Ramanan — On The Blogs

Ramanan takes Roger Farmer and Michael Pettis to task.

The Case for Concerted Action
On The Blogs

V. Ramanan

Brian Romanchuk — Output Gaps And MMT

A commenter on my blog drew the article "Thin Air’s money isn’t created out of thin air," (by Michael Pettis) to my attention. It refers to output gaps, which appears related to my recent article on output gaps. In his article, he makes some statements about Modern Monetary Theory (MMT). Although I would put myself in the MMT camp, I would note that I cannot write on behalf of an official MMT line; I disagree on a few points, and it is unclear what the MMT position is on some topics.

Pettis' article is quite long and contains a great deal of content. Although I find myself in agreement with much of what he says, he packs in so many theoretical asides that I cannot hope to summarise them. As a result, I am not attempting to respond to his underlying thesis. Instead, I just want to highlight some hidden assumptions around output gaps.

What Does MMT Say?

My reading is that "MMT says" that involuntary unemployment, that is, unemployment in excess of transitional, estimated to be about 2%, is evidence of an "output gap" defined as idle resources that could be put to use. The assumption is that there is enough potential work and enough other resources to perform the extra work in order to eliminate involuntary unemployment by creating a job offer for all those willing and able to work and supporting those unable to work with transfer payments. The constraint is demand side inflation, which can be addressed by functional finance and a price anchor, that is, the JG wage paid for an hour of unskilled labor.

No need for economic models to determine the output gap, which is an unobservable theoretical construct. Instead "look at the length of the unemployment line."

That leaves measuring inflation. One way to do that is to observe the size of the JP pool. If there is no one in it, then wage pressure has risen.

Admittedly, this is a simplified conceptual model. But it conveys the point that government as currency issuer can always "afford" to employ available resources by purchasing any resources in excess of what the private sector is willing to purchase and which would otherwise be idle. The government can also address the price level using its power as the currency monopolist as well.

Under the concept of popular sovereignty, state sovereignty rests with the people acting through the representatives they choose, who are commissioned to act for public purpose rather than for private gain by interests. Under this framework, the people can expect that the government will be guided by the welfare state as a model that emphasizes the general welfare and common good, rather by a market state model that privileges interests and private gain.

Under a welfare state model in which the government as currency issuer can put all available resources to use continuously, full employment (excluding transitional) becomes a civil right.

Bond Economics
Output Gaps And MMT
Brian Romanchuk

Andrew Lainton — ‘Thin Air’ and Economic Causality

Michael Pettis has a a long and interesting post which is effectively a critique of Steve Keen.

Decisions, Decisions, Decisions
‘Thin Air’ and Economic Causality
Andrew Lainton

David Glasner — Keynes and Accounting Identities

In principle, I have no problem with such a use of accounting identities. There’s nothing wrong with pointing out the logical inconsistency between wanting Germany to pay reparations and being unwilling to accept payment in anything but gold. Using an accounting identity in this way is akin to using the law of conservation of energy to point out that perpetual motion is impossible. However, essentially the same argument could be made using an equilibrium condition for the balance of payments instead of an identity. The difference is that the accounting identity tells you nothing about how the system evolves over time. For that you need a behavioral theory that explains how the system adjusts when the equilibrium conditions are not satisfied. Accounting identities and conservation laws don’t give you any information about how the system adjusts when it is out of equilibrium. So as Pettis goes on to elaborate on Keynes’s analysis of the reparations issue, one or more behavioral theories must be tacitly called upon to explain how the international system would adjust to a balance-of-payments disequilibrium.…

Uneasy Money
Keynes and Accounting Identities
David Glasner

Anthony Kuhn — As China Cracks Down On Cultural Fringe, Indie Rock Finds A Home In Beijing [Michael Pettis]

"Some guys have sports cars I have this."

That's how Michael Pettis, an American economist based in Beijing, has always explained his rather extravagant hobby: running his very own corner of the Chinese music scene via his record label, Maybe Mars, and a couple of gritty rock dives.

As a label- and club-owner, Pettis has been key in curating a specific, traditionally American sound aligned with his own background in the noisy, avant-garde, punk-aligned no wave scene of 1980s New York. He's assembled a stable of Chinese bands similar in sound to American and British groups from that era, like Sonic Youth, Television and The Fall.

Pettis's dual identity started while he was in business school and, later, working as an investment banker. He ran a rock club in lower Manhattan, at the same time that bands like Blondie, Talking Heads and the Ramones were rocking CBGB on the Bowery. 

"When I was in New York, I wanted to hang out with all these amazing musicians that I really admired," Pettis says. "But I wasn't cool enough. So I figured, well, if I create a club and they all play there, then I get to hang out with them."

The same idea led Pettis to delve into Beijing's underground music scene, which runs the gamut from hip-hop to grunge to noise. Four years after arriving in China in 2002, Pettis opened a rock club called D-22. In 2012, he started an experimental music venue called XP. Most nights, when he wasn't busy working, Pettis spent much of his time behind the bar at one of the two clubs, wearing flannel and sensible sandals and offering a bit of levity as he soaked in the latest sounds.…

Rock on.

GPB News
As China Cracks Down On Cultural Fringe, Indie Rock Finds A Home In Beijing
Anthony Kuhn

Bloomberg — Meet the Economic Expert who says Punk-Rock Is a Bullish Sign for China

The double life of Michael Pettis.

Pettis has been bearish on China for going on then years. It's getting old in the tooth. But it looks like he is doing OK for a culture entrepreneur.

Bloomberg
Meet the Economic Expert who says Punk-Rock Is a Bullish Sign for China

Michael Pettis — “…not with a bang but a whimper”

Doug Pancoast, an American entrepreneur living in Shanghai, asked to interview me for his blog, and I agreed to do so. I think it was meant to be a brief interview, but I began to respond on a Saturday evening, while waiting for the performance at my club to begin (my office is at my CD label, just upstairs from my music club), and as the performance started late and the questions were interesting and covered a lot of ground, I ended up writing quite a lot. 

I thought I might reproduce the interview on my blog, not so much for the interview itself, which you can anyway find elsewhere, but because I decided that I could significantly add to the responses (they are twice as long as the original interview) with a lot of examples and with historical material that I find very interesting, both of which I think many regular readers of my blog do too.

I linked to the original interview yesterday.

China Financial Markets
“…not with a bang but a whimper”
Michael Pettis | Professor of Finance at Peking University’s Guanghua School of Management

Doug Pancoast — Special interview with Michael Pettis

"ControversialTruths.com" is truly honored that Michael Pettis agreed to do an interview with our site. Michael Pettis, as many of our readers already know, is a finance professor at Beijing University (commonly referred to as "China's Harvard"). On his site, he mentions his experience as a "Wall Street veteran, merchant banker, equities trader, economist, finance professor, (and) entrepreneur." I've read two of his most recent books The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy and Avoiding the Fall: China's Economic Restructuring and I personally guarantee you that Michael Pettis is a leading thinker when it comes to both the Chinese economy and the overall global balance of trade. He's one-of-a-kind individual who throughout his books is passionate about trying to judge things fairly...and not see economic issues from a single country's perspective or from a single ideological framework. When he speaks, you know you should listen because you're going to get information that is not only based on decades of experience both in the private sector and academia, but you're getting it from a person who seems to have absolutely no biases whatsoever. Michael Pettis is a diamond and we're so thankful he took so much time to answer our questions. Here is a transcript of the interview. Both the questions and the answers are here in their entirety.

Controversial Truths
Special interview with Michael Pettis
Doug Pancoast

Michael Pettis — Monetary policy under financial repression

In order to understand much of what is happening in China I believe it is crucially important to understand how financial systems operate under condition of financial repression. Because most of what we know about economics is derived from economists whose operating environment is the classical “anglo-saxon” economies (I stress “classical” because for much of the 19th Century, operating under the so-called “American System”, the US itself was not, in my opinion, a classic anglo-saxon economy), there is a tendency to assume that what happens in those economies is somehow the default position in economics, and this not only causes us to underrate important economists that don’t follow this tradition, like the German Freidrich List or the American Albert O. Hirschman, but it also leads us into mistaken assumptions, like the belief that higher interest rates lead automatically to higher savings rates.

We do know some things about financial repression. Two of the first important texts to discuss financial repression comprehensively are Edward S. Shaw,Financial Deepening in Economic Development and Ronald I. McKinnon,Money and Capital in Economic Development. There is, however, a lot more to it than what is generally known, and even this is largely ignored by most economists. It seems to me that many of the mistakes we make when we think about the relationship between cause and effect, for example the impact of monetary policy on China’s economy, arise because we assume that relationships that hold in the US economy are universal and must hold in the Chinese economy too. So to return to the assumption that higher interest rates must lead to higher savings rates, I would argue that this is true mainly under two unstated assumptions, neither of which holds for China.

China Financial Markets
Monetary policy under financial repression
Michael Pettis | Professor of Finance at Peking University's Guanghua School of Management

Ron Rimkus — Michael Pettis On China: Too Much Credit Not Just A Problem For Shadow Banking System

To help shed some light on recent developments in China, we'll be asking several in-country experts to share their views. For our first installment, we turned to Michael Pettis, senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University's Guanghua School of Management. Pettis may be known as a China bear, but he has said that he prefers to be characterized as a "China skeptic." Last year, he predicted that the growth rate in investment in China would collapse.

Seeking Alpha
Michael Pettis On China: Too Much Credit Not Just A Problem For Shadow Banking System
Ron Rimkus, CFA

Matias Vernengo — Michael Pettis on the Chinese Growth Model

Matias looks at China somewhat differently than Pettis does.

Naked Keynesianism
Michael Pettis on the Chinese Growth Model
Matias Vernengo | Associate Professor of Economics, University of Utah

Michael Pettis parses Chinese debt

Michael Pettis looks at China and debt

Read it at China Financial Markets
Building debt
by Michael Pettis

Quality of debt matters as quantity increases.

Michael Pettis on understanding global trade in terms of current and capital account balances

Europe’s underlying problem is not budget deficits or even unsustainable debt.  These are mainly symptoms.  The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral countries have diverged by anywhere from 20% to 40%.  This divergence has made the latter uncompetitive and has resulted in the massive trade imbalances within Europe.

Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances.  While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs.  Of course if they don’t resolve this problem, the problem will be resolved for them in the form of a break-up of the euro.

The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus....

Read the rest at China Financial Markets
If no trade reversal now, then when?

by Michael Pettis

Krugman on 2012 — Will China Break?

Now the bubble is visibly bursting. How much damage will it do to the Chinese economy — and the world?

Some commentators say not to worry, that China has strong, smart leaders who will do whatever is necessary to cope with a downturn. Implied though not often stated is the thought that China can do what it takes because it doesn’t have to worry about democratic niceties.

To me, however, these sound like famous last words. After all, I remember very well getting similar assurances about Japan in the 1980s, where the brilliant bureaucrats at the Ministry of Finance supposedly had everything under control. And later, there were assurances that America would never, ever, repeat the mistakes that led to Japan’s lost decade — when we are, in reality, doing even worse than Japan did.

Read it at The New York Times

Will China Break?

by Paul Krugman

Could Krugman be right that we've seen this before?

I hope that I’m being needlessly alarmist here. But it’s impossible not to be worried: China’s story just sounds too much like the crack-ups we’ve already seen elsewhere. And a world economy already suffering from the mess in Europe really, really doesn’t need a new epicenter of crisis.

See also Michael Pettis on capital misallocation in China (Dec. 3) if you missed it.

Read it at China Financial Markets
How do we know that China is overinvesting?
by Michael Pettis

UPDATE: Don't overlook Dr. Doom on this either.

Read it at Project Syndicate
China’s Bad Growth Bet
by Nouriel Roubini

However, Roubini doesn't see a hard landing hitting until 2013.

Roubini tweets: "Paul Krugman asking 'Will China Break?' Consistent with what RGE/I have been writing for a year on hard landing risks."

Michael Pettis on euro failure

Pettis concludes what I have suggested from the beginning of the crisis — Germany need to leave the EZ and go back to the DM, and political realities will force it to do so. This would save the euro, and then after the crisis is in the past, the EZ could be reconsidered. Otherwise, the asymmetry is too great for a workable solution, and there is no political will to take on the powerful financial industry that is largely responsible for the crisis.

Read the whole post at China Financial Markets, The euro once again

Pettis — "An Exorbitant Burden"

Why keeping the dollar as the world's reserve currency is a massive drag on the struggling U.S. economy.

Michael Pettis has a new piece in Foreign Policy, An Exorbitant Burden

Michael Pettis — Some predictions for the rest of the decade

Michael Pettis is somewhat pessimistic and foresees continued stagnation and deflationary tendencies in his crystal ball.

To summarize, my predictions are:

• BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.

• Over the next two years Chinese household consumption will continue declining as a share of GDP.

• Chinese debt levels will continue to rise quickly over the rest of this year and next.

• Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.

• Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.

• If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.

• Much slower growth in China will not lead to social unrest if China meaningfully rebalances.

• Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.

• European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.

• Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.

• Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.

• Trade protection sentiment in the US will rise inexorably and unemployment stays high for a few more years.

Read it all at his blog, China Financial Markets, Some predictions for the rest of the decade

Michael Pettis explains why China will continue to hold US tsys, again

It sounds like this time the PBoC might be pretty serious about diversifying their risk away from USG bonds, right? Let’s leave aside the fact that every six months we have heard the same thing for the past several years, and nothing has happened, shouldn’t we nonetheless be worried? Won’t reduced PBoC purchases be hugely disruptive to the US economy and to the US Treasury markets?

No, they won’t. There is so much nonsense still being said about this, even by economist[s] who should know better, that I thought I would try to address what it would mean if the PBoC were actually serious and not simply making noises aimed at domestic political constituents.

First of all, remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy.

You cannot run a current account surplus unless you are also a net exporter of capital, and since the rest of China is actually a net importer of capital, the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, the PBoC must be willing to purchase as many dollars as the market offers at the price it sets. It pays for those dollars in RMB.

It is able to do so by borrowing RMB in the domestic markets, or by forcing banks to put up minimum reserves on deposit. What does the PBoC do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and – and this is the crucial point – whose economy is willing and able to run a large enough trade deficit.

Remember that when Country A exports huge amounts of money to Country B, Country A must run a current account surplus and Country B must run the corresponding current account deficit. In practice, only the US fulfills those two requirements – large financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds.

Read the full post, Foreign capital, go home!

Michael Pettis on Debt in China

The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.

When is an increase in debt unsustainable?

As I see it there are three things that make increases in debt unsustainable. The first, obviously, is borrowing for consumption. This is what happened in the US and in the peripheral countries of Europe until the 2007-08 crisis, and it is pretty clear that this kind of borrowing cannot go on forever. Why not? Simply because with consumer financing the value of liabilities rises more quickly than the value of assets, and this cannot go on forever unless the borrower has an infinite amount of excess assets….

The second way we can experience an unsustainable increase in debt is when borrowing is used to fund investment that is misallocated or wasted. Whenever the value of liabilities rises more quickly than the value of assets, the increase in debt is by definition unsustainable unless, of course, the borrower has an unlimited amount of excess assets….

The third kind of unsustainable debt increase is caused by a sudden explosion in contingent liabilities. When balance sheets are structured in risky or mismatched ways, an unexpected change in circumstances can cause a sharp change in the relationship between the values of assets and liabilities, and so result in a net surge in indebtedness….

It is important to remember this when thinking about financing risks in China. We often hear analysts argue that because China has little consumer financing and because mortgage margins are high, they don’t have a debt problem. This argument is about as useless as the claim that because China has large reserves it is unlikely to have a financial problem. The limited consumer and mortgage financing in China means that china will not have a US-style financing problem, and the large amount of reserves means that China won’t have a Korean-style financing problem, but no one has ever seriously argued that those are the kinds of risks China faces. What matters is the level of debt, whether or not its growth is sustainable, and the kinds of contingent structures that are embedded. I would argue that all three measures are worrying.

Pettis provides the rationale and data in Incentives and debt

Michael Pettis on RMB "Appreciation" and Rebalancing

Many people have been arguing that the RMB has been appreciating againt the dollar and that rebalancing has begun. Michael Pettis says, in nominal terms, yes, but in real terms, not so much.

So what does it all mean? Just this: the claim that one of the key components of rebalancing – an appreciating currency – has been occurring may be vastly overstated or even simply wrong. There has been little or no real appreciation of the RMB and there may actually have been some depreciation....

Moreover, not only currency appreciation is involved in the rebalancing equation. There are also real versus nominal interest rates and wage growth, as well as productivity.

There are some interesting implications of this constellation of adjustment processes that are worth examining. To summarize, there are three important causes of the consumption imbalances that are plaguing long-term growth prospects in the Chinese economy. One of these, the undervalued exchange rate, hasn’t changed much in the past year and so has not contributed to rebalancing. The second, excessively low [real] interest rates, has gotten significantly worse in the past year and so has exacerbated the imbalances. The third, lagging wage growth, has gotten much better and so has contributed to Chinese rebalancing.

What is the net effect of the three processed? Unfortunately there is no real way of comparing the impact of each variable, and so there is no real way of judging the net effect. All we can do is look at household consumption and its relationship to GDP growth, and infer the net impact from that.

If the World Bank analysis is correct, and if household consumption growth has been slowing, it suggests that because the imbalances are getting worse, not better, the adverse impact of declining real interest rates may be greater than the positive impact of rising wages. Or it may suggest that there is a lag in the impact and we will just have to wait out the end of 2011 before we can determine what has really happened....

Factoring all this, Pettis concludes:

China isn’t yet rebalancing. The way that its growth model works suggests that it cannot happen except with a sharp contraction in investment growth, something we are not seeing, and the empirical evidence so far seems to support the theory. It will probably take a couple of years of this kind of unbalanced growth before this point is more widely recognized, but I suspect that another year or two of stagnant consumption as a share of GDP is finally going to convince policymakers. Until then, expect more of the same, and with it rapidly rising debt levels.

Read his entire analysis at China Financial Markets, Rebalancing through Wage Increases. This is an excellent summary of what is likely happening in China now, in spite of what you may be hearing.