Michael Pettis at China Financial Markets gets to the heart of the trade imbalance issue in his email update today: “The Trade Imbalance Dilemma and Soaring Chinese Debt“.
Over the past two years we have become pretty used to the spectacle of Chinese government officials warning the US about its responsibility to maintain the value of the huge amount of US treasury bonds the PBoC has accumulated. More recently we have been hearing complaints in Germany about the possibility that defaults in peripheral Europe will lead to losses among the many German banks that hold Greek, Portuguese, Irish, Spanish and other European government obligations.
In both cases (and many others) there seems to be an aggrieved sense on the part of creditors that after providing so much helpful funding to undisciplined debtors, the creditors are going to be left with losses. There is, they claim, something terribly unfair about the whole thing. To me this whole argument is pretty surreal. Not only have the creditors totally mixed up the causality of the process, and confused discretionary foreign lending with domestic employment policies, but an erosion in the value of the liabilities owed to them is an almost certain consequence of their own continuing domestic policies. It is largely policies in the creditor countries, in other words, that will determine whether or not the value of those obligations must erode in real terms.
Take the US-China case, for example. The US has been arguing for years that China had to raise the value of the currency sharply in order to rebalance the global economy and bring down China’s current account surplus and, with it, the US deficit.
China responded that it could not do so without causing tremendous damage to its economy and that anyway the problem lay with the US propensity to consume. For that reason China continued to accumulate US dollar assets. As it bought US government bonds it was able to generate higher domestic employment by running large trade surpluses, with corresponding deficits in the US.
Likewise with Germany. The strength of the German economy in recent years has largely to do with its export success. But for Germany to run a large current account surplus – the consequence I would argue of domestic policies aimed at suppressing consumption and subsidizing production – Spain and the other peripheral countries of Europe had to run large current account deficits. If they didn’t, the euro would have undoubtedly surged, and with it Germany’s export performance would have collapsed. Very low interest rates in the euro area (set largely by Germany) ensured that the peripheral countries would, indeed, run large trade deficits.
Trade Imbalances Lead to Debt Imbalances
The funding by German banks of peripheral European borrowing, in other words, was a necessary part of deal, arrived at willingly or unwillingly, leading both to Germany’s export success and to the debt problems of the deficit countries. If the latter behaved foolishly, they could not have done so without equally foolish behavior by Germany, and now both sets of countries – surplus countries and deficit countries – should have do deal jointly with the debt problem.
As long as Germany runs current account surpluses for many years and Spain the corresponding deficits, it is by definition true there must have been net capital flows from Germany to Spain as Germany bought Spanish assets (which includes debt obligations) to balance the current account imbalances. The capital and current accounts for any country, and for the world as a whole, must balance to zero.
In the old days of specie currency – gold and silver – this meant that specie would have flowed from Spain to Germany as the counterbalancing entry, and of course this flow created its own resolution. Less gold and silver in Spain relative to the size of its economy was deflationary in Spain and more gold and silver in Germany was inflationary there – until the point where the real exchange rate between the two countries had adjusted sufficiently because of changes in domestic prices to reverse the trade imbalances.
The Current Account Dilemma
In today’s world things are different. There is no adjustment mechanism – specie flow or imperialism – that permits or prevents persistent current account imbalances.
This means that if Germany runs persistent trade surpluses with Spain, there are only three possible outcomes. First, Spain can borrow forever to finance the deficit (of which the ability to sell off national assets is a subset). This may seem like an absurd claim – no country has an unlimited borrowing capacity – but it is not quite absurd. If Germany is very small – say the size of Sri Lanka – or if Germany runs a very small trade surplus, for all practical purposes we can treat the borrowing capacity of Spain as unlimited as long as the growth in debt is more or less in line with Spain’s GDP growth. However if Germany is a large country or runs large surpluses, this clearly is not a possible outcome.
That leaves the other two outcomes. First, once Spanish debt levels become worryingly large Germany and Spain can reverse the policies that led to the large trade imbalances. In that case Germany will begin to run a current account deficit and Spain a current account surplus. In this way German capital flows to Spain can be reversed as Spain pays down those claims with its own current account surplus. Neither side loses.
Second, Spain can take steps to erode the value of those claims in real terms. It can do this by devaluing its currency, by inflating away the value of its external debt, by defaulting on its debt and repaying only a fraction of its original value, by expropriating German assets, or by a combination of these steps.
Why must those claims be eroded? Because Spain does not have unlimited borrowing capacity (and presumably does not want to give away an unlimited amount of domestic assets). If Spain’s current account deficit is large enough, in other words, its debt must grow at an unsustainable pace and so it must eventually default (this, by the way, is a variation on the famous Triffin Dilemma). The only way to avoid default is to erode the real value of the debt, and ultimately these are variations on the same thing – Germany will get back in real terms less than it gave.
Without unlimited borrowing capacity these are the only two options, and once the market decides debt levels are too high, a decision must be made. Either Germany must accept a reversal of the current account imbalances or it must accept an erosion in the value of the Spanish assets it owns as a consequence of the current account imbalances. This is the important point. Once you have excluded infinite borrowing capacity there are arithmetically no other options.
It is pretty clear that the countries of the world represented in my example by Germany (Germany, China, Japan, etc.) are doing everything possible to resist the first option. They are not taking the necessary steps to reverse their anti-consumptionist policies and plan to continue running current account surpluses for many more years. Even Japan, for example, a country that has abandoned its old growth model and has finally been adjusting domestically for nearly two decades has been unable, or has refused, to take the necessary steps to reverse its current account surplus.
In that case some mechanism or the other must erode the value of the Spanish assets the German banks have accumulated. Either Spain must devalue, or if must inflate away the real value of the debt, or it must default, or it must appropriate German assets – perhaps in the form of a large German gift to Spain.
Given the limits, especially debt limits, it is irrational for anyone to expect that Germany can continue to run large current account surpluses while Spain does nothing to erode the value of Spanish assets held by Germans. This is an impossible combination. We must have either one or the other. I suspect that Germany is hoping and arguing that Spain can somehow reverse its current account deficit without the need for Germany to undermine current account surplus. But this won’t work.
China, for example, implicitly makes the same argument when it demands that the US raise its savings rate while China avoids making the necessary domestic adjustments, including to the currency. But of course this means nothing more than that some other country must replace the US as the current account deficit country of last resort. This obviously cannot solve the underlying problem. It simply pushes off the imbalance onto another country, and ultimately with the same dire consequences.
8-Point Plan Proposed, 9th Key Point Missing
In response to Bill Gross’ Fatally Flawed Plan to Fix the Education System and the Fractured U.S. Job Market; Mish’s 8-Point Alternative Plan I received a nice email from Hugo Salinas Price informing me that I left off a key point in my 8-point plan.
I see your 8-point plan for jobs and education. However, you forgot to mention the fundamental problem that has created trade and jobs imbalances.
Since dollars became a “means of settlement of debt” in 1971, and gold was eliminated from the international monetary system, the tendering of dollars as settlement of international trade balances allowed first Japan, and now all Asia and China in particular, to flood the US and the rest of the world with cheap goods. Meanwhile, China buys much less from both the US and the rest of the world.
This is what has destroyed jobs in the US, and will continue to do so.
With best regards
Gold’s Honest Discipline
I did indeed fail to mention the consequences of Nixon closing the gold window as the cause of all sorts of global imbalances.
However, I have discussed that concept on many occasions, even as early as 2005, shortly after I first started my blog.
Please consider Gold’s Honest Discipline
I just finished reading a copy of a book entitled “The Monetary Elite vs. Gold’s Honest Discipline” by Vincent R. LoCascio.
LoCascio makes a compelling case that although it’s possible to maintain the integrity of money in a fiat system, historically only the discipline of a gold standard has succeeded in preventing massive abuses by the monetary elite.
Of course the above should be painfully obvious to everyone by now, but unfortunately it is not.
I offer as proof Ron Paul’s final debate with Greenspan before the House Financial Affairs Committee, July 20, 2005. ….
I invite you to finish reading that post and also to pick up a copy of LoCascio’s book.
Gold Standard is Generator and Protector of Jobs
Hugo Salinas Price writes The Gold Standard: Generator and Protector of Jobs
The abandonment of the gold standard in 1971 is closely tied to the massive unemployment the industrialized world has suffered in recent years; Mexico, even with a lower level of industrialization than the developed countries, has also lost jobs due to the closing of industries; in recent years, the creation of new jobs in productive activities has been anemic at best.
In this article we discuss the relationship between loss of the gold standard and the present financial chaos, which is accompanied by severe “structural imbalances” between the historically dominant industrial powers and their new rivals in Asia.
In the early months of 1971, Henry Hazlitt, a solid classical economist, predicted that the dollar would have to be devalued; he said it would be necessary to increase the number of dollars that would be needed to obtain an ounce of gold from the United States Treasury.
What Henry Hazlitt never imagined was that instead of devaluing the currency – the recommendation of Paul Samuelson, Nobel Prize Winner in Economics, published the week before August 15, 1971 – President Nixon took the advice of Milton Friedman and declared that from that time forward the US would no longer redeem dollars held by the world’s central banks at any price. The US unilaterally violated the terms of Bretton Woods. In effect, it was actually financial bankruptcy.
Since then, all world trade – or most of it, as the euro, the pound sterling, and to a lesser extent the yen all compete with the dollar – is conducted using dollars that are nothing more than fiat money, fake money. Because all the world’s other currencies were bound to gold through the dollar, the immediate consequence was that simultaneously they also became fiat money, fake money with no backing.
Consequences of abandoning the gold standard
The consequences of that fateful day have overthrown all order and harmony in economic relations among the nations of the world, while facilitating and expediting the global expansion of credit because part of the dollars exported by the US ended up in the reserves of Central Banks around the world.
As the loss of gold ceased to be a limiting factor, the last restrictions on the expansion of credit were stripped away. A heavy flow of dollars to all parts of the world spurred the expansion of global credit, which did not stop until 2007.
The US, which paid the rest of the world with its own irredeemable dollars of no intrinsic value, lauded the adoption of “free trade” and “globalization”. The US could buy whatever it wanted, anywhere in the world, in any quantity, and at any price. Starting in the 1990s, its export deficits became alarming, but nothing was done to reduce them; on the contrary, they grew year by year.
Free Trade is unquestionably beneficial for humanity at large. It is good to be able to buy goods where they are cheapest; some countries enjoy conditions that favor them in production of certain things; each country should produce those things in which it has an advantage over other countries. Thus, the whole world can benefit from the good things each country has to offer. It is an appealing and sound doctrine, but… there is a crucial catch: the doctrine of Free Trade was conceived for a world where the sole means of payment was gold.
When the doctrines of “Free Trade” and the “Comparative Advantages of Nations” were developed, the economists of the day could not imagine a world that did not use gold, but instead relied on a fiat money that could be created at will by a single country.
The “globalization” of the 1980s and 1990s and to date is based on the ideas of “Free Trade”. However, in the absence of the gold standard that existed when the doctrine was conceived, “globalization” had completely destructive results, which have caused the de-industrialization of the West and the rise to power of Asia.
My readers will know how many industries, large and small, have ceased to exist in the US and the West in general, because Chinese competition killed them. They will know as well how hard it is to find a product that can be produced at a profit in the developed countries. It is very difficult to find a niche for any product to be manufactured locally. The flight of factories to Asia to take advantage of lower wages caused unemployment where local factories were closed. For the same reason job creation is slow or non-existent.
The gold standard imposed order and harmony. If President Nixon had not “closed the gold window” in 1971, the world would be radically different today.
Everything changed because the United States, having removed gold from the world monetary system, could “pay” everything in dollars, and without the gold standard as a limiting institution, it could print dollars ad libitum – without limit. Thus, in the 1970s the United States started to buy huge amounts of high quality products from Japan, while the Japanese boasted: “Japan sells; Japan does not buy.”
A situation that was impossible under the gold standard became perfectly possible under the fiat dollar standard. The Japanese became gigantic producers, their country an island transformed into a factory. Japan accumulated vast reserves of dollars sent from the US in exchange for Japanese products. This in turn triggered the de-industrialization of the US.
It is no coincidence that some analysts have observed that in real terms, American workers have had no real increase in their income since 1970.
The current malaise: financial crisis, industrial crisis, crisis of unemployment
Today the situation is far worse. China, with a population of 1.3 billion, has become a formidable power. No one can compete with China in price. China sells vast quantities of goods to the rest of the world, without the rest of the world having any chance of selling similar quantities to China. China can do so, because today trade deficits are “paid” not in gold, but in dollars or euros or pounds sterling or yen, which will never be scarce: they are created at will by the USA, the European Central Bank, the Bank of England, or the Bank of Japan.
A fearful monster has been created as a consequence of the elimination of the gold standard, which imposed a limit: “You can only sell to those who sell to you; you can only buy from those who buy from you.” This limit no longer applies; everything is disarray, inequality, imbalance; “structural imbalance” prevails because we no longer have the gold standard.
Richard Nixon’s elimination of the gold standard has proven to be the US’s best possible strategic gift to China and the rest of Asia. Today, China has a colossal industrial base that might have taken centuries to build, while the US is to a great extent devoid of factories and incapable of reclaiming its former glory. How tragic a fate for the US!
Gold vs. Paper Reserves
Gold, up until the Bretton Woods Agreements of 1944, figured as the complement to the international exchange of merchandise or services and did settle outstanding balance of payments deficits, because it was a merchandise or commodity used as money.
According to the Bretton Woods Agreements, the fiduciary dollar was accepted as being as good as gold, with trust on the part of Central Banks upon the ability to redeem the dollar into gold. From 1944 up until 1971 then, these fiduciary dollars were held in Central Bank reserves as a credit call upon US gold; the final payment had not been effected and was delayed as a credit granted to the US until the dollars held in reserves were to be cashed in for gold at some future date.
In 1971 the US reneged on the Bretton Woods Agreements of 1944, “closed the gold window” and stiffed the creditor countries. No final settlement of international commerce debts took place in 1971, nor has any taken place since then; the truth of this statement is obscured by the mistaken idea that tendering a fiat currency in payment of an international debt constitutes settlement of that debt.
Once that false idea – that fiat money can settle a debt – is accepted as valid, then the problem of the enormous “imbalances” in world trade becomes an insoluble enigma.
The best and brightest of today’s accredited economists attempt in vain to find a solution to a problem that cannot be solved except by the renewed use of gold as the international medium of commerce.
I have been exchanging emails with Hugo Salinas Price for about two years. I consider him a friend. He is correct when he stated my 8-point proposal was insufficient.
For sake of completeness here is my proposal again.
Mish’s Proposed Plan for Jobs and Education
- Scrap Davis-Bacon and all prevailing wage laws
- Enact national right-to-work laws
- Kill defined benefit plans for public workers
- Scrap student loan programs entirely
- End all support for for-profit colleges
- Revise corporate tax laws
- Stop corporate tax repatriation holidays
- Slash military spending. The US can no longer afford to be the world’s policeman.
Those ideas will increase corporate tax revenues, end corporate tax unfairness to small US businesses, lower infrastructure costs, lower education costs, allow more public workers to be hired at the same costs as before thereby lowering the unemployment rate.
A key reason we have a jobs problem and an education problem is costs are too high. Gross purports to fix the problem via more government spending.
The solution cannot be the same as the problem, yet Gross proposes just that. Unions, untenable wages and benefits, and excessive government spending caused Greece to go bankrupt. Massive public works programs put Japan in a very precarious situation, with nothing but debt to show for its efforts.
History has proven time and time again that public spending proposals cannot and will not work. Gross and Krugman are blind to history. Immelt is talking about what is good for GE, not America.
The bond market forced Greece’s hand. If we listen to Gross, Krugman, and Immelt, the US will soon be in the same spot.
Internal vs. External Imbalances
The above 8 ideas are all valid. They will correct US internal imbalances.
However, as Hugo states, they will not correct external imbalances. Both are killing the United States.
Sadly, there is no impetus to fix either problem. Bankers and Wall Street benefit from “too big to fail” and monetary printing. Unions buy votes from corrupt politicians.
Inflation benefits those with first access to money. Who has that first access? Banks and the already wealthy.
Reserve Currency Sideshow
All this talk about the US losing reserve currency status to a “basket of currencies” is meaningless nonsense. It will not solve a damn thing, nor will it wreck the US dollar per se.
Nixon wrecked the US dollar by reneging on the Bretton Woods agreement. It has been downhill ever since for the middle class.
“Gold’s Honest Discipline” can restore balance. However, “Gold’s Honest Discipline” would also stop war-mongering, union pandering, and a host of other problems that banks and special interest groups do not want stopped.
Unfortunately, this means the imbalances will continue until the entire mess blows up in a currency and derivatives crisis of immense magnitude. I cannot tell you when that will happen, I can only tell you it will.
Please see Michael Pettis Warns of “Virulent Political Turn Against Euro”, Adds Clarification to “Gold’s Honest Discipline” for additional comments from Michael Pettis.
Mike “Mish” Shedlock
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