 - it appeared that the US consumption binge could not continue - though it has. We have seen a dress rehearsal of this in the 1987 crash - when the trade deficit reached 3.5% before reversing over the 1990s. That period also marked the end of the Japanese miracle, though party didn't end for several years.
Quick note on Japan - following the Plaza Accord, as the Yen appreciated versus the dollar, Japan's surplus with the U.S. expanded, driven by a surge in credit (and informally guaranteeing borrowers, so profitability did not affect lending decisions) which allowed producers to expand production while consumers subsidized this production - trade surplus.
The Asian Development model then involves policies that directly/indirectly boost savings and channel huge subsidies (usually provided by the savers, thus depressing consumption) into investment and manufacturing. Consumer restraint and surging production inevitably lead to large and consistent trade surpluses and equal capital exports.
When large countries, or groups of large countries have policies aimed at creating trade surpluses, they face a binding constraint - a country or group of countries willing to run the concurrent deficit. Without deficit countries, the Asian growth model would run into 19th century cycle of rapid production and overinvestment. There must be an importer of last resort.
In the lasts decade, the U.S. trade deficit grew from 1% of GDP to 7%. When consumption growth is faster than GDP growth - necessary when a country builds a trade deficit -there is a necessary build up in debt. When households repair their balance sheets - we would expect a decline in consumption relative to GDP and a decline in the deficit.
Declines in deficit countries will force concurrent declines in trade surpluses from growing. The Asian growth model is dependent on growing deficits, particularly the US with the largest market for consumers and deep financial markets. The end of U.S. trade deficits will likely be the end of the Asian Growth model.
This is why the surge of lending and investment in 2009, 2010, and 2011 is so disturbing. This investment will lead to even more overcapacity, NPLs, misallocation of capital, and suppression of consumption (through an implicit tax on household by lowering interest rates to reduce debt burdens and recapitalize insolvent banks). Instance after instance of wealth transfer from households to producers.
Beginning in 2009 - the massive expansion of credit and investment is an extension of the same policies observed in China since 2004 - driven by the Ministry of Commerce, export constituencies, and provincial and municipal leaders focused on short term growth targets and unemployment.
In late 2009 - it appeared that the US consumption binge could not continue - though it has. We have seen a dress rehearsal of this in the 1987 crash - when the trade deficit reached 3.5% before reversing over the 1990s. That period also marked the end of the Japanese miracle, though party didn't end for several years.
Quick note on Japan - following the Plaza Accord, as the Yen appreciated versus the dollar, Japan's surplus with the U.S. expanded, driven by a surge in credit (and informally guaranteeing borrowers, so profitability did not affect lending decisions) which allowed producers to expand production while consumers subsidized this production - trade surplus.
The Asian Development model then involves policies that directly/indirectly boost savings and channel huge subsidies (usually provided by the savers, thus depressing consumption) into investment and manufacturing. Consumer restraint and surging production inevitably lead to large and consistent trade surpluses and equal capital exports.
When large countries, or groups of large countries have policies aimed at creating trade surpluses, they face a binding constraint - a country or group of countries willing to run the concurrent deficit. Without deficit countries, the Asian growth model would run into 19th century cycle of rapid production and overinvestment. There must be an importer of last resort.
In the lasts decade, the U.S. trade deficit grew from 1% of GDP to 7%. When consumption growth is faster than GDP growth - necessary when a country builds a trade deficit -there is a necessary build up in debt. When households repair their balance sheets - we would expect a decline in consumption relative to GDP and a decline in the deficit.
Declines in deficit countries will force concurrent declines in trade surpluses from growing. The Asian growth model is dependent on growing deficits, particularly the US with the largest market for consumers and deep financial markets. The end of U.S. trade deficits will likely be the end of the Asian Growth model.
This is why the surge of lending and investment in 2009, 2010, and 2011 is so disturbing. This investment will lead to even more overcapacity, NPLs, misallocation of capital, and suppression of consumption (through an implicit tax on household by lowering interest rates to reduce debt burdens and recapitalize insolvent banks). Instance after instance of wealth transfer from households to producers.
Tuesday, April 19, 2011
Consumption, Savings, Investment, Surplus, Deficit
This post draws significantly on M. Pettis, P. Krugman, S. Roach.
Given the sheer size of the PBoC intervention, the tremendous comcomitant need to sterilize and supress interest rates, and resistance to currency appreciation, its seems the PBoC capital exports is a policy choice. This is policy choice is supported since PBoC and other Asian reserve accumulation exploded after 1997 Asian Financial Crisis.
The U.S. could have resisted the increase in capital account (capital imports) by sharply raising interest rates, which would have reduced investment faster than U.S. savings. The resulting rise in unemployment would have lowered consumption and imports which would have reduced the current account deficit.
The Fed did not do this. The capital surplus rose. Since the current account is investment minus savings, the capital suplus rises either when savings declines, investment rises, or the some combination in that relationship.
Unfortunately for the world and the U.S., private investment doesn't surge enough. The current account deficit means production is moving abroad, partly because of currency intervention and other factors, which makes foreign investment more profitable.
Here, the government could surge investment to offset the increase in capital account. The result may have been increased future profitability, recapturing the advantage in production it has lost. The U.S. would have run a huge trade deficit, but the deficit would result in a surge in investment, not consumption.
Instead, without the surge in investment, the savings rate declined. Here again, capital exports from another country forces down saving, and forces debt up. No moral finger wagging on over consumption. By the same token, if China forces capital exports, its people must save more. They are not suddenly thrifty, household wealth is reduced to reduce consumption.
So here, the simple conclusion to reverse this is by forcing China to stop exporting capital, which would result in a rise of the RMB.
Of course, the cause might not be capital exports, but a result of US policies that forced savings down and consumption up. Or, it might be that Chinese just save a lot, "naturally", which is augmented by the extremely cheap cost of labor relative to the rest of the world.
Given the sheer size of the PBoC intervention, the tremendous comcomitant need to sterilize and supress interest rates, and resistance to currency appreciation, its seems the PBoC capital exports is a policy choice. This is policy choice is supported since PBoC and other Asian reserve accumulation exploded after 1997 Asian Financial Crisis.
The U.S. could have resisted the increase in capital account (capital imports) by sharply raising interest rates, which would have reduced investment faster than U.S. savings. The resulting rise in unemployment would have lowered consumption and imports which would have reduced the current account deficit.
The Fed did not do this. The capital surplus rose. Since the current account is investment minus savings, the capital suplus rises either when savings declines, investment rises, or the some combination in that relationship.
Unfortunately for the world and the U.S., private investment doesn't surge enough. The current account deficit means production is moving abroad, partly because of currency intervention and other factors, which makes foreign investment more profitable.
Here, the government could surge investment to offset the increase in capital account. The result may have been increased future profitability, recapturing the advantage in production it has lost. The U.S. would have run a huge trade deficit, but the deficit would result in a surge in investment, not consumption.
Instead, without the surge in investment, the savings rate declined. Here again, capital exports from another country forces down saving, and forces debt up. No moral finger wagging on over consumption. By the same token, if China forces capital exports, its people must save more. They are not suddenly thrifty, household wealth is reduced to reduce consumption.
So here, the simple conclusion to reverse this is by forcing China to stop exporting capital, which would result in a rise of the RMB.
Of course, the cause might not be capital exports, but a result of US policies that forced savings down and consumption up. Or, it might be that Chinese just save a lot, "naturally", which is augmented by the extremely cheap cost of labor relative to the rest of the world.
Accounting Identities and Trade
This post draws in large part on M. Pettis, P. Krugman, and S. Roach
To think about trade lets start by understanding that China's government engages in massive capital export, accumulating foreign assets funded with domestic liabilities. It does this in part due to restrictions on capital inflows.
Two basic accounting identities:
Capital Account + Current Account = 0
Current Account = Domestic Savings (Prod- Cons) - Domestic Investment
So, China has a capital account deficit, and thus a current account surplus - so we can say it exports its savings to the rest of the world. Thus, the rest of the world must import savings and spend in excess of what it produces. This is an accounting necessity.
Note - we can further break this down into:
Households + Business + Government + Current Account (foreign) = 0.
So if households and businesses decide to run a large surplus, then the governement and foreigners must run a deficit.
The accounting identity for the capital account is therefore : Domestic Investment - domestic savings (prod - cons). In other words, a country borrows the excess of its investment over its domestic saving.
This also means that domestic savings - domestic investment = current account.
Note - this says nothing about causality. If (Krugman) argues that foreign currency intervention forces China to export capital, then other must import it. If Chinese are forced to save, then either domestic or foreign entities are forced to borrow. If American's went on a consumption binge, someone must sell them their goods.
To think about trade lets start by understanding that China's government engages in massive capital export, accumulating foreign assets funded with domestic liabilities. It does this in part due to restrictions on capital inflows.
Two basic accounting identities:
Capital Account + Current Account = 0
Current Account = Domestic Savings (Prod- Cons) - Domestic Investment
So, China has a capital account deficit, and thus a current account surplus - so we can say it exports its savings to the rest of the world. Thus, the rest of the world must import savings and spend in excess of what it produces. This is an accounting necessity.
Note - we can further break this down into:
Households + Business + Government + Current Account (foreign) = 0.
So if households and businesses decide to run a large surplus, then the governement and foreigners must run a deficit.
The accounting identity for the capital account is therefore : Domestic Investment - domestic savings (prod - cons). In other words, a country borrows the excess of its investment over its domestic saving.
This also means that domestic savings - domestic investment = current account.
Note - this says nothing about causality. If (Krugman) argues that foreign currency intervention forces China to export capital, then other must import it. If Chinese are forced to save, then either domestic or foreign entities are forced to borrow. If American's went on a consumption binge, someone must sell them their goods.
PBOC and Reserves
This post draws significantly from M. Pettis
First - TIC data only shows direct foreign ownership, so the data does not account for UST held by PBoC indirectly or in other street names (see D. Scissors). Tic data does not show if matured/sold UST is replaced by other dollar assets.
Second, China has a huge trade surplus and the U.S a huge deficit. It is very difficult for China to reduce holdings of US assets and impossible without foreign supply to replace them.
China is not Washington's Banker
China runs a current account surplus - which means it necessarily accumulates net foreign claims by the same amount. And the entities of which it accumulates those claims must run a corresponding deficit. Given China had the largest current account surplus ever as a % of GDP (global GDP) and the US current account deficit the largest ever as a % of GDP - China had to buy dollar assets, and given the sheer size of the amounts, they had to buy UST.
This is not a discretionary lending decision, it is the result of China's currency regime. In order to fix its currency, China must take the opposite side of the market. Everyone else is a net seller of RMB (buyer of $), so the PBoC must do the opposite. As soon as the PBoC stops buying dollars, the market will clear the price for RMB (so, the PBoC cannot stop buying $ in anticipation of rising RMB).
The PBoC funds, $ purchases by borrowing in domestic money markets, selling PBoC bills, repos, or by creating money by crediting accounts of commercial banks that sell it $. Thus, the PBoC runs a mismatched balance sheet, assets $, Liabil in RMB. Reserves are borrowed money.
Reserves are not usable within China - it can only be used to import goods (so long as the country can afford them) and to repay foreign debt and investment. So, if USD assets drop by 10% relative to RMB, so does the value of foreign goods relative to RMB, with less PBoC borrowing to pay for it. So the real value of the assets hasn't changed, just the accounting value in RMB.
So, the PBoC has a mismatched and levered balance sheet long dollars and short RMB, but the rest of China has the opposite, long RMB and short dollars. In RMB appreciation, PBoC loses in the form of increase in net debt. Exporters (rev in $, cost in RMB) lose, because they are long dollars. Companies with foreign assets in excess of debt lose too.
Everyone else wins because they are short dollars (import from abroad) and long RMB.
So a revaluation represents a shift in wealth from the PBOC, exporters, commodity hoarders and foreign asset holders to the rest of the people.
Unfortunately, because the PBoC holds 3tril $, a 10% revaluation is a 300bn loss, which ultimately increases government debt. That increase in government debt will be paid for by explicit or implicit tax on households, which makes rebalancing even more difficult. This also has implications for other balance sheet assets like large banks who have lent to SOE, exporters, and investment companies. The distribution of losses could very well be extremely focused.
First - TIC data only shows direct foreign ownership, so the data does not account for UST held by PBoC indirectly or in other street names (see D. Scissors). Tic data does not show if matured/sold UST is replaced by other dollar assets.
Second, China has a huge trade surplus and the U.S a huge deficit. It is very difficult for China to reduce holdings of US assets and impossible without foreign supply to replace them.
China is not Washington's Banker
China runs a current account surplus - which means it necessarily accumulates net foreign claims by the same amount. And the entities of which it accumulates those claims must run a corresponding deficit. Given China had the largest current account surplus ever as a % of GDP (global GDP) and the US current account deficit the largest ever as a % of GDP - China had to buy dollar assets, and given the sheer size of the amounts, they had to buy UST.
This is not a discretionary lending decision, it is the result of China's currency regime. In order to fix its currency, China must take the opposite side of the market. Everyone else is a net seller of RMB (buyer of $), so the PBoC must do the opposite. As soon as the PBoC stops buying dollars, the market will clear the price for RMB (so, the PBoC cannot stop buying $ in anticipation of rising RMB).
The PBoC funds, $ purchases by borrowing in domestic money markets, selling PBoC bills, repos, or by creating money by crediting accounts of commercial banks that sell it $. Thus, the PBoC runs a mismatched balance sheet, assets $, Liabil in RMB. Reserves are borrowed money.
Reserves are not usable within China - it can only be used to import goods (so long as the country can afford them) and to repay foreign debt and investment. So, if USD assets drop by 10% relative to RMB, so does the value of foreign goods relative to RMB, with less PBoC borrowing to pay for it. So the real value of the assets hasn't changed, just the accounting value in RMB.
So, the PBoC has a mismatched and levered balance sheet long dollars and short RMB, but the rest of China has the opposite, long RMB and short dollars. In RMB appreciation, PBoC loses in the form of increase in net debt. Exporters (rev in $, cost in RMB) lose, because they are long dollars. Companies with foreign assets in excess of debt lose too.
Everyone else wins because they are short dollars (import from abroad) and long RMB.
So a revaluation represents a shift in wealth from the PBOC, exporters, commodity hoarders and foreign asset holders to the rest of the people.
Unfortunately, because the PBoC holds 3tril $, a 10% revaluation is a 300bn loss, which ultimately increases government debt. That increase in government debt will be paid for by explicit or implicit tax on households, which makes rebalancing even more difficult. This also has implications for other balance sheet assets like large banks who have lent to SOE, exporters, and investment companies. The distribution of losses could very well be extremely focused.
Thursday, April 14, 2011
China's Current Account, Rebalancing, & U.S. Interest Rates
This post draws significantly on M. Pettis.
The argument: If China's consumption (as a % of GDP) rises faster than investment declines, this will reduce China's current account surplus (decline in savings); and thus a reduction in the capital it exports. This means China recycles less of the worlds (and history's) largest surplus, it purchases less US treasuries which causes U.S. interest rates to rise.
Martin Feldstein wrote: "...change driven by Chinese domestic considerations, it could have significant impact on capital flows and interest rates."
As China re-balances, the savings rates will contract as a % of GDP. This will shrink the current account unless investment grows more slowly than savings, which is unlikely because a sharp reduction in investment would force a collapse in top line GDP. (Note - this means China will keep investment high to reduce impact of a slowdown AND will extend the period of slowdown in China once it happens).
The point that is wrong here is that a contracting surplus and less capital exports means higher interest rates. Conversely an expanding surplus and higher capital exports don't mean lower U.S. interest rates, though this did happen from 2004-2008. Rather, its the way in which the surplus expands or declines that will have a high affect on U.S. interest rates.
If the U.S. current account deficit rises due to surge in U.S. investment, than higher capital imports will not affect interest rates, because the supply of savings will be met by demand of savings. In fact, if the investment brings jobs, the increase income would lead to consumption and interest rates could rise.
If the current account deficit rises because of a reduction in net foreign consumption, then the drop in global demand for labor will create unemployment, growth drops, and either the government increases deficits to offset the decline or the fed encourages a surge in consumer financing - either way debt levels surge. Depending on the size of deficit or consumer financing, rates could do anything. More likely, they fall because of the weak growth and unemployment
In other words, interest rates don't fall because the U.S. is lucky enough to have foreigners lending them money.
Conversely - if China's current account deficit declines by recycling the surplus onto another country - Brazil for example - by stockpiling commodities, then the US current account is unchanged and the capital is imported from Brazil.
Lastly, if China's current account surplus is collapsed by a surge in Chinese consumption, then the U.S. deficit will decline. In that case, China would export less capital as Martin Feldstein explained. But a decline in the U.S. deficit would be expansionary, so less government bonds (or private borrowing) would be issued. In this instance, its not obvious that rates would rise or fall, though they would be responding to higher and the fiscal and monetary responses to growth.
Warnings about what happens if China stops buying government bonds are no different than warnings about what might happen when the U.S. closes its trade deficit. It all depends - if the deficit contracts because investment drops faster than savings that will be bad, and if Chinese consumers import more goods from the U.S. that will be good, regardless of the interest rates.
The argument: If China's consumption (as a % of GDP) rises faster than investment declines, this will reduce China's current account surplus (decline in savings); and thus a reduction in the capital it exports. This means China recycles less of the worlds (and history's) largest surplus, it purchases less US treasuries which causes U.S. interest rates to rise.
Martin Feldstein wrote: "...change driven by Chinese domestic considerations, it could have significant impact on capital flows and interest rates."
As China re-balances, the savings rates will contract as a % of GDP. This will shrink the current account unless investment grows more slowly than savings, which is unlikely because a sharp reduction in investment would force a collapse in top line GDP. (Note - this means China will keep investment high to reduce impact of a slowdown AND will extend the period of slowdown in China once it happens).
The point that is wrong here is that a contracting surplus and less capital exports means higher interest rates. Conversely an expanding surplus and higher capital exports don't mean lower U.S. interest rates, though this did happen from 2004-2008. Rather, its the way in which the surplus expands or declines that will have a high affect on U.S. interest rates.
If the U.S. current account deficit rises due to surge in U.S. investment, than higher capital imports will not affect interest rates, because the supply of savings will be met by demand of savings. In fact, if the investment brings jobs, the increase income would lead to consumption and interest rates could rise.
If the current account deficit rises because of a reduction in net foreign consumption, then the drop in global demand for labor will create unemployment, growth drops, and either the government increases deficits to offset the decline or the fed encourages a surge in consumer financing - either way debt levels surge. Depending on the size of deficit or consumer financing, rates could do anything. More likely, they fall because of the weak growth and unemployment
In other words, interest rates don't fall because the U.S. is lucky enough to have foreigners lending them money.
Conversely - if China's current account deficit declines by recycling the surplus onto another country - Brazil for example - by stockpiling commodities, then the US current account is unchanged and the capital is imported from Brazil.
Lastly, if China's current account surplus is collapsed by a surge in Chinese consumption, then the U.S. deficit will decline. In that case, China would export less capital as Martin Feldstein explained. But a decline in the U.S. deficit would be expansionary, so less government bonds (or private borrowing) would be issued. In this instance, its not obvious that rates would rise or fall, though they would be responding to higher and the fiscal and monetary responses to growth.
Warnings about what happens if China stops buying government bonds are no different than warnings about what might happen when the U.S. closes its trade deficit. It all depends - if the deficit contracts because investment drops faster than savings that will be bad, and if Chinese consumers import more goods from the U.S. that will be good, regardless of the interest rates.
On Containing Inflation
This post draws significantly from M. Pettis.
"Raising interest rates should encourage depositors to hold more money in their savings accounts." This is a very U.S. centric view of how financial systems translate changes in interest rates into changes in savings rates, via changes in household wealth.
It is hard to understand why China has such a high savings rate with such low real deposit rates. Negative real interest rates actually reduce household wealth by reducing the value of savings. Few households in China borrow and few households hold assets whose value benefits from declining interest rates (which is the opposite of the US).
So raising real interest rates (NOT NOMINAL) would in fact be inflationary by increasing household wealth, and thus reducing their incentive to save money.
Inflation reduces the value of household savings and reduces consumption, which is a self correcting measure for inflation.
The bad news is China's (Asian) financial system doesn't just counter act CPI inflation, it converts it into asset price inflation. This is a real concern in an economy that is likely misallocating capital. China's economy is dependent on expanding credit to fund investment. Raising interest rates by 25 (or 100bps since Nov?) are far too low to have a meaningful impact on credit supply. Reducing the flow of credit through PBoC sterilization, the flow of government deposits, Required Reserve Ratios, and reduced shadow banking credit, quickly translates into economic pain.
"Raising interest rates should encourage depositors to hold more money in their savings accounts." This is a very U.S. centric view of how financial systems translate changes in interest rates into changes in savings rates, via changes in household wealth.
It is hard to understand why China has such a high savings rate with such low real deposit rates. Negative real interest rates actually reduce household wealth by reducing the value of savings. Few households in China borrow and few households hold assets whose value benefits from declining interest rates (which is the opposite of the US).
So raising real interest rates (NOT NOMINAL) would in fact be inflationary by increasing household wealth, and thus reducing their incentive to save money.
Inflation reduces the value of household savings and reduces consumption, which is a self correcting measure for inflation.
The bad news is China's (Asian) financial system doesn't just counter act CPI inflation, it converts it into asset price inflation. This is a real concern in an economy that is likely misallocating capital. China's economy is dependent on expanding credit to fund investment. Raising interest rates by 25 (or 100bps since Nov?) are far too low to have a meaningful impact on credit supply. Reducing the flow of credit through PBoC sterilization, the flow of government deposits, Required Reserve Ratios, and reduced shadow banking credit, quickly translates into economic pain.
Monday, April 11, 2011
The China Dream
This post draws significantly on Edward Chancellor's white paper "China's Red Flags"
Past manias and financial crises have shared many characteristics. Below is a list of "leading indicators" of financial distress.
1. Compelling Growth Story - usually associated with some new technology or exciting prospects for a particular economy.
2. Faith in the competence of authorities -examples include the Fed in 1920s and the "Greenspan put".
3. A general increase in investment - capital is mis-pent during periods of euphoria. J.S. Mills said "panics do not destroy capital, the merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works."
4. Surge in corrpution
5. Easy Money - Low rates lead investors to chase higher yields and riskier assets. Bagehot said "John Bull can stand many things, but he cannot stand two percent"
6. Fixed currency regimes - which generally lead to too low rates and large capital inflows. The EMU lead to property and consumption booms. Asian crisis of 1997 is similar.
7. Rampant Credit Growth - liabilities are contracted that cannot be repaid (NPV of a project cash flows is less than the stock of debt). Sharp deviations of credit growth from past trends and lagging credit growth tends to be a leading indicator of financial distress.
8. Moral hazard - the belief that authorities won't let bad things happen. Irresponsibility is not punished.
9. Financial Structures Become Precarious - Investments do not generate enough income to finance the loans (Ponzi Scheme). As a result, the market becomes vulnerable to what otherwise might be considered insignificant events.
10. Dodgy loans are securitized by collateral. Real Estate busts are generally worse because they are associated with real economic activity (construction).
Past manias and financial crises have shared many characteristics. Below is a list of "leading indicators" of financial distress.
1. Compelling Growth Story - usually associated with some new technology or exciting prospects for a particular economy.
2. Faith in the competence of authorities -examples include the Fed in 1920s and the "Greenspan put".
3. A general increase in investment - capital is mis-pent during periods of euphoria. J.S. Mills said "panics do not destroy capital, the merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works."
4. Surge in corrpution
5. Easy Money - Low rates lead investors to chase higher yields and riskier assets. Bagehot said "John Bull can stand many things, but he cannot stand two percent"
6. Fixed currency regimes - which generally lead to too low rates and large capital inflows. The EMU lead to property and consumption booms. Asian crisis of 1997 is similar.
7. Rampant Credit Growth - liabilities are contracted that cannot be repaid (NPV of a project cash flows is less than the stock of debt). Sharp deviations of credit growth from past trends and lagging credit growth tends to be a leading indicator of financial distress.
8. Moral hazard - the belief that authorities won't let bad things happen. Irresponsibility is not punished.
9. Financial Structures Become Precarious - Investments do not generate enough income to finance the loans (Ponzi Scheme). As a result, the market becomes vulnerable to what otherwise might be considered insignificant events.
10. Dodgy loans are securitized by collateral. Real Estate busts are generally worse because they are associated with real economic activity (construction).
Saturday, April 9, 2011
Earnings Forecasts Versus Cyclically Adjusted Earnings
12 month S&P 500 earnings peaked in the third quarter of 2007 at $90 per share. So, from the third quarter of 2006 to third quarter of 2007, 12 month earnings peaked, and began to subsequently decline. During the first quarter of 2009, the 12 month earnings bottomed at a staggering $7 per share. Based on forward estimates, 12 month earnings are supposed to surpass the 2007 peak in the third quarter of 2011. This is the fastest recovery according to Robert Schiller and S&P.
The gap between projected 12 month profits and the 10 year average annual earnings is set to widen to the most since 1951.
Following the credit crisis, profits tumbled 92%, but will have recouped their peak in 50 months. That compares to 52 months following the dot.com bubble when earnings dropped by 52%. Following the great depression, profits did not recoup their 67% losses for 19 years.
The S&P500 has traded at an average of 15.7x reported annual profits since 1900, according to Robert Schiller (show this with data). Estimated earnings for 2011 are $95.21. $95.21 x 15.7 values the SP500 at $1,491.
The 10 year inflation adjusted average earnings is for the SP500 is $60 (research this). If earnings are $95.21 in 2011, they will be 59% higher than the inflation adjusted average earnings over the past ten years. The only other times since 1951 where forward earnings have approached that level was in December 2006 and August 2000, at the peaks of profit and economic expansion (research this).
The SP500 cyclically adjusted PE is currently 22 (or 24 times; research this?). The historical average for the cyclically adjusted PE is roughly 15.5 times , which is in right on top of the average PE versus annual reported earnings (nick - research this).
The gap between projected 12 month profits and the 10 year average annual earnings is set to widen to the most since 1951.
Following the credit crisis, profits tumbled 92%, but will have recouped their peak in 50 months. That compares to 52 months following the dot.com bubble when earnings dropped by 52%. Following the great depression, profits did not recoup their 67% losses for 19 years.
The S&P500 has traded at an average of 15.7x reported annual profits since 1900, according to Robert Schiller (show this with data). Estimated earnings for 2011 are $95.21. $95.21 x 15.7 values the SP500 at $1,491.
The 10 year inflation adjusted average earnings is for the SP500 is $60 (research this). If earnings are $95.21 in 2011, they will be 59% higher than the inflation adjusted average earnings over the past ten years. The only other times since 1951 where forward earnings have approached that level was in December 2006 and August 2000, at the peaks of profit and economic expansion (research this).
The SP500 cyclically adjusted PE is currently 22 (or 24 times; research this?). The historical average for the cyclically adjusted PE is roughly 15.5 times , which is in right on top of the average PE versus annual reported earnings (nick - research this).
Wednesday, April 6, 2011
The Cost of Low Interest Rates
This post draws heavily on M. Pettis.
What is the cost of the transfer of wealth from households and savers to banks?
Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. (Appendix 1 - the case for and against nominal interest rates equal to nominal GDP).
Assuming IR are 75% of nominal GDP, then China's 14% average growth rate means nominal IR should be 10.5%, versus the actual 6% lending rate. This means interest rates are at between 350 and 800 basis points too low. If we add the excess bank spread (estimated at between 150 and 250 bps) we can say that at the very low end, nominal IR are 500 basis points too low.
That means that 5% of GDP is transferred from Households to Businesses every year. Lets show some numbers for context.
In 2009, total bank deposits in China were RMB64 tr; 60% of those deposits belong to households (rough guesstimate); RMB64 tr * 60% * 5% = RMB 1.9 tr. That represents 5% of GDP.
Of course, households are not only paying to subsidize banks, they pay to subsidize manufacturing investments, real estate investments, infrastructure investment, sterilization bills, PBOC borrowing - investments that have negative NPVs without the subsidy. (Capital misallocation).
Even if banks are insolvent, China can protect itself from illiquidity because the government controls funding and interest rates. In the past, China could grow its way out, despite declining relative consumption (and a rising savings rate and rising trade balance), because of the growing world economy. As long as debt levels in deficit countries could rise to counteract adverse unemployment effects the world (US) has no problem absorbing the trade surpluses.
Things are different now
Unemployment is high in deficit countries. Debt levels are being forced down. China must reduce its dependence on trade and investment by increasing the share of household consumption. Household consumption is dependent on household income, so as/if household income is taxed away by banking costs - it will be impossible for household consumption to surge.
The result is for total GDP to drop sufficiently where household consumption takes on a larger share. Japan is the example of this, where consumption growth declined to 1-2% annually as households were forced to subsidize insolvent institutions through repressed interest rates and undervalued currency. In Japan's case, total economic growth has been less than consumption growth as China rebalances its economy.
Appendix 1
Against - historically, developing countries have not had nominal interest rates equal to nominal GDP. When IR < Nominal GDP, then providers capital get less than their share of growth. In China, households are providers of capital, businesses & govenment are users of capital (they use it for FGF) = transfer of wealth. (Note, is the savings rate an independent variable that forces down interest rates; or is the savings rate a consequence of low interest rates and other policies that "tax" households and "subsidize" production - Think of it this way - policies that tax households and subsidize production forces more production than consumption, which forces up the savings rate).
For - the "sample" of developing countries have closed or sticky capital accounts - which are used to repress currency value to protect trade; these countries also systematically repress interest rates.
On average, nominal IR are 75% of nominal GDP with wide dispersion around the mean.
What is the cost of the transfer of wealth from households and savers to banks?
Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. (Appendix 1 - the case for and against nominal interest rates equal to nominal GDP).
Assuming IR are 75% of nominal GDP, then China's 14% average growth rate means nominal IR should be 10.5%, versus the actual 6% lending rate. This means interest rates are at between 350 and 800 basis points too low. If we add the excess bank spread (estimated at between 150 and 250 bps) we can say that at the very low end, nominal IR are 500 basis points too low.
That means that 5% of GDP is transferred from Households to Businesses every year. Lets show some numbers for context.
In 2009, total bank deposits in China were RMB64 tr; 60% of those deposits belong to households (rough guesstimate); RMB64 tr * 60% * 5% = RMB 1.9 tr. That represents 5% of GDP.
Of course, households are not only paying to subsidize banks, they pay to subsidize manufacturing investments, real estate investments, infrastructure investment, sterilization bills, PBOC borrowing - investments that have negative NPVs without the subsidy. (Capital misallocation).
Even if banks are insolvent, China can protect itself from illiquidity because the government controls funding and interest rates. In the past, China could grow its way out, despite declining relative consumption (and a rising savings rate and rising trade balance), because of the growing world economy. As long as debt levels in deficit countries could rise to counteract adverse unemployment effects the world (US) has no problem absorbing the trade surpluses.
Things are different now
Unemployment is high in deficit countries. Debt levels are being forced down. China must reduce its dependence on trade and investment by increasing the share of household consumption. Household consumption is dependent on household income, so as/if household income is taxed away by banking costs - it will be impossible for household consumption to surge.
The result is for total GDP to drop sufficiently where household consumption takes on a larger share. Japan is the example of this, where consumption growth declined to 1-2% annually as households were forced to subsidize insolvent institutions through repressed interest rates and undervalued currency. In Japan's case, total economic growth has been less than consumption growth as China rebalances its economy.
Appendix 1
Against - historically, developing countries have not had nominal interest rates equal to nominal GDP. When IR < Nominal GDP, then providers capital get less than their share of growth. In China, households are providers of capital, businesses & govenment are users of capital (they use it for FGF) = transfer of wealth. (Note, is the savings rate an independent variable that forces down interest rates; or is the savings rate a consequence of low interest rates and other policies that "tax" households and "subsidize" production - Think of it this way - policies that tax households and subsidize production forces more production than consumption, which forces up the savings rate).
For - the "sample" of developing countries have closed or sticky capital accounts - which are used to repress currency value to protect trade; these countries also systematically repress interest rates.
On average, nominal IR are 75% of nominal GDP with wide dispersion around the mean.
How to Clean Up a Bank
This post draws heavily on MPettis:
How to Clean Up a Banking Crisis
Reduce accumulation of NPLs by keeping borrowing rates low. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount. By lowering rates, central banks able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers. But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did by repressing deposit rates. Households pay for this in the form of low returns on their savings. (appendix 1 - alternative investment opportunities are also affected when savings rates are held too low).
Direct equity injection, when financed by government borrowing at low (suppressed) interest rates is also passing the cost to savers. If other banks provide the financing, then suppressed lending and suppressed deposit rates have the same effect as above.
Lending Spread - provide the banks a wide spread between lending and deposit rates that allows them to rebuild their capital through profitability. This is a second "tax" on households
(the first is through deposit rates) that subsidizes profitability of the banks.
These three mechanisms are how households and other savers clean up banking problems. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points.
How much does it cost?
How to Clean Up a Banking Crisis
Reduce accumulation of NPLs by keeping borrowing rates low. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount. By lowering rates, central banks able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers. But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did by repressing deposit rates. Households pay for this in the form of low returns on their savings. (appendix 1 - alternative investment opportunities are also affected when savings rates are held too low).
Direct equity injection, when financed by government borrowing at low (suppressed) interest rates is also passing the cost to savers. If other banks provide the financing, then suppressed lending and suppressed deposit rates have the same effect as above.
Lending Spread - provide the banks a wide spread between lending and deposit rates that allows them to rebuild their capital through profitability. This is a second "tax" on households
(the first is through deposit rates) that subsidizes profitability of the banks.
These three mechanisms are how households and other savers clean up banking problems. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points.
How much does it cost?
Tuesday, April 5, 2011
The Way Financial Systems Allocate Capital
This post draws heavily on M. Pettis.
Every financial system is capable of periods of capital misallocation, and this almost always seems to happen during periods of very low interest rates and rapid money expansion, but some financial systems do this more extravagantly than others.
As I see it there are broadly speaking two very different conceptions of the role of a country’s financial systems.
In one, banks act largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Since banks are in the business of taking risk, and since rapid credit expansion is inherently risky, the only way to guarantee financial stability is to extract much or all the risk from the banks and imbed them elsewhere. In practice the only “elsewhere” big enough is the state. In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors. This system generates tremendous growth for underdeveloped economies where economic value is easy to identify. Identifying economic value in developed (particularly with respect to infrastructure) economies is more difficult
In that case these kinds of financial systems inevitably run into the problem of capital misallocation. It doesn’t matter if at one point they do a great job of allocating capital and generating real growth. As long as the same allocation process is maintained, it seems, at some point they begin to overinvest. Perhaps this is because the economic sectors that benefit most from the regulatory, credit and economic subsidies, not surprisingly, become increasingly powerful within the political system and increasingly reluctant to allow the system to change.
The other type of system, in which the problem of systematic capital misallocation is much reduced, is one in which banks decide for themselves the kinds of activities they fund, and their shareholders and depositors bear both the rewards and risks of their capital allocation. These kinds of banking system are much more prone to instability, but they are also much more efficient at allocating capital over the long term. In part this is because there is a fairly robust mechanism for recognizing and liquidating poor investment. In the former system, because risk tends to be socialized, there is no obvious mechanism, besides that of an omniscient and disinterested credit committee, for identifying and correcting misallocation.
The prestige of the Anglo-Saxon model soared in the past two decades precisely because its biggest competitor for prestige, the Japanese banking system, collapsed so spectacularly in the 1990s.
In practice of course there is no pure example of one financial system or the other, but as the statement above suggests it is pretty safe to say that Japan during its growth period, and the countries that copied the Japanese model, are closet to the extreme version of the former. The current Chinese financial system, even more than Japan, is clearly one in which the purpose of the financial system is to act as the state’s fiscal agent and in which banking stability is guaranteed by the state. It is also clearly one in which capital misallocation can become a huge problem.
Every financial system is capable of periods of capital misallocation, and this almost always seems to happen during periods of very low interest rates and rapid money expansion, but some financial systems do this more extravagantly than others.
As I see it there are broadly speaking two very different conceptions of the role of a country’s financial systems.
In one, banks act largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Since banks are in the business of taking risk, and since rapid credit expansion is inherently risky, the only way to guarantee financial stability is to extract much or all the risk from the banks and imbed them elsewhere. In practice the only “elsewhere” big enough is the state. In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors. This system generates tremendous growth for underdeveloped economies where economic value is easy to identify. Identifying economic value in developed (particularly with respect to infrastructure) economies is more difficult
In that case these kinds of financial systems inevitably run into the problem of capital misallocation. It doesn’t matter if at one point they do a great job of allocating capital and generating real growth. As long as the same allocation process is maintained, it seems, at some point they begin to overinvest. Perhaps this is because the economic sectors that benefit most from the regulatory, credit and economic subsidies, not surprisingly, become increasingly powerful within the political system and increasingly reluctant to allow the system to change.
The other type of system, in which the problem of systematic capital misallocation is much reduced, is one in which banks decide for themselves the kinds of activities they fund, and their shareholders and depositors bear both the rewards and risks of their capital allocation. These kinds of banking system are much more prone to instability, but they are also much more efficient at allocating capital over the long term. In part this is because there is a fairly robust mechanism for recognizing and liquidating poor investment. In the former system, because risk tends to be socialized, there is no obvious mechanism, besides that of an omniscient and disinterested credit committee, for identifying and correcting misallocation.
The prestige of the Anglo-Saxon model soared in the past two decades precisely because its biggest competitor for prestige, the Japanese banking system, collapsed so spectacularly in the 1990s.
In practice of course there is no pure example of one financial system or the other, but as the statement above suggests it is pretty safe to say that Japan during its growth period, and the countries that copied the Japanese model, are closet to the extreme version of the former. The current Chinese financial system, even more than Japan, is clearly one in which the purpose of the financial system is to act as the state’s fiscal agent and in which banking stability is guaranteed by the state. It is also clearly one in which capital misallocation can become a huge problem.
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