Michael Pettis at China Financial Markets taught me much of what I know about global trade. I am very appreciative. I tend to agree with most of his views.
I recommended his book "Great Rebalancing", and still do.
In a recent email, however, Pettis revives the "Global Savings Glut" thesis and I strongly disagree. This is a somewhat lengthy discussion, but an extremely important one.
"Income Inequality" is a front-page topic so let's take a close look.
From Pettis ...
Reviving the “Underconsumption” School
In the current issue of the newsletter I have decided largely to ignore current events and will try to dig deeper into the model I use to understand the sources of global imbalances, and how they have driven much of what has happened around the world in the past decade. This model rests on an understanding of how distortions in the savings rates of different countries have driven the great trade and balance-sheet distortions with which we are wrestling today, just as they have in most previous global crises, including those of the 1870s, the 1930s, and the 1970s. Rising income inequality is key to understanding this model.
Much of what I am going to argue is not new, and is merely a revival of the old “underconsumption” debate. Before jumping into the argument I want to start by quoting the remarkable former Fed Chairman (1932-48) Marriner Eccles, who may well have been the most subtle economist of the 20th Century, from his memoir, Beckoning Frontiers (1966):
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations.
But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
The key point here is that all other things being equal, rising income inequality forces up the savings rate. The reason for this is pretty well understood: rich people consume a smaller share of their income than do the poor. The consequence of income inequality, Eccles argued, is an imbalance between the current supply of and current demand for goods and services, and this imbalance can only be resolved by a surge in credit or, as I will show later, by rising unemployment.
Mish: Despite the obvious casino-like structure of global equity and bond markets, the poker game analogy is an extremely poor one.
From the wheel to the telegraph to the phone it took fewer and fewer people to produce the same amount of output. Today, a single farmer can produce as much wheat as 200 farmers at the turn of the century.
Unlike a group of guys playing a winner-take-all poker game, the global economy does not have a fixed number of chips. Because of increasing productivity and technology improvements, the number of chips increases every year.
That initial error in conjunction with equating debt to savings, cascades into a series of miscalculations by Pettis.
Rising income inequality reduces demand. It does so in two ways. First, it directly forces down the consumption share of GDP, and second, it reduces productive investment by reducing, as Eccles says, “the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.”
But – and here is where I will presume to add something new to the historical debate about income inequality and underconsumption – there is another very important form of rising income inequality that also forces up the savings rate in a very similar way, and this has been especially important in the past two decades. A declining household share of GDP has the same net impact as rising income inequality.
We have seen this especially in places like Germany and China during the past decade. In both countries policies were implemented which, in order to spur growth and, with it, employment, effectively transferred income from households to producers of GDP.
The main form of this transfer, in the case of Germany, was an agreement around fifteen years ago to restrain wage growth. By keeping wage growth lower than productivity and GDP growth, unit labor costs declined in Germany and German workers became more “competitive” in the international markets. This forced up the German savings rate and converted Germany’s current account from large deficits in the 1990s to the largest surpluses in the world.
Mish: Is the problem lack of wage growth, or something else?
I suggest "something else". For starters, the Euro was structurally flawed (and still is) One cannot blame Germany for that.
What about competition in general?
Rising productivity by definition means more goods produced with fewer people. What does basic economics tell us about an increase of goods with constant demand?
The answer of course is prices should fall. Did they? Nope. Central banks in particular, and the Fed in general strive for 2% annualized inflation. In practice, and until recently, central banks allowed inflation to overshoot that target.
Worse yet, central banks also ignored asset bubbles, especially housing prices that were not directly accounted for in the CPI.
In the case of China there were also restraints on wage growth relative to productivity growth – not so much a policy choice, I would argue, but a consequence of the huge number of underemployed rural workers in China – but there were at least two other very important transfers. First, China has had an undervalued currency ever since 1994, which acts as a spur to growth in the tradable goods sector by effectively taxing foreign imports (and notice, by the way, that something similar happens in Germany, which also has an “undervalued” euro in relationship to the “overvalued” euro of countries like Spain, Italy and France). This reduces the real value of household income as a share of GDP.
Second, and most importantly, interest rates in China have been severely repressed during much of this century, perhaps by as much as five to ten percentage points or more. This has acted as a huge transfer from net savers, who are the household sector for the most part, to net borrowers, who consist mainly of manufacturers, infrastructure developers, real estate developers, state-owned enterprises, and government entities.
In both cases, and this is true of other countries, especially if they have large state sectors, one of the consequences of these hidden transfers is that GDP, which is the total production of goods and services, rose faster than household income for many years, meaning that households retained a smaller and smaller share of the total amount of goods and services they produced. Of course as the total share of GDP they retained contracted, it is not a surprise that they also consumed an ever-declining share of GDP.
Mish: I agree with Pettis regarding the huge transfer of wealth from savers to borrowers. However, I suggest the transfer is a direct result of central bank inflation policies, not a result of a savings glut.
The squeezing of the household sector
Even if German or Chinese households kept their savings rates steady (i.e. they consumed and saved the same share of their income as before), their consumption as a share of GDP had to decline in line with the household income share of GDP. Most consumption is household consumption, and so as household consumption declines as a share of GDP, total consumption also tends to decline as a share of GDP, which is just another way of saying that total savings rise as a share of GDP.
This is a point that is often missed. Rising income inequality can have the same impact on savings and consumption as a rising state or business share of GDP.
Mish: Here is the key point Pettis and others miss: "inflation is theft".
By holding down interests rates, while massively increasing the money supply, central banks fostered malinvestments and stock market speculation, then bailed out the banks. Those actions effectively robbed savers of their money.
To equate "theft by inflation" to a global savings glut is an enormouserror.
In any closed economy, savings is always equal to investment. This simple truth, which is true by definition, has very powerful implications.
Let us assume now that something has happened that caused a transfer of wealth in our economy from the poor to the rich, or that caused the household share of income to drop. This transfer of wealth must have an impact on both total savings and total consumption.
At first the impact might seem obvious. Total consumption will decline and total savings will rise. But it is not that obvious. In order to maintain the balance expressed in the two equations, mainly the requirement that savings is always exactly equal to investment, something else must happen. There are only two possible things that can maintain the [savings=investment] balance:
1. Investment must rise in line with the increase in savings.
2. Savings in fact do not rise, which implies that any increase in savings caused by the transfer of wealth was matched by some other event that caused an equivalent reduction in savings.
Let’s take the first condition. Will investment rise? There are, again to be terribly obvious, only three ways investment can rise.
1. There can be an increase in productive investment.
2. Unproductive investment can rise in the form of unwanted inventories.
3. Other forms of unproductive investment can rise.
What causes investment to rise?
Let’s consider each of these three in turn before we consider our second possibility, that savings in fact do not rise.
1. There can be an increase in productive investment.
This is obviously the best-case scenario. Because the increase in investment is productive, over time total goods and services will grow, and, presumably, households will be able to increase their consumption in the future.
How likely is this to be happening in the current environment? It is probably not very likely. It is hard to believe that in rich countries, like the US, there are a lot of productive investments that are neglected simply because there is an insufficient amount of savings to fund them.
I am not saying that every productive investment in the US has already been made, but just that if there are productive investments that remain unfunded, it isn’t because of insufficient savings. It might be because of political gridlock, high levels of uncertainty, or something else.
2. Unproductive investment can rise in the form of unwanted inventories.
This, as I understand it, is the process Keynes eventually described after his famous 1930 debate with Ralph Hawtrey. The process is quite easy to explain. As income inequality rises, total consumption tends to decline.
Of course manufacturers are unwilling to pile up infinite inventory levels so this process must eventually stop. Rising inventory levels, in other words, can only be a temporary counterbalance to rising income inequality.
3. Other forms of unproductive investment can rise.
The third way for investment to rise is if the additional savings are used to fund other forms of unproductive investment. Perhaps the tendency for savings to rise without an equivalent increase in productive investment forces down interest rates, with suddenly-cheap capital leading to speculative behavior.
[paraphrased paragraph] Vast tracts of empty apartment buildings, spectacular but mostly empty airports, railroad lines, super highways and other infrastructure, and increases in manufacturing capacity even in industries that experienced overcapacity all seem profitable because of the expectation that asset prices would continue to rise.
Needless to say this seems to have been a pretty good description of recent investments in places as far apart as Arizona housing tracts, Dublin apartments, extravagant but unused Spanish airports, Chinese ghost cities, or Chinese solar manufacturers. We have seen a lot of this before the global crisis of 2007-08, and the seemingly obvious conclusion it that the tendency to increase the savings rate beyond the productive needs of the economy was balanced at least in part by a surge in speculative and unproductive investments.
Mish: I am in agreement regarding the description of malinvestments that Pettis mentioned.
To that I will add that the pool of real savings was transferred from savers to banks and other speculators. When the bubble burst, the banks were bailed out at the expense of savers.
As far as I can work out there are really only three logical ways a transfer of wealth is consistent with no change in the total savings and consumption shares of GDP.
1. The wealthy or the state consume as much as ordinary households.
2. Ordinary households increase their consumption rate and reduce their savings rate.
3. Unemployment rises.
That number 2 is what happened in the United States and peripheral Europe, is one of those brutally obvious points that so many commentators and economists have failed to grasp. I think the mechanism is fairly easy to understand and has already been much discussed, for example well over 100 years ago by John Hobson who showed how rising income inequality can cause both higher savings and lower opportunities for productive investment. The difference, he argued, poured into speculative stock, bond and real estate markets or was exported abroad to finance foreign demand for home products.
As money poured into stock, bond and real estate markets, either at home or abroad, it caused these markets to soar, making everyone feel richer. The consequence was that although ordinary households saw their share of total GDP decline, rising asset prices nonetheless made them feel wealthier, and encouraged them to maintain or increase their consumption.
Higher savings generated by the rich or the state, in other words, were matched by lower savings (or rising debt, which is the same thing) among ordinary households. Of course this can only be sustained if asset prices rise forever, but assets are locked into a circular process in which rising asset prices cause rising demand and rising demand justifies higher asset prices.
It takes rising debt to combine the two processes, so it is only a question of time before we reach debt capacity constraints, in which the system has to reverse itself, which it did in the developed word as a consequence of the 2007-08 crisis. This process, in other words, is the default reaction to a forced increase in the savings rate in one part of the economy, but it is not sustainable because it requires a permanent rise in consumer debt.
Mish: I certainly agree it's only a "question of time" before we reach debt capacity constraints. And it's equally clear that ordinary households are dis-saving.
Interestingly, the lower the interest rate, the longer the imbalance can continue before it all blows sky high again (which by the way explains the desire of the Fed to artificially suppress interest rates).
My disagreement with Pettis stems from his belief the wealthy are over-saving. Up next is the crux of the debate as well as another fatal flaw in the arguments presented by Pettis.
If the savings rate in one part of the economy rises, without an equivalent rise in investment the only way for the economy to balance is for savings elsewhere to decline, and this can happen either in the form of a (usually credit-backed) consumption binge, or in the form of rising unemployment. The first is unsustainable.
Once we understand this it is pretty easy to explain much of what has happened in the global economy over the past decade or two. As an aside, it may seem strange to many to think that excess savings is not a good thing.
We are used to thinking of thrift as good for us, and even more thrift as better, and this belief is embedded with so much moral certainty that we react with repugnance to anyone who suggests otherwise. But excess thrift is a much more serious problem than insufficient thrift.
Mish: Let me react with moral certainty and repugnance of the preceding paragraph.
On March 10, Bloomberg reported Debt Exceeds $100 Trillion as Governments Binge.
The amount of debt globally has soared more than 40 percent to $100 trillion since the first signs of the financial crisis as governments borrowed to pull their economies out of recession and companies took advantage of record low interest rates. The $30 trillion increase from $70 trillion between mid-2007 and mid-2013 compares with a $3.86 trillion decline in the value of equities to $53.8 trillion, according to the Bank for International Settlements and data compiled by Bloomberg. The jump in debt as measured by the Basel, Switzerland-based BIS in its quarterly review is almost twice the U.S. economy.
To depict $100 trillion in debt ($30 trillion of it since mid-2007) as "savings glut" is preposterous. I will present a detailed explanation why after one more clip from Pettis.
Pettis concludes ...
Either the world has to embark on a surge in productive investment, or we need to reduce the income share of the state and of the rich, or we must accept that unemployment will stay high for many more years.
The first is possible, but with so much excess manufacturing capacity and excess infrastructure in many parts of the world, and with significant debt constraints, we need to be very careful about how we do this. Certainly countries like the United States, India and Brazil lack infrastructure, but they do so largely because of political constraints, and it is unreasonable to assume that any of these countries will soon embark on an infrastructure-building boom.
Even if they do, the amount of excess savings is likely to be huge, and without a significant redistribution of income to the middle classes and the poor, it is hard to see how we can avoid high global unemployment for many more years. Because trade war is the form in which countries assign global unemployment, I would expect trade relations to continue to be very difficult over the next few years, as countries with high unemployment and low savings intervene in trade, thus forcing the savings back into countries with excess savings.
So what are the policy implications? Clearly Europe, the US, China, Japan, and the rest of the world must take steps to reduce income inequality. Just as clearly countries like China and Germany must take steps to force up the household income share of GDP (in fact polices aimed at doing this are at the heart of the Third Plenum reform proposals in China). Because it will be almost impossible to do these quickly, as a stopgap countries with productive investment opportunities must seize the initiative in a global New Deal to keep demand high as the structural distortions that force up the global savings rate are worked out.
But redistributing income downwards is easier said than done in a globalized world, especially one in which countries are competing to drive down wages.
In a globalized world, it is much safer to “beggar down” the global economy than to raise domestic demand, and so I expect that there will continue to be downward pressure on international trade.
Until we understand this do not expect the global crisis to end anytime soon, except perhaps temporarily with a new surge in credit-fueled consumption in the US (which will cause the trade deficit to worsen) and more wasted investment in China (which, because it is financed with cheap debt, which comes at the expense of the household sector, may simply increase investment at the expense of consumption). These will only make the underlying imbalances worse. To do better we must revive the old underconsumption debate and learn again how policy distortions can force up the savings rate to dangerous levels, and we may have temporarily to reverse the course of globalization.
I will again quote Mariner Eccles, from his 1933 testimony to Congress, in which he was himself quoting with approval an unidentified economist, probably William Trufant Foster. In his testimony he said:
"It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they cannot save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying.
It is for the interests of the well-to-do, to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit."
Mish: Once again I react with moral certainty and repugnance of the preceding two paragraphs.
In his arguments, not all of which are shown above, Pettis painstakenly and with great precision outlined a number of accounting identities (e.g. savings = investment) that step-by-step seem to indicate he is correct.
Interestingly, I agree with all of his accounting identities in isolation.
So how can Pettis be so wrong? To understand where Pettis misses the mark, we have to focus on an even more basic accounting questionregarding the nature of savings.
What is Saving?
Accounting Identity: Savings = Production Minus Consumption
This is a fundamental economic law: You cannot consume what you don't produce. Sure, for periods of time you can consume that which is saved, but you cannot eat three loaves of bread if only two were ever produced.
Saving by definition, is what remains after consumption. Is not more production a good thing? Of course it is. Increased production lowers costs and raises standards of living (at least it should, in the absence of central bank and government intervention).
Money and Savings
It is impractical for the baker to save loaves of bread for next year he does not want today. Perhaps he wants a pair of shoes instead of extra bread. But finding a shoemaker who wants bread is a problem. Perhaps the shoemaker wants apples, not bread.
Money came into existence for precisely this reason. And where gold has been available, gold has always been used as money. It is scarce, stable, divisible, malleable, and pretty. Gold cannot be conjured into existence; it has to be mined.
Dollars vs. Gold
In contrast to gold, trillions and trillions of dollars have been fabricated out of thin air.
Pettis makes an assumption that those dollars represent "savings". Let me ask Pettis a simple question: What was produced?
The answer of course is nothing. And if nothing was produced, nothing can possibly be saved!
The hoard of "savings" that Pettis wants to distribute is not really "savings" at all but rather money-substitutes fabricated for the sole benefit of already wealthy asset-holders at the expense of everyone else.
Mauldin Misses the Boat as Well
John Mauldin has written a series of articles recently on the subject of income inequality. In his latest Thoughts From the Frontline on Inequality and Opportunity Mauldin states ...
If we want to do something about income inequality, perhaps we should think about the data that shows the remarkable correlation between education, educational opportunity, and income. ... the causes of income inequality are more difficult to come by than are the simple correlation analyses presented in many academic and political policy papers offered by various advocates in support of their personal policy choices (both conservative and liberal).
I suggest to both Pettis and Mauldin that it is useless to complain about income inequality unless one also complains about the cause of it.
The cause is not "difficult to come by" as Mauldin states. Nor is the cause an excess of savings. Here are some of the real causes.
Causes of Income Inequality
- Central banks set interest rates by decree causing boom-bust cycles of increasing amplitude over time
- Governments guarantee the pensions of public union workers at the expense of everyone else
- Minimum wage laws encourage the use of hardware and software robots
- Central banks have inflation targets higher than can be sustained by current debt levels
- Governments sponsor war-mongering activities that are capital destructive
- Prevailing wage laws ensure workers on government contracts are overpaid relative to everyone else
- Corrupt politicians take campaign contributions in return for sponsoring extremely bad ideas
None of the above remotely has anything to do with a "savings glut". There was no "savings glut" in 1933 and there sure isn't one today.
Ironically, it was the explosion of debt, not the lack of savings that fueled the Great Depression and the Global Financial crisis. Margin debt and speculation soared in the late 1920s and is at an all-time high again now.
Only by confusing the expansion of credit and money printed out of thin air with savings, can one propose a "savings glut" thesis.
Realistically, debt does not equal savings and credit is not the same as money. To suggest, as Pettis does, that "excess thrift is a much more serious problem than insufficient thrift" is ridiculous.
"Excess Thrift" Implies Two Falsehoods
- Someone can identify "excess" thrift.
- Increased standards of living are bad.
Why does it imply the latter? The answer stems from the identity: Savings = Production Minus Consumption.
In the absence of central bank and government manipulation, excess production will not last long. Goods will spoil or prices will fall. Malinvestment does not happen to any significant degree because unproductive businesses quickly fail. Competition ensures growth of supply and growth of jobs.
In a free market society, real (inflation adjusted) wages would rise, even if nominal wages didn't. And that is precisely why the minimum wage debate is so wrongly focused.
Falling prices and rising production raises standards of living. More people than ever before can consume goods because prices drop. When people get more for their money, standards of living rise. Then, what's left is saved. That savings is money available for future investments.
There is no such thing as excess saving. It only appears that way when the Fed (central banks in general) distort price signals causing, speculation, rising asset prices, and malinvestment in unproductive assets.
Mish Model on Cause of Income Inequality
- Central banks print money out of thin air. To the extent there is productive use of the money, those with first access to it are the beneficiaries. Who has first access to money? Banks and the already wealthy of course.
- By the time those low on the totem pole get access to credit, loans are nothing more than a debt trap. The collapse of the housing bubble is proof enough.
- When bubbles burst, banks are bailed out at the expense of true middle class savers. This is a transfer of wealth from the low and middle class to those holding the assets.
- When there is little productive use for the money (as in right now) money goes into speculative assets. The price of stocks rise. CEOs get paid in stocks, options, and salary on the basis of share prices.
- Central banks inflate money and hold down interest rates robbing savers of money.
- The wealthy accumulate trillions of dollars, but it's not a "savings glut" per se. There was no corresponding production.
One Astonishingly Bad Idea
Other factors enter the equation, notably transfers from ordinary taxpayers to public union pensioners. Also, bad ideas brought about by corrupt politicians on the take influences the picture, but central banks and fractional reserve lending, not wealthy hoarders are at the root of the problem.
Much of this originates from one astonishingly bad idea, that falling prices are a bad thing. Note that increased production should lead to falling prices and rising standards of living.
But central banks are hell-bent on preventing price deflation. To do that, they increase money supply. The money has no productive use. So it goes into speculation, bailouts, and malinvestments. Prices don't fall as they should. This punishes savers for the benefit of asset holders. Stock prices soar, and CEOs pay themselves massive amounts of stock options, a form of shareholder dilution.
Countrywide Financial CEO Angelo Mozilo cashed out $1 billion in stock options over the years while driving the company into the ground. Does that really constitute a "savings glut" or is it something more like Fed-sponsored fraudulent conveyance of wealth?
For further discussion of the one "astonishingly bad idea" that is a fundamental driver of income inequality, please see Monetarism, Abenomics, QE, and Minimum Wage Proposals: One Bad Idea Leads to Another, and Another
Mike "Mish" Shedlock