I was reminded by Michael Pettis’ most recent blog post of the importance of taking into account the global economy as a whole when analysing national economies. That is, an analysis of global flows of income and the balance of payments is vital to an understanding of national economic performance.
An example of this is the accumulation of consumer and mortgage debt in the US in the run up to the beginning of the 2008 financial crisis and subsequent recession. It is quite common to blame US citizens for profligacy or US policymakers for running monetary policy that was too loose (ie interest rates were kept too low in the early 2000s). But this view should be seen as only partially correct if one brings into the analysis economic developments in the rest of the global economy, particularly in China and other countries running current account surpluses over the same period. This is important, since at the level of the global economy as a whole, the current accounts of all countries added together must sum to zero (until we start trading with other planets!). In practice, they do not quite do this, due to measurement errors, but this is a problem of statistics and not of economic reality.
The US would not have been able to run current account deficits if other countries had not run corresponding surpluses. In this sense, China, as the country with one of the largest absolute surpluses during the early to mid-2000s, enabled the US to run deficits by exporting excess savings, in the form of lending, to the latter. China’s large surpluses were a consequence of an excess of domestic savings over investment and an undervalued currency and industrial policy which allowed the rapid growth of manufacturing exports to the rest of the world, thus sustaining the surplus. Corresponding to the latter was a large capital account deficit, that is China exported capital to the rest of the world, including the US. Much of this flow of capital went into US government bonds, which kept long-term US interest rates low and contributed to the accumulation of debt through the impact on other borrowing rates in financial markets.
China was not the only country running current account surpluses during the early 2000s. Oil exporters in the Middle East did the same, due to the relatively high price of oil, alongside some European countries, especially Germany. But China, as a rapidly developing major economy prior to the financial crisis, is the most helpful to analyse and looking at too many countries at once can make things unnecessarily complex.
Capital exports from China and other countries running current account surpluses enabled domestic and foreign US borrowing to rise rapidly, with debt reaching a higher level than it would have otherwise. This accumulation of debt fuelled a housing bubble, helping to create a particular pattern of incentives in the financial markets and among potential home-owners with poor credit ratings, giving rise to the sub-prime fiasco. Subject to these economic forces, US citizens as a whole thus had no choice but to borrow and accumulate debt. The increase in the excess of domestic investment over saving was created through private saving falling and staying low, so that rising debt tended to fuel consumption rather than investment, which ultimately proved unsustainable.
China’s economic structure and pattern of growth therefore had a major impact on the opportunities and constraints facing the US economy and its citizens. One could equally say that borrowing and spending in the US allowed China to run a current account surplus, through sustaining a rising demand for Chinese exports. So the relationship runs in both directions. It is hard to say which set of domestic developments were ultimately responsible for the situation, or which came first. What is important to note is that these developments produced and sustained each other until the crisis broke. Looking ahead, it is also important how these global economic relationships evolve and what policies on both the domestic and international front can resolve the imbalances that accumulated and led to the financial and economic crisis whose aftermath we are still dealing with.
Analysis of the balance of payments is thus vital to an understanding of domestic economic developments in any country open to global flows of trade and investment. Ignoring these global forces can result in a misleading analysis of any particular national economy and the apportioning of blame to citizens, consumers or businesspeople who may have had little choice in the face of such forces. Viewing US consumers as profligate or the Chinese as thrifty is of little help when economic forces much larger than those driven by the morals of individuals are in play. This is not to deny the role of individual responsibility and social morality. But those who peddle economic theory beginning with the isolated individual or even the isolated national economy as a unit of analysis ignore too much in the larger picture and the forces emanating from the behaviour of the economic system as a whole and the interaction of different economies, which includes the impact of government policies. All are important, and none should be neglected.