The Great Rebalancing – whether we like it or not

This is a book that should be read by: (a) politicians, central bankers and anybody else involved in macroeconomic policy; (b) all economists; (c) all students of economics; and (d) everybody else.

The Great Rebalancing: Trade, Conflict and the Perilous Road Ahead for the World Economy by Michael Pettis is as sharp and clear as a cut diamond in its analysis of the continuing global imbalances. The author brings logic, accounting identities and clarity of thought and language to bear on the issue of prospects for the global economy, putting most other commentators into the shade.

He also provides a small but fundamental shift in perspective: the questions of balance of payments and capital flows are approached in terms of global general equilibrium – in other words, everything is connected. Thus Greece’s problems are not only caused by Greek tax avoidance or low productivity, but by German domestic policy choices too. Pettis writes: “I extend our basic knowledge of open economies and apply it to the global economy as a single closed system in order to show the many surprising ways policies and conditions are related.” Every country affects all others through the capital and current accounts. And the balance of payments balance – a large current account surplus requires large capital exports to a large current account deficit (group of) countries. A large gap between domestic savings and investment, or correspondingly between GDP growth and consumption growth, will result in a current account gap.

The book looks at two broad sets of imbalances, US-China and Germany-Eurozone periphery. “Very large persistent surpluses and deficits are almost always the result of distorted policies in one or more countries.” The distortions he identifies are the investment-driven focus of Chinese policy, at the expense of domestic consumers, brought about by ultra-low interest rates on savings in domestic banks (there being no alternative investment opportunities for most Chinese people). In Germany, rather than this Chinese-style direct financial repression, the distortion has been ever since reunification in 1990 constraining wages and consumption growth in order to favour employment and exports, with production growing faster than consumption.

Pettis is keen to point out that to analyse the Euro crisis in terms of thrifty and productive Germans versus idle, spendthrift Spaniards or Greeks is nonsense. The references to culture and morals in trying to explain what has happened in the global economy are misplaced. Given a persisting German savings surplus, perforce exported, the Euro periphery countries have only four options: 1. use German capital exports to fund investment, paid for by debt; 2. let consumer borrowing rise to spend more; 3. devalue or impose trade restrictions – both ruled out by Euro and EU membership; 4. engineer a recession to cut domestic production. When the debt levels required by opting for (1) and (2) got too high, only (4) remained available, as (3) has seemed unthinkable. But the book goes on to argue that unless the Germans will accept that the burden of adjustment must fall on their domestic policy, default and the break-up of the Euro are inevitable. “It is impossible to expect Spain to repay its debt to Germany unless Germany runs a trade deficit and Spain a trade surplus.” The echoes of the 1930s (when France played the role of Germany today, complacent about its economic strength until the strains reached breaking point) are horribly clear.

Pettis is a little more optimistic about the prospect of a policy adjustment in China. A renminbi revaluation would help ordinary households at the expense of the central bank and the very wealthy. Slower GDP growth and lower exports would actually enable faster consumption growth, and would make for greater social stability. Combined with a slow but effective rebalancing of US policy, this part of the global imbalance could be worked out in a reasonably orderly way.

However, the book ends with some gloomy predictions. Pettis concludes that there has been hardly any adjustment, post-crisis, in the global economy. Unless Germany and China, as well as the US and Euro periphery, adjust their policies, then:

– German growth will slow sharply and its banks will suffer large losses

– much of peripheral Europe will both default and abandon the Euro

– China could adjust still but is running out of time, and unless it writes down bad bank debts and transfers some state and corporate wealth to households it will end up with a ‘lost decade’

– the world economy will be weak for many years

– trade tensions will increase

– but, one way or another, the world economy will rebalance.

“Major imbalances are unsustainable and will always eventually reverse, but there are worse ways and better ways they can do so…..Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained.”  Unfortunately, he ends, that isn’t what’s happening.

There is one idea buried away here that seems to me to hold out a spark of hope. Given that the persistent surplus countries seem determined not to reverse their anti-consumptionist policies, and to continue running current account surpluses, it is inevitable that something will erode the value of the Euro periphery assets held by German banks – default, devaluation, inflation in the periphery. Alternatively, Germany could grant assets to the struggling countries – something akin to the Marshall Plan, Pettis suggests. Given the deeply-held worldview Germans clearly hold about the superiority of their approach to the economy, maybe the idea of a Marshall Plan to save the Euro is the one idea that could catch on there?

It will be obvious that I think this is an excellent book, albeit very gloomy indeed. Its logic seems irrefutable: the unsustainable is not sustained. The only question is how the global rebalancing will come about, and it doesn’t look a pretty prospect.

I’d not come across Michael Pettis before, but looking him up now find that his previous book, The Volatility Machine, analysing emerging market financial crises, also attracted rave reviews. He was previously at Bear Stearns and Columbia University and is now a professor at Peking University – he blogs on China’s economy. His work obviously deserves to be widely read and above all, please, in policy circles.

The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy