A Twitter Thread and an Essay by Michael Pettis

Both of which are a continuation of the theme for this week.

The thread:

This thread answers the question about whether China finds itself in a liquidity trap. In English, it would seem that no matter what levels of interest rates in the economy, Chinese businesses prefer to save rather than invest.

You may agree or disagree with the conclusion (I most certainly agree), but the data is instructive. Please read the article linked in the first tweet.

The essay:

Any economy broadly speaking has only three sources of demand that can drive growth: consumption, investment, and trade surpluses. For that reason, there are basically five paths that China’s economy could take going forward.

China can stay on its current path and keep letting large amounts of nonproductive investment continue driving the country’s debt burden up indefinitely

China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with productive investment in forms like new technology

China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with rising consumption

China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with a growing trade surplus

China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply

The Only Five Paths China’s Economy Can Follow

Quick note: Blogging may be sporadic and light in the coming days.

Michael Pettis on The Continued Inevitability of the Dollar’s Dominance

Rathin Roy on Michael Pettis’ Thread on Adam Tooze’s Newsletter

Which, by definition, makes it self-recommending!

In which Michael Pettis tells us that institutions and culture remain underrated

A Tale of Two Countries

Although I should note that I have given up on trying to figure out if it is the best or worst of times. Who knows?

But rhetoric aside, today’s blogpost continues our attempts at trying to understand just what the hell is going on in China. And we do so by reading an excellent report written by Michael Pettis (here are previous EFE posts where Michael Pettis has been mentioned):

In the United States and China, rising debt is structural, and necessary to the way in which their economies currently operate. While it is indeed likely that part of the debt in both countries is due to profligacy, irresponsible behavior, and even fraud, these do not explain the bulk of the increase in debt. Even with the strictest controls, until more fundamental changes are made to the two economies, either debt must continue to rise or growth must slow to politically unacceptable levels—levels that cause unemployment to rise.


Michael Pettis makes the claim (and in my opinion it is a convincing one) that investment in China is not going to come down anytime soon. Which means, we know by now (see the first two posts of this week), that investment by government will not come down anytime soon. And why will it not come down anytime soon? Because China needs to grow, and growth can’t come from anywhere else but government led investment.

Think of three questions:

  1. Why does China need to grow?
  2. If we accept that China needs to grow, how can China ensure that it continues to grow?
  3. So what happens next? This question I can answer right away, actually. It is, currently, anybody’s guess!

Question 1: why does China need to grow?

Well, because growth is good – is that not a good enough reason?

Sure, it is, but more importantly, a lack of growth is not politically acceptable. How can low growth be possible when it is Xi himself at the helm? And so China Must Grow. Or be seen to be growing. Or don’t see the fact that China is not growing. But preferably, China Must Grow.

Question 2: How can China ensure that it continues to grow?

Well, let’s have China consume more! Except that this is easier said than done:

China suffers from two forms of income distortions that limit demand for Chinese businesses. The one most discussed is income inequality: rich Chinese individuals (like rich Americans) retain a disproportionately high share of household income. But the second, more important form of income distortion is the very low share Chinese households retain of the country’s GDP—roughly 60 percent versus the roughly 80 percent typical in the United States. The low household share of GDP has the same effect on demand as income inequality.


OK, then how about getting China to invest more?

Well, that pretty much describes the twenty year period between 1995 to 2015 (more or less). But that party ended a while back:

In fact, in more recent years, they have actually reduced investment in response to stagnant domestic consumption. In both the United States and China, the biggest constraint to productive investment by private businesses is weak domestic demand.


So OK, China has to continue to grow rapidly, but that can’t happen via consumption. Because inequality, and because Chinese households get a very low share of China’s GDP. It can’t happen via private investment either, because faced with weak domestic demand, private investment prefers to stay out of the game. So what comes next? Government led, non-productive investment.

The problem is that around the mid-2000s, investment in infrastructure, property, and government-owned projects in the aggregate began to create less economic value than it cost. The result was that China responded to the high savings of wealthy individuals and the government with a surge in nonproductive investment, which led to a surge in the country’s debt burden. This is the reason that China is forced to encourage a rapid rise in debt as the only way to prevent a rapid rise in unemployment.


Or, alternatively, if domestic demand is weak, cater to global demand:

China’s trade surplus allows it to externalize a part of the domestic demand deficiencies caused by low consumption, and so reduces the amount of nonproductive investment (and debt) needed to balance Chinese supply and demand. The American trade deficit forces it to absorb foreign demand deficiencies and so increases the amount of debt needed to balance American supply and demand. But while the countries’ different trade positions exacerbate U.S. debt and reduce Chinese debt, it leaves China overly sensitive to changes in external demand and to trade conflicts, while the United States actually benefits from trade conflict.


But now, post the pandemic, and post the world’s reluctance to remain overly dependent on China, “externalizing domestic demand deficiencies” is no longer possible. And China has done more than its fair share of government-led, non-productive investment. And so China is now faced with two choices:

  1. Don’t accumulate debt, and therefore grow more slowly. But hey, Great Helmsman, so China Must Grow.
  2. Accumulate debt, and grow rapidly, but by making stuff nobody wants. But even this has run its course in 2023, it would seem.

There is secret option 3: liberalize markets, let investments be market driven, and let consumption grow organically and therefore eventually more rapidly. This is the theoretically correct answer, if you ask any economist. This is the politically impossible answer, if you ask any political scientist even remotely familiar with China.

Which boils down to the all-important question:

In a fight between good economics and bad politics, who wins?

My answer to this question is another question:

What time horizon do you have in mind?

“What Are You Optimizing For?”, The International Macro Edition

It is one of my favorite questions to ask whenever students come to me with doubts about “what to do next” in terms of either further education or a job.

(Side note: asking me what to do next probably isn’t a good idea, because my career has been gloriously unplanned. But that’s a whole separate story)

But one should be clear about what one is optimizing for: is it income, or free time, or job satisfaction, or rapid career growth – or something else altogether? And whatever it may be, optimizing for one will quite probably mean having to give up on some or all of the others.

And this applies to many more things than just the What To Do Next question, of course. In fact, relentlessly asking this question in many different contexts can take you a very long way in terms of understanding what seem like really difficult and complex topics.

Such as, for example, what China has been up to in terms of international trade, and what went so gloriously wrong.

The simple story of international trade (or trade in general for that matter) isn’t difficult to grasp. Bear in mind that reality is a little more complex, but it really boils down to comparative advantage.

As Michael Pettis points out at the start of this excellent Twitter thread, the so-called “China shock” *is* a shock, but it is not an indictment of the basic concept of international trade. China, as we’re about to find out, was playing a zero-sum game.

One of the most glorious things about economics is the fact that trade is a non-zero sum game. Both parties that have voluntarily entered into a trade with one another benefit for the trade having gone through, and so nobody loses. This is as true at your local chai tapri (you give ten bucks for a cup of chai, and both you and the chaiwala are happy with the trade) as it is in the context of international trade between the United States of America and China.

But beware overly simplistic stories, for they can trip up many a happy ending:

Isabella Kaminska, in an old but excellent article on FT Alphaville made a very similar point. I’ll get to that point in a bit, but may I also use this opportunity to urge the good folks at FT to make FT Alphaville free again?

Here’s the point from that old article:

What those who accused China of using its exchange rate to gain advantage probably misunderstood was that it wasn’t the currency which was being undervalued, it was the people. Stephen Roach, then chief economist of Morgan Stanley, explained this point in the Financial Times in 2003 (our emphasis):
“The Chinese phenomenon hardly amounts to grabbing market share from the rest of the world. It is more a by-product of the struggle for competitive survival by high-cost producers in the industrial world. Last year, a record $53bn of foreign direct investment flowed into China, making the country the largest recipient of such funds in the world.
These investments did not occur under coercion. A high-cost industrial world has made a decision that it needs China-based outsourcing to ensure competitive survival. Dismantling China’s currency peg would destabilise the very supply chain that has become so integral to new globalised production models in Japan, the US and Europe.
There are several other reasons why China should leave its currency unchanged. Contrary to widespread perception, China does not compete on the basis of an undervalued currency. It competes mainly in terms of labour costs, technology, quality control, infrastructure and an unwavering commitment to reform.

https://www.ft.com/content/d11a4c5e-d5fb-32f4-a606-e64d1483cea1 (Emphasis added)

This article was written in 2015, but it holds up very well. In fact, it is instructive to see how, in addition to labour costs and infrastructure, China has now centralized under government authority technology as well. It is also instructive to think about how (and in what direction) the “unwavering commitment to reform” has evolved, but that is a separate story.

To come back to the common thread between the old FT Alphaville article and the Twitter thread by Michael Pettis:

Stephen Roach, in 2003, spoke about how China was undervaluing its people. Isabella Kaminska in 2015 spoke about China competes (at least in part) on labor. And Michael Pettis in 2021 is talking about China competing by suppressing its wages (relative to productivity levels). But they’re all making the same point, and it is a point that merits greater emphasis:

The China shock needn’t have been a shock, in the sense that it is not as if economic theory stopped working once China started trading more with the rest of the world.

China, as it turns out, wasn’t optimizing for international trade. China was – and is – optimizing for an increase in her exports, and that over time.

That problem manifests itself in many different ways: The USA’s persistent trade deficit with China is just one glaring example. The Belt and Road Initiative is another (what the hell do you do with all those forex reserves, dammit?). And there’s many, many more.

But as Michael Pettis reminds us in this thread, the “China Shock” phenomenon becomes way more comprehensible when you ask a deceptively simple question: what is China optimizing for?

What is India optimizing for when it comes to international trade? What should India be optimizing for? In both cases, whatever your answer, why?

Critique this blogpost, and write your responses to the questions above. It is a great way to test yourself if you think you’re good to go in open macroeconomics or international trade.

Reflections on RE and China

The love-hate relationship goes on. For almost two years China’s leaders cracked down on borrowing to build and bet on property, plunging the market into a crisis. Now that the economy has been weakened by the failures of the “zero-covid” policy, the government is racing to rescue real estate. Ni Hong, China’s housing minister, has said his ambition this year is to restore confidence; a series of measures announced in the past few months seek to make it easier for developers to raise capital. These efforts are reviving the property market. Unfortunately, they leave it just as vulnerable to boom and bust as ever.


That’s The Economist, in January of this year. China’s RE problems are well known, of course. But the economics of how the Chinese government is “managing” this market is a fascinating story. As most economists (but not all!) will tell you, managing markets in general isn’t that easy. And “managing” the Chinese RE market is about as challenging a task as you can imagine.

As with diseases and doctors, so with problems in a market and its management. Getting the dose of the medicine right is tricky, and figuring out how long to keep the dose going is trickier still. As the same Economist article points out, “technocrats tend to respond to crises with lots of liquidity”. In other words, they apply too strong a dose, and keep it going for too long. This has happened in the past with many markets, but especially with the Chinese real estate market back in 2014. That led to a predictable boom, with predictable consequences.

The current crisis isn’t just bad for real estate buyers and sellers, however. It is also bad for government, because a slump in real estate markets takes away the chief source of revenue for local governments (land auctions). And so the real estate market needs to grow, but well, isn’t.

And that comes through not just in the case of the market for RE, but also in the labor market associated with RE:

In 2013, architecture was named the top career choice for Chinese graduates in education consulting firm MyCOS’s annual report. Architects not only enjoyed the highest employment rate and job conditions, they also reported the greatest career satisfaction scores. But by 2015 it had disappeared from the league table completely, and it has never featured in the list since.
When technology media outlet 36Kr asked over 1,200 Chinese graduates whether they regretted their choice of major this month, architecture students were among the most likely to say yes. “Architecture may have fallen from the throne faster than any other major,” the newspaper Southern Weekly commented in a recent report.


And there are two factors to keep in mind from a long term perspective. First, of course, is the fact that China’s population has almost certainly peaked, and that will of course have a knock-on effect on the RE market in the years to come. Second:

Another parameter also showed signs of peaking. The average urban residential area per capita in China was only 18.7 square meters in 1998, but reached 41.76 square meters by 2020. As a reference, the average residential area per capita in major developed European countries falls within the range of 35-45 square meters. Based on this information, the future space for growth under this metric is limited in China.


You could fire three arrows, or throw in a fourth. The market is likely to be a challenge in 2023, and will continue to remain so for some time. What the Chinese would like, in effect, is a moderation of prices with not much impact on demand. A soft landing, in other words. Easier said than done, as Michael Pettis says:

And the reason this matters is because the real estate sector was a major source of employment, investment, tax revenue, and a way to save for millions of Chinese folks. That’s a dangerous mix!

Is there no way out? Are there no bright spots? Well, consider Chengdu:


What explains this success? Since 2016 officials in every Chinese city have been able to devise their own measures for cooling or heating local property markets. Most of the rules employed are restrictions on who can buy a flat, how many they may purchase and the size of the downpayment required. In most large cities, only people with local hukou, or residence permits, are allowed to buy homes. In Chengdu, high-level purchase controls remain in place. But officials have sought to attract families as a way of expanding the city and increasing demand for homes. Residents with two or more children are, for instance, allowed to buy additional homes, and local hukou-holders may buy up to three. Even those without a hukou may buy two. Since the start of the year, elderly parents who move to Chengdu to join their adult children may also purchase a flat.


There are other factors at play too in Chengdu, but my biggest takeaway is that Chengdu is attempting to raise its population, and therefore the demand for RE. But that will only work by pulling people away from other parts of China – and so it’s a band-aid solution at best. As the Economist article itself points out “there simply aren’t enough people in China for another population boom”.

I’ve said it before, and I’ll say it again: the Solow model remains underrated!

Which begs the question: how should we use the Chinese experience today to think about the Indian RE market of, say, 2040?

That would need us to be familiar with the trajectory and current status of the Indian RE market – and if any of you have any information or stuff worth reading about this, please do share. Thank you!

More Than An Inconvenient Iota of Truth

Regular people everywhere are being deprived of purchasing power — and tricked by chauvinists and opportunists into believing that their interests are fundamentally at odds. A global conflict between economic classes within countries is being misinterpreted as a series of conflicts between countries with competing interests.


An extract twice removed, as it were, for Noah Smith extracted this bit in his excellent review of a book called Trade Wars are Class Wars, by Michael Pettis and Matthew C. Klein. I have not read it yet, but it has shot to the top of my reading list.

Any student who has attended a class in which I have taught aspects of international trade will tell you that I bore them to death with one particular theme: that the textbook study of international trade doesn’t adequately cover (in my opinion) the study of inequality.

Now that might sound weird if you are a student new to the study of international trade. What on earth, you might think, does inequality have to do with international trade?

Well, here’s the thesis put forward in the book, via Noah:

Trade Wars are Class Wars offers a provocative thesis — that what looks like economic competition between nations is actually just a manifestation of economic competition between classes within those nations.


Again, I haven’t read the book, but this is slightly confusing to me. I have always thought of the causality running the other way around: increased competition between nations has exacerbated economic competition (and therefore inequality) within nations. It would seem that the authors think of it differently. Excellent, more things to ponder upon!

Why do I think that international trade is one causal factor where inequality is concerned? Let’s begin with an excellent article published by The Economist a few years ago:

In rich countries, skilled workers are abundant by international standards and unskilled workers are scarce. As globalisation has advanced, college-educated workers have enjoyed faster wage gains than their less educated countrymen, many of whom have suffered stagnant real earnings. On the face of it, this wage pattern is consistent with the Stolper-Samuelson theorem. Globalisation has hurt the scarce “factor” (unskilled labour) and helped the abundant one.


Please, pretty please with a cherry on top, read the whole thing, especially if you have studied the Stolper Samuelson theorem. This article remains the best explainer that I have come across.

But what is being said here should be at least somewhat surprising to a student just beginning to study international trade. Trade, it would seem, may well be welfare enhancing, but it does not affect everybody a) equally and b) not necessarily positively! But, you might think as an Indian student, this might imply that unskilled labor in India might benefit from international trade.

Remember, one thing a good student of economics always bears in mind is a specific question: relative to what? That is, unskilled labor in India might well benefit from international trade, but relative to what? And the answer turns out to be, well, an unexpected one:

But look closer and puzzles remain. The theorem is unable to explain why skilled workers have prospered even in developing countries, where they are not abundant.


What might explain this?

Enter Professors Maskin and Kremer:

Nineteenth-century economist David Ricardo’s theory of comparative advantage predicts that China’s poorest workers should benefit most from the growth in trade. Before globalization, that country had a huge supply of unskilled workers and relatively few high-skill workers, who were thus in high demand; the situation was just the opposite in the United States. When two such countries begin to trade, the theory states, the less-developed nation has the advantage in producing relatively low-tech products—so demand and income for under-educated workers should shoot up, while their high-skill countrymen suffer. Thus, the theory predicts, globalization should lower inequality in the developing world.
Instead, as Gates professor of developing societies Michael Kremer explains, in much of the developing world, “The empirical evidence is not really consistent with the idea that trade is reducing inequality.” He and Adams University Professor Eric Maskin, a 2007 Nobel laureate in economics, have therefore proposed a new model to help explain the discrepancy between traditional theory and current reality. The key, they say, lies in a more nuanced understanding of how global production cycles sort workers into different jobs.


Here’s one way to understand their model. Note, before you proceed to read, that this is my explanation of their model, and I have simplified it a bit. I’ll add more nuance in as we go along:

Think of two countries, and two types of workers in both countries. Let’s say country 1 has Type A and Type B workers, and Country 2 has Type A1 and Type B2 workers. A and A1 are skilled workers, and B and B2 are unskilled workers. Maskin and Kremer make the point that international trade and the advent of modern globalization has resulted in skilled workers across countries “matching” with each other. As a result, their incomes go up, relative to unskilled workers in their own countries. So while the Stolper Samuelson theorem may be unable to explain why skilled workers have prospered even in developing countries, we now have a plausible answer to the question.

As an illustrative example, consider the fact that I joined a multinational firm called Genpact straight out of college.

And of course, one can think of many countries, not just two, and one can imagine a spectrum of skill sets across workers, rather than a binary framing. The point still holds!

And to complicate the matter further still, there may well be explicit/implicit choices made by policymakers in their own countries.

Back in the good old days, FT Alphaville used to be a free blog. And about seven years ago or so, it carried an excellent, excellent post written by Isabella Kaminska. The title of the (two-part) post was “What Are Chinese Capital Controls, Really?”. The post is a must-read for any student of international trade, but this excerpt is especially relevant for us today:

What those who accused China of using its exchange rate to gain advantage probably misunderstood was that it wasn’t the currency which was being undervalued, it was the people.

There are several other reasons why China should leave its currency unchanged. Contrary to widespread perception, China does not compete on the basis of an undervalued currency. It competes mainly in terms of labour costs, technology, quality control, infrastructure and an unwavering commitment to reform.

https://www.ft.com/content/d11a4c5e-d5fb-32f4-a606-e64d1483cea1 (Emphasis Added)

“It competes mainly in terms of labor costs” is a dry, academic way to put it. Elsewhere in this post, Isabella puts it much more plainly, when she says that it sucked to be a Chinese worker. And it did! Not just because of low labor costs, but because of a whole host of other reasons that should excite students of macroeconomics. Read the whole thing to get a richer understanding of how China has gone about doing what it has. As I always say to folks in my classes who wish we “grew like China”: be careful what you wish for!

You might also want to take a look at David Autor’s work on The China Shock. A good place to begin would be Russ Roberts’ podcast with David Autor, and for those who are interested, there’s a follow-up symposium about this episode as well. The point I’m making is that where trade between China and the USA is concerned, it would seem that inequality has gone up in both countries, but for different reasons.

This applies to international trade in general, of course – I’ve used China and US as examples because we are more familiar with them.

So, to return to the original question: are trade wars class wars? And more importantly, are class wars causing trade wars, or is it the other way around?

And so here we get to the book’s primary thesis. The authors only return to it in the conclusion, having reached it by a circuitous route that took them through history, data, theory, and more history.
The conclusion they ultimately draw is more nuanced than the one initially promised (and that’s a good thing, since nuance is good). In Klein and Pettis’ telling, global imbalances feed inequality in the U.S., but the fundamental cause isn’t inequality.


Yup, that I completely agree with, and “get”. But it doesn’t solve the original problem of course, it only helps us understand that it exists: trade does seem to exacerbate inequality.

How we should think of this problem, how we might resolve it, and with what consequences, is likely to be fertile ground for economic research in the years to come. If you are a student wondering about how to go about picking a topic to work on, well, please do consider this one! And a good place to begin would be Noah’s post, (and the book itself sounds like a must read too).

Bonus material alert: I simply had to share this extract from Noah’s blog, written by Paul Krugman. If you have recently studied macro, you can thank me later for bringing this to your attention:

[E]conomic explanations…have to [describe] how the actions of individuals…add up to interesting behavior at the aggregate level.
And the key point is that individuals in general neither know nor care about aggregate accounting identities…. [I]f you want to claim that a rise in savings translates directly into a fall in the trade deficit, without any depreciation of the currency, you have to tell me how that rise in savings induces domestic consumers to buy fewer foreign goods, or foreign consumers to buy more domestic goods. Don’t tell me about how the identity must hold, tell me about the mechanism that induces the individual decisions that make it hold…. [O]nce you do that, you realize that something else has to be happening — a slump in the economy, a depreciation of the real exchange rate, it depends on the circumstances, but it can’t be immaculate, with nothing moving to enforce the identity….
Accounting identities… inform your stories about how people behave, [they do] not act as a substitute for behavioral analysis.