Michael Pettis — Internal and external balance

Even if you don't read Michael Pettis's post, this one is worthwhile. It is about trade, capital flows, and accounting identities, and what can be learned from them now as well as similar occurrences in economic history. Those even superficially knowledgeable will recognize that this is an issue of sectoral balance with each country's domestic private sector balance, government sector balance and external sector balance summing to zero as an accounting identity. Pettis invites us to look at the consolidated balance sheet of the global economy as closed system in terms of each country's place it in it, and what that implies.

I was recently asked by an Australian economics journal to write a review of a book I had already read, The Leaderless Economy, by Peter Temin and David Vines (published in 2013). Because the book is a great place from which to start a discussion on the links within the global economy, I decided to base this essay on the book. I had already read Peter Temin’s Lessons from the Great Depression (1991), The Roman Market Economy (2012), and Prometheus Unshackled (2013), and I know his work fairly well.

There is substantial overlap between the way Temin and Vines view the global economy and the way I do. I am a regular reader of Diane Coyle’s blog, The Enlightened Economist, in which she reviews books, usually on economics-related topics but also on anything else that might catch her attention. Besides having said very nice things about my book, The Great Rebalancing, and including it in her shortlist of top books for 2013 (I am bragging a little) she has also reviewed The Leaderless Economy, and has noted the similarities in the way both books approach the balance of payments.

She is right. Both books analyze the global economy in pretty much the same way, as an economic system in which any country’s domestic economy is inextricably linked to other economies through the balance of payments mechanisms. The ability to place events within their global context is consequently crucially important in understanding any country’s economic performance, but actually doing so tends more to be the exception than the rule....

The Leaderless Economy makes the same point I try to make in The Great Rebalancing: the economic analysis of any country is largely useless if it ignores, or treats as a minor issue, links with the external sector – i.e. other countries – and this is even more true today than in the past....

In their book Peter Temin and David Vines don’t discuss the US savings rate but they do a lot of the same thing by changing the focus slightly. Whereas in my book I argue that because global savings and global investment must balance, if any country’s savings exceeds its investment by some amount, investment in the rest of the world must exceed savings by exactly the same amount. Temin and Vines express the same relationship between conditions in one country with conditions abroad in a way that can be summarized in two sentences. First, the domestic imbalance in any economy – i.e. high levels of unemployment or demand, large gaps between savings and investment, and so on – must be consistent with and equal to that country’s external imbalance at all times. Second, that country’s external imbalance must be consistent with and equal to the external imbalance of the rest of the world at all times. 

These two statements are basically identical. Any country’s capital account of course is simply the gap between its domestic savings and its domestic investment, and because the capital account must balance the current account (the two always add to zero), to say that the gap between savings and investment in any country must be equal to an opposite gap between savings and investment abroad is simply to restate the far more intuitively familiar claim that every current account surplus in the world must be matched by a current account deficit. Until we begin trading with extra-terrestrials the total must add up to zero.

This should all be obvious, but if an imbalance in one country must be matched by an opposite and equal imbalance abroad, there are only two possible explanations. Either the imbalances in every country are set endogenously, and, by some miracle, at every point in time, they balance out perfectly, or an imbalance in one country can force imbalances onto other countries. The first explanation is obviously absurd, so the gap between the amount a country saves and the amount it invests is as likely to be determined by external conditions as by internal. This is why it is possible to argue that a country’s savings rate (or its unemployment rate, or its investment rate, etc.) is determined by policies abroad as much as by policies at home. This is what it means to live in a “globalized” world....

Pettis reminds that the household analogy applied to other sectors is wrong. It is like based more on moral sentiment than factual reasoning.

Countries that run large and persistent trade deficits, on the other hand, buy more from foreigners than they sell, and because this seems to suggest they are living beyond their means, we usually think of these people, let’s call them grasshoppers, as lacking discipline and prudence. Grasshoppers excite our scorn, even if we sometimes envy their carefree ways and their bohemian morals.

If households that are careful to spend less than they earn, making sure to save part of their earnings, are seen as admirably thrifty, while households that are too quick to pull out their credit cards to buy things they cannot afford are seen as foolish, and will in the end implicitly require that their prudent neighbors bail them out, the same, we assume, should be true of countries. It is unfair that ants have to bail out grasshoppers, and so naturally we tend to abhor policies aimed at favoring grasshoppers over ants, and by extension we also abhor policies that seem to favor trade deficits over trade surpluses.
But countries are not at all like households....

But Pettis is still caught up in his saving-investment analysis and.I think, gets the causality wrong. He misses the simple explanation that if a country runs a current account deficit, like the US or the EZ periphery, then it has to allow net exporting countries to save in its currency and vice versa. If a country wishes to run a trade surplus with another country then it has to save in the currency in order to accommodate it. In the global economy net exports* and net imports** must always sum to zero***.

Where I think the ant colony analogy that Pettis employs in his explanation breaks down is in explanation of motivation as a matter of causality.

So if households [ants in his analogy] consume a declining share of what they produce, either they must increase investment commensurately, so that savings rise and GDP remains the same, or, if investment cannot rise fast enough (in fact in most cases it is likely to fall), unemployment must rise fast enough to keep total savings from exceeding total investment. Of course if they force the demand shortfall onto the rest of the world, they can keep unemployment down by exporting their excess savings and running a current account surplus, the counterpart of which is a current account deficit somewhere else. These are just accounting identities – the internal imbalance between a country’s savings and investment is at all times consistent with and equal to its external imbalance, and a country’s external imbalances is at all times consistent with and equal to the external imbalances of the rest of the world. To understand which country will run the corresponding external imbalance depends on the nature of the institutions through which economic behavior is mediated, and this is why a deep grounding in economic and financial history is so important.

Countries like Germany and China are not net exporters because the German and Chinese peeople desire to save in another currency. Their elites choose to be net exporters and this necessitates saving in the net importers currency or investing in that country, FDI being "real saving" externally. Moreover, while it is correct to say that in aggregate, "countries" do this, that doesn't imply that this is a mutual decision, even in so-called democracies. This is a matter of policy, and that policy benefits interests that play a key role in shaping it.

Pettis admits this toward the end of the post.

...we failed to work through the logic of the balance of payments, to the point where in some countries we actually applaud measures that reduce the share of production allotted to hard-working households on the grounds that their real reward is a higher national trade surplus [that benefits owners of exporting countries and top management that can extract a share, but not ordinary workers].

Pettis also makes another important point.

By showing us how useful history is in understanding current events, the authors also reveal, indirectly, how little value there is in the vast literature of economic theorizing that emerges from the abstract and distorted world of academia, bereft as it is of historical context.

For most economists, history is usually little more than a data sequence whose values are plugged into mathematical models – whose implicit assumptions too often these same economists fail to understand....

Finally, while Pettis is on the right track by taking at accounting-base approach, his explanation would greatly benefit by incorporating either the MMT three sector model or a four sector model that doesn't consolidate the household and firm sectors based on the conventional income-expenditure model based on accounting identity, Y= C + I + G + NX. I think it would be clearer than his present approach.

China Financial Markets
Internal and external balance
Michael Pettis | Professor of Finance at Peking University’s Guanghua School of Management

 * actually current account surplus
**  actually current account deficit
***  equating trade balances with the current accounts for convenience