Investment-savings, global imbalances and crisis: the economics of Michael Pettis

the-great-rebalancing-coverI have been greatly inspired by economist Michael Pettis, who blogs here. His work on the causes of the Great Recession, the eurozone crisis and, especially, Chinese development, seems to me to be both original and revelatory. In what follows I will outline the basic elements of his insightful theory of the global economy.

Pettis’ work draws on the ideas of Keynes, Minsky and many others, and incorporates lessons from economic history and political economy, which makes its scope broad and widely applicable.

At the heart of his theory are some accounting identities which are basic to international macroeconomics.

To begin with, for any economy, the current account surplus is equal to the excess of domestic savings over domestic investment. To put it another way, net domestic savings (gross savings minus gross investment, whether private or public) is equal to foreign borrowing, or domestic lending abroad.

The three balances

In standard notation: (S-I) + (T-G) = CAB where S is private sector (firms and households) savings, I is private sector investment, T is taxation or government income, G is government spending, and CAB is the current account balance (exports minus imports plus net income from foreign investment).

S-I is the private sector surplus, net private saving or the excess of private income over private expenditure.

T-G is the public sector surplus, net public saving or the excess of government income over expenditure.

One could describe the above identity by saying that the private sector surplus plus the government budget surplus is equal to the foreign deficit in the rest of the world economy. These three ‘financial balances‘ can be found in the work of the late post-Keynesian economist Wynne Godley who, working very much against the mainstream tide, had a remarkable track record of using his evolving ‘stock-flow consistent’ model to predict a number of recessions in the UK and US over several decades, most famously the Great Recession of 2008-9.

The equality of net national savings with the current account surplus is an identity and does not imply any particular economic behaviour, although it does impose constraints on what can and cannot be said theoretically.

The balance of payments

For any economy, the current account and the capital account must balance. Thus if an economy is running a current account surplus with the rest of the world, it must also be running a capital account surplus, ie exporting capital or lending abroad. If it runs a current account deficit, it must also be running a capital account deficit, ie importing capital or borrowing from abroad.

A nation’s current account and its capital account are the two major components of its international balance of payments which, to repeat, must balance and therefore sum to zero.

The sum of all the current account surpluses and deficits in the world economy must also sum to zero. Typically they do not quite do so, but this is due to problems with measurement.

Pettis describes the world economy as a closed system. In economic terms it does not trade with any other systems. The individual economies of which it is composed are ‘open’ to flows of trade and investment. Economic change in one part of the system (eg a country) affects the other parts and vice versa.

For the world economy total investment is always equal to total saving. For individual economies, this is typically not so and one will be in excess of the other.

Another identity used by Pettis is that, for an economy, total production, or GDP, is equal to consumption plus saving. Everything that a country produces must be either consumed or saved. So GDP = C + T + S where C is consumption, T is taxation or government income and S is private savings.

National character or economics?

An implication of all this is that for any economy, imbalances between domestic savings and investment are only partly determined by domestic policy in that economy, and even less so by national ‘character’ (thriftiness or profligacy). They are also determined by policies abroad. So, to take the run-up to the eurozone crisis as an example, the German current account surplus and the corresponding deficits of Spain and other peripheral nations were not down to the greater thriftiness of German households or the profligate ways of the Spanish. Rather, these behaviours were the outcomes of larger economic forces, policies and institutions, in Germany and Spain and in the eurozone as a whole.

Thus Pettis uses the identities above to describe how the global imbalances which produced the Great Recession had their origin in domestic imbalances in particular countries, as a result of specific economic trends, policies and institutions.

Excess savings and the Great Recession

He puts the main cause of the Great Recession down to excessive savings in countries such as China, Germany and Japan, due to policies and institutions which repressed the growth of household income and thus consumption relative to GDP, and therefore raised national savings relative to investment. In a closed economy, excess savings would lead to recession, as weakening consumption reduces investment opportunities. In an open economy there is an alternative to this: the savings can be exported abroad, lent via the financial system to economies in the rest of the world.

These capital exports were typically invested in the US, UK and peripheral Europe and funded these countries’ current account deficits.

The potential outcomes of a savings glut

As already mentioned, global savings always equals global investment. If a particular country has excess savings (which is sometimes called a ‘savings glut’) due to repressed consumption, which is weakening the demand for investment (the potential destination for those domestic savings), these excess savings can lead to any one of three outcomes in the world economy: higher productive investment; a higher debt burden; or higher unemployment.

If the rest of the world suffers from a shortage of savings and abundant productive investment opportunities, then savings can be exported abroad and can find their way into productive investment, which will raise output.

If there is not a shortage of savings in the rest of the world, the surplus may flow into speculative and unproductive investment, either at home or abroad, potentially causing asset price bubbles in housing, stocks etc. This can increase consumption and reduce saving via a wealth effect, as the higher asset prices make owners feel wealthier, inducing them to run down savings or borrow to fund consumption. Since the investment is unproductive, this will lead to a higher debt burden, which will force a deleveraging process when the bubble bursts, as firms and/or households attempt to pay down debt in order to repair their balance sheets.

Finally, if the excess savings in the original country do not find an outlet in greater productive or unproductive investment, at home or abroad, then the weakened consumption will reduce demand, growth will slow, and unemployment will rise.

Explaining the savings glut

Pettis offers two explanations for the global savings glut: higher inequality, and a decline in the household share of GDP.

Higher inequality leads to a greater concentration of income and wealth in the hands of those with a higher propensity to save. Poorer households typically spend a greater proportion of their income than richer ones. A trend towards higher inequalities of income and wealth in many nations has been well documented in recent decades.

A decline in the household share of GDP was evident in China and Germany prior to the crisis. In Germany, policies which repressed wage growth relative to productivity during the 2000s increased corporate profits, but due to the resulting weaker consumption growth which reduced investment opportunities, business savings rose relative to investment, and this corporate financial surplus was exported abroad by German banks to peripheral Europe, the US and the UK, financing unproductive investment in the form of debt-fueled asset-price bubbles and higher consumption. This higher consumption was in part spent on German exports, which sustained the latter’s current account surplus.

When these bubbles burst, net savings rose dramatically in the periphery, as in much of the world, as the private sector began to deleverage. It was this process that created a collapse in demand, a deep recession and the explosion in government budget deficits which led to the sovereign debt crisis.

The Great Recession may have been triggered by the sub-prime debacle, but this was not the deeper cause of the crisis. As Pettis notes, this had its origin in domestic policies which gave rise to global imbalances in trade and investment and excess savings in the current account surplus nations.

As always, I welcome any constructive feedback on this post. A test of whether one has understood an idea is if one can teach it successfully to someone else. Some of the above may not be clear to all my readers, but I am convinced that Pettis is on the right track with his economics. I hope it will be reasonably clear to you. I will be exploring more of his ideas in future posts.

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