Dilemma over current account vendor financing
By Michael Pettis
Creditors nations are worried. Their obligors seem determined to take steps, they claim, to undermine or erode the value of their obligations – at the expense, of course, of the creditors.
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.
Before I explain why I make the second point, let me address the first point. As I have argued many times before, the accumulation of US government bonds by the PBoC and the surging Greek, Portuguese, and Spanish loan portfolios among German banks were not the acts of disinterested lenders. They were simply the automatic consequence of policies in the surplus countries that may very well have been opposed to the best interests of the deficit countries.
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. Remember that net capital exports are simply the obverse of trade surpluses (or, more correctly, current account surpluses), and one requires the other. If China buys huge amounts of dollars, the US must run a trade deficit.
Whichever argument you think is the more just – that the imbalances are mainly the fault of the US or the fault of China – since the Chinese accumulation of US Treasury bonds was the automatic consequence of Chinese policies that the US opposed, it seems a little strange that the US should feel any strong obligation to maintain the value of the PBoC’s portfolio. That is not to say that the US should not be concerned about inflation and the value of the dollar – only that the reasons for its concern should be wholly domestic.
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.
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.
In that case it is strange for Germans to insist that the peripheral countries have any kind of moral obligation to prevent erosion in the value of that loan portfolio. It is like saying that they have a moral obligation to accept higher unemployment in order that Germany can reduce its own unemployment. Whether or not these countries default of devalue should be wholly a function of their national interest, and not a function of external obligation.
Trade imbalances lead to debt imbalances
But aside from whether or not there is a moral obligation for creditor countries to protect the value of portfolios whose accumulation was the consequence of policies that those countries opposed, there is a more concrete reason why it does not make sense to demand that deficit countries act to protect the value of the portfolios accumulated by surplus countries. This has to do with the sustainability of policies aimed at generating trade surpluses. It turns out that the maintenance of the value of those obligations is largely the consequence of trade policies in the surplus countries.
To explain why this is the case, let me again, following my practice from last month’s newsletter, simplify matters by calling all surplus countries “Germany” and all deficit countries “Spain”. Germany and Spain jointly have put into place policies that ensure that Germany runs a large current account surplus and Spain a large current account deficit for many years. As I argued three weeks ago, I think that it is far more likely that German policies rather than Spanish policies created the huge distortions, but for our purposes we can ignore the direction of causality.
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.
Large current account surpluses and deficits, in other words, could not persist because they were limited by the gold and silver holdings of the deficit countries. This was pretty much an automatic limit – although in later centuries it could be extended by central bank loans of specie – and the limit was pretty firm. In the days of Hapsburg Spain, seemingly infinite discoveries of silver in Eastern Europe and the Americas allowed Spain to act as if it had infinite capacity to run trade deficits, but of course the never-ending religious and dynastic wars that seemed so much to delight the Hapsburgs ensured that silver outflows were high enough even to drain the silver discoveries fairly quickly (in fact new silver discoveries were almost always spent before they were actually delivered).
During the imperial period in the late 19th Century this adjustment mechanism was subverted by a process described most famously by British economist John Hobson in his theory of under-consumption. Hobson argued that the imperial centers systematically under-consumed and exported huge amounts of their savings to the colonial periphery, which of course allowed them to run large and profitable trade surpluses against the periphery.
This export of money from the center to the periphery was seen as the primary mechanism of colonial exploitation. Even Lenin thought so, and wrote about it most famously in “Imperialism, the Highest Stage of Capitalism”. “Typical of the old capitalism, when free competition held undivided sway,” Lenin wrote. “was the export of goods. Typical of the latest stage of capitalism, when monopolies rule, is the export of capital.”
Since they controlled the periphery and since obligations were denominated in gold or silver, the imperial centers exporting capital never had to worry about today’s worry – the refusal or inability of the periphery to repay the capital imports. They “managed” the colonial economies and their tax systems, and so they could ensure that all debts were repaid. In that case large current account imbalances could persist for as long as the colony had assets to trade. Regular readers will remember that I discussed this in an early May blog entry in reference to a very interesting paper by Kenneth Austin.
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. By the way you can think of the US Marshall Plan as a way of allowing Europe to appropriate US assets in the days when the problem was persistent large US current account surpluses, matched by a refusal of the US to change its domestic economic policies in a way that generated trade deficits and an inability of Europe to continue borrowing. The alternative to the Marshall Plan was either a collapse in the US export market, a European default, or a less friendly European expropriation of US assets.
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.
This is why I find the moaning and gnashing of teeth over the possible erosion of the value of claims accumulated by surplus countries surreal. There is only one possible way to avoid that erosion of value, and that requires that the surplus countries work with the deficit countries to reverse the trade imbalances. If the surplus countries refuse to take the necessary steps, an erosion in the value of those claims is the automatic and necessary consequence. In practice that means that either the claims must be devalued or they will lead to default.
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