Mathematical Impossibilities
1. Germany wants the rest of Europe to raise
exports and become more competitive while simultaneously protecting its export
machine and imposing numerous austerity measures on the rest of Europe.
Mathematically, it cannot happen.
2. China wants to wean itself off an export
model but does not want the pain associated with measures that would
actually increase domestic demand. Mathematically, it cannot happen.
3. Japan wants to raise taxes, increase
consumer spending, and protect its export model, all at the same time.
Mathematically, it cannot happen.
4. The US needs to reduce its budget deficit,
rein in pension promises, and fix various structural problems (many associated
with public unions - the same as in Greece and Spain), but lacks the political
will to do so. Mathematically, U.S. deficit spending is not sustainable.
In all four
situations above, I have described situations that are mathematically
impossible, not just unlikely.
Bug in
Search of Windshield
With the
world's worst demographics, Japan has no politically acceptable solution to its
trade imbalance problem. Japan is a "bug in search of a windshield"
as writer John Mauldin puts it.
Global Trade
Imbalances Poised to Worsen
With the
above principles in mind, please consider a few snips from an email from
Michael Pettis at China Financial Markets regarding "Japan's
Debt Disaster and China’s Non-Rebalancing Act".
China’s current
account surplus has declined sharply from its peak of roughly 10% of GDP in the
2007-2008 period to probably just under 4% of GDP last year. Over the next two
years the forecast is, depending on who you talk to, either that it will rise
significantly, or that it will decline to zero and perhaps even run into
deficit. The Ministry of Commerce has argued the latter and the World Bank the
former.
I am not sure
which way the surplus will go, but I would argue that either way it is going to
be a very strained and difficult process for both China and the world. On the
one hand if the Ministry of Commerce is arguing, as many do, that the rapid
contraction in the surplus indicates that China is indeed rebalancing and will
continue to do so, I think they are almost certainly wrong. China is not
rebalancing and the decline in the surplus was driven wholly by external
conditions. In fact until 2010, and probably also in 2011, the imbalances have
gotten worse, not better.
For proof take
a look at the graph below sent to me by Calla Weimer, a Visiting Scholar at the
US-China Institute, University of Southern California. It shows China’s total
savings rate as a share of GDP as well as China’s total investment rate. As you
can see, both numbers are extraordinarily high.
The current
account surplus, of course, is equal to the excess of savings over investment –
any excess savings must be exported, and by definition the current account
surplus is exactly equal to the capital account deficit. This is the standard
accounting identity to which I have referred many times in my newsletters.
As the graph
shows, the last time investment exceeded savings was in 1993-94, and during
that time China of course ran a current account deficit.
So is China
rebalancing? Of course not. Rebalancing would require that domestic consumption
rise. Is the consumption share of GDP rising? From the graph it is pretty clear
that consumption has not increased its share of GDP since the onset of the
crisis. If it had, the savings share of GDP would be declining.
And yet savings
continue to rise. This is the opposite of rebalancing, and it should not come
as a surprise. Beijing is trying to increase the consumption share of GDP by
subsidizing certain types of household consumption (white goods, cars), but
since the subsidies are paid for indirectly by the household sector, the net
effect is to take away with one hand what it offers with the other. This is no
way to increase consumption.
What then
explains the decline in China’s current account surplus over the past three
years? The graph makes it pretty obvious. The sharp contraction in China’s
current account surplus after 2007-08 had was driven by the external sector,
and in order to counteract the adverse growth impact Beijing responded with a
surge in investment in 2009.
Meanwhile
investment continues to grow and, with it, debt continues to grow, and since
the only way to manage all this debt is to continue repressing interest rates
at the expense of household depositors, households have to increase their
savings rates to make up the difference.
Can China’s
surplus rise further?
Declining trade
deficits around the world require declining trade surpluses. Part of the
adjustment in Europe I suspect will be absorbed by a contraction in Germany’s
surplus, but the Germans of course are resisting as much as possible since
they, too, are dependent for growth on absorbing foreign demand. I don’t know
how this will pan out, but certainly Europe as a whole expects its trade
surplus to rise, and if instead it begins to run a large deficit, German growth
will go negative and the debt burden of peripheral Europe will be harder than
ever to bear.
Don’t expect
Europe, in other words, easily to accommodate China’s need for a growing trade
surplus. If foreign capital flows to Europe increase – perhaps as China and
other BRICs lend money to Europe – Europe’s exports will certainly decline
relative to imports, but because this means much slower growth for Europe, I
don’t think it is sustainable.
The problem
of Japan
Tokyo is
clearly worried that it is running out of time to manage the debt, and the
indications are that it has finally become serious about reducing its debt
burden. What’s more, Japan’s current account surplus has already contracted
substantially in the past two years, and in January it ran the biggest monthly
trade deficit it has ever run – $5.4 billion, although the early Spring
Festival this year may have distorted the number.
[Mish comment:
For further discussion, please see Japan Faces
Moment of Truth: First Annual Trade Deficit Since 1980; New Trend or Simply the
Tsunami Effect?]
How can Japan
reduce its debt? I am no expert on Japanese policies but according to much of
what I am hearing Tokyo is planning to raise taxes further, especially
consumption taxes, and to use the proceeds to pay down the debt.
[Mish comment:
Japanese government officials without a doubt want to hike taxes. Please
consider Japan's Prime
Minister Seeks Doubling National Sales Tax; No Winning Play for Japan.
Also consider World’s Biggest
Economies Face $7.6T Debt Led by Japan $3 trillion, U.S. $2.8 trillion;
Rollover Problems in Japan and Europe]
In addition
Tokyo and the business community are putting downward pressure on wages in
order to increase the competitiveness of the tradable goods sector. The
Financial Times article Low wages
compound Japan’s grim prospects highlights the problem.
Bonuses have
been coming under heavy pressure in Japan for years as part of a wider effort
to restrain incomes. And while workers around the developed world have been
complaining of a squeeze on incomes over the past two decades, in Japan thinner
pay packets fuel wider deflation. That makes it even harder for the government
to rein in its runaway debt and for the central bank to use monetary policy to
boost growth.
Japan
Reverses Course
Yikes! This
could turn out to be a huge problem for China and the world. Why? Because
raising consumption taxes and reducing wages will push up the Japanese savings
rate substantially. Either action pushes the growth rate of disposable income
down relative to GDP growth, and lower disposable income usually means lower consumption
– which is the same as higher savings.
These policies
will probably also reduce the investment rate. Lower Japanese consumption,
after all, should reduce business profits and so reduce the incentive for
expanding domestic production, while pressure for austerity should restrain or
even reduce government investment.
By definition
more savings and less investment mean that Japan’s trade surplus must rise.
Japan, in other words, is planning to move backwards in terms of rebalancing.
This Isn't
Going to Work
Pettis
concludes with "Needless to say this isn’t going to work. The 'good
news' is that if this conflict leads to much slower global growth, as it
certainly will, the resulting reduction in commodity prices, including oil,
will help absorb some of the changes in the trade imbalances as commodity
exporting countries see their exports fall sharply. But I don’t see much other
relief."
That bit of
"good news" is certainly not good news for the commodity exporting
countries like Australia, Canada, and Brazil all of which have their own
problems, especially Australia and Canada with enormous property bubbles.
Moreover,
Europe is an absolute basket case. Greece, Portugal, and Spain are in economic
"depressions". Expect European balance of trade problems to worsen
until those countries exit the eurozone. Unfortunately career politicians like
German Chancellor Angela Merkel have bet their reputations on preserving the
impossible.
Eventually,
Germany is going to pay an enormous price for European imbalances and ECB
president Mario Draghi's LTRO program, now hailed as an enormous success, is
likely to be viewed as anything but success when countries exit the eurozone
piecemeal down the road.
Economic
Toxic Brew Portends Currency Crisis
As I said
upfront, every country in the world understands the need for global trade
rebalancing. Yet, politicians have done nothing but take stances that
mathematically cannot work, some of which are likely to further exacerbate the
problems.
This economic
toxic brew will simmer until the pot explodes in a massive currency crisis at
some unknown point down the road.
Mike
"Mish" Shedlock