Wednesday, July 3, 2013

The Great Rebalancing

The symptoms of the Great Recession are by now well-understood. Housing markets rocketed to obscene levels; loans were made to borrowers who could not repay. But conditions surely existed for such events to occur prior to the past decade, so why didn't they? In The Great Rebalancing, Michael Pettis attributes the cause of the recession to an oft-ignored meme: international trade imbalances.

Economists generally see trade as a good thing. Comparative advantage allows consumers to live higher standards of living than they otherwise could. But the policies of some governments distort trade markets, resulting in massive trade imbalances. Prior to the crisis, imbalances as a percentage of GDP had reached rather large levels.

Interestingly, it is the trade deficit countries that are blamed for these imbalances. If only they could save more and spend less, the media decries, these imbalances wouldn't exist. But Pettis puts the blame squarely on the shoulders of the over-saving countries. It is policies in these countries that cause imbalances in other parts of the world, and invariably it is these countries that are hurt the most when rebalancing occurs, as it always does.

Some of the large countries singled out for policies that encourage trade imbalances include Germany, Japan and China. These countries repress consumers (using tools such as currency manipulation, interest rate maximums on deposits, efforts to keep household income low) resulting or for the purpose of forcing capital flows into its trading partner countries. These flows then turn into trade deficits (thanks to this accounting identity) in the countries who don't practice financial repression on their citizenry.

The countries that experience capital flows then experience investment booms in the non-tradeable goods sectors (e.g. housing), as there is a lot of capital chasing few investment opportunities. This is what happened in Spain and the United States as trade imbalances grew pre-crisis, for example. Alternatively, these countries can ratchet down their investment levels, but this leads to high unemployment; this is what is currently occurring in Spain and the US.

Ultimately, Pettis argues that it's the trade surplus countries who will get hurt the most, as an inevitable rebalancing will cause the most pain to the countries that rely on foreign markets for its goods.

For those interested in reading more from Pettis, he blogs here.

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