Michael Pettis began his career on Wall Street, specializing in Latin America in the years after the debt crisis of the 1980s. By the late 1990s he was a managing director at one of the big Wall Street firms, running its Latin American capital markets. A few years later he found that the work had become repetitive, and he wanted to study an economy he knew little about, so he moved to China to teach finance. He taught first at Tsinghua University and then, for more than two decades, at Peking University. He remains based in Beijing, where he is a non-resident senior fellow at the Carnegie Endowment for International Peace. He is the author of several books, most recently Trade Wars Are Class Wars, written with Matthew C. Klein.
Michael is one of the few Western economists who follows the Chinese economy from the inside. His work centres on one question: why does China save so much and America so little? Most answers point to national character, but Michael points to policy. When a country holds down the household share of income through suppressed interest rates on savings, a weak currency, or wage restraint, the surplus it exports is the other side of the consumption it has taken from its own workers. A trade dispute, on Michael’s view, is a dispute over income between countries.
In this conversation, he explains why China’s overinvestment and its strong infrastructure are the same story, why infrastructure is a cost of growth rather than a source of it, and why financial repression pushed down the Chinese household share through the 2000s. He uses Europe, from Germany’s labor reforms to Spain’s credit boom, to show how these imbalances spread, and argues that deficit countries do not choose to deindustrialize but have it forced on them. He sets out his doubts about the dollar’s exorbitant privilege and about stablecoins, and reviews a century of precedents to reach the question he thinks the next round of talks will turn on: not how everyone wins, but who pays for the adjustment.
Michael writes for Carnegie’s China Financial Markets newsletter and on Substack, and is on X at @michaelxpettis.
We usually share these conversations in video, but a problem uploading the HD files means this one is audio only. Apologies for the change, and thank you for your understanding.
Nicolas: Hello, I’m Nicolas Colin.
Marieke: And I’m Marieke Flament.
Nicolas: And this is the Currency of Power podcast, the companion to the Currency of Power newsletter, where we dig into currencies, power, and the people connecting the two. Today our guest is Michael Pettis.
“Infrastructure is not a source of growth, it’s a cost of growth”
Michael, welcome. You’re a non-resident senior fellow at the Carnegie Endowment for International Peace, and you’re the author of several books, one of them being Trade Wars Are Class Wars with Matthew C. Klein. I think it’s the most recent, and it’s very much about the topic we will be discussing today, which is macro imbalances, macroeconomics in general, China exporting so much and the US consuming so much, and all the consequences of that situation all over the world, including, maybe, Europe.
We’d like to start with your journey. You’re based in Beijing. You’re a rare Western economist commenting on the Chinese economy from the inside, from the ground. Can you tell us what brought you to China in the first place, and what made you decide that you wanted to stay?
Michael: I started my career on Wall Street, where I specialized in Latin America. This was right after the global debt crisis of the 1980s. By the end of the 1990s, I was a managing director at one of the big Wall Street firms, in charge of Latin American capital markets.
At some point, it had become a little bit boring, in the sense that when I first started, everything we did was very new, had never been done before, so you had to put together the entire transaction. By the end of it, it was very cookie cutter. Every deal was the same as every previous deal. So I thought I would take some time off and learn something that I didn’t know much about. India and China were the two really big economies that I had very little familiarity with, so I decided to go to China for two years. I didn’t want to go as a banker. I had been teaching at Columbia University while I was working on Wall Street and I thought I could use that to teach a couple of years in China and get a chance to learn the economy from a point of view different to that of a banker.
I was very lucky. I was offered a position by one of the top two schools, Tsinghua University. But after two years, I decided that, although I’m a New York fanatic, I wasn’t ready to move back to New York yet. So I switched to Peking University, because people told me it was a very different school. Not really, but at the time that’s what I believed. And I’ve been there for 24 years.
Nicolas: Do you speak the language? Did you learn Mandarin?
Michael: Terribly. I can order a beer, I can tell a taxi cab what to do, but not much better than that.
Marieke: It’s really interesting, because you came at economics through a background as a finance person. You’ve been in the guts of the system. What different outlook does that give you when you look at teaching economics?
Michael: I stay away. I’ll tell you the truth, I’m very skeptical about academic economics, particularly of the so-called Anglo-Saxon variety, what’s taught in the US and the UK. I think it does a really good job of describing a world that frankly doesn’t exist, sort of an Adam Smithian world in which no one is big enough to intervene in the markets. But that’s not really what the world looks like. So my focus tends to be much more practical. The most famous course that I gave at Peking University was called the PBOC Shadow Committee, where the students pretended that they were the monetary committee of the Central Bank of China. We went through regular events occurring in the world, and we really spoke about how that affected investment, how that affected businesses, things like that. So as an economist I would fit much more in the world prior to the 1960s and ‘70s, which I think is the last time we were really good at economics, because I think we took a wrong turn in the 1970s towards a much drier, less useful understanding of economics.
Nicolas: That’s funny, because when Trump was re-elected in 2024 and conveyed the message that he was really serious about imposing tariffs and waging trade wars this time, I realized we all had to dust off our macroeconomic textbooks. I used to study macroeconomics at Sciences Po in 2000 and never used it for 25 years. Suddenly it’s become the main thing, and really a discipline you need to master to understand what’s going on. Maybe that’s the same impression.
Michael: It’s what I tell my friends. We have to reread Keynes. We have to read Joan Robinson, who I think is particularly important here; I think she did some of the best work on trade. We have to reread Ragnar Nurkse, we have to read Michał Kalecki, all of those ways of understanding macro, particularly within a globalized world, which is very different from macro in a non-globalized world.
Nicolas: So what does being based in China give you that other economists or analysts don't have? What do you learn? What do you observe on the ground that's difficult to decipher from the outside?
Michael: I’m very skeptical of the argument that the people who really understand an economy are the ones in the middle of the economy. I don’t think there is that much historical evidence that supports that. What happens is that if you live in a country you get many of the small things right that people who don’t live in your country might not get. But there’s no evidence that you get the big things right. If you look at the criticisms of the US in the 1920s, they mostly came from Europe. It was only in the 1930s that American economists started to recognize those criticisms.
If you look at something that’s very close to me, because my career started out of that, the huge borrowing and current account deficits of Latin America in the 1970s, it was mostly foreign economists, not a lot, but mostly foreign economists, who said this is completely unsustainable. In Japan, it was often Americans and Europeans who were the earliest to recognize problems in the Japanese growth model. In the late ‘80s, when Paul Krugman started saying there really are problems with this model, the standard response is something that we hear today: you’re a foreigner, you’ll never be able to understand Japan.
And I think we hear that a lot about China. But as I said, there is no evidence that an outsider is more likely to be systemically wrong than an insider. In fact, you could argue that maybe outsiders can be a little bit more open about some of the issues.
Now, having said that, I don’t want to say that my having spent 24 years in China is totally worthless. You do get a very different view. For example, I mentioned the small things. They’re not small, but they’re very specific. People have been telling China again and again that if you have a problem of deflation, it’s very simple, expand your money supply. That’s what they used to say to Japan in the ‘80s and ‘90s: it’s very simple, if you expand your money supply, everyone knows more money means inflation. And yet that hasn’t happened. Money has grown quite quickly in China, as it did in Japan in the late ‘80s and ‘90s, and yet they suffer from even deeper deflation.
The reason there is when it’s very useful to be close to a system. One of the first things you notice about the Chinese banking system, which was true about the Japanese banking system, is that unlike the banking system in the US and Europe, very little credit expansion is directed towards consumption. It’s almost all directed towards investment. So when you expand the money supply and expand loans, which is what happens in a really bank-centered system, then what you’re really doing is expanding supply more than you’re expanding demand. And as anyone can tell you, that’s disinflationary, not inflationary. So those are the kinds of things that you need to know about China. I’m not sure living in China gives you a particular advantage there, but if you specialize in trying to understand the Chinese economy, those are the advantages that you get.
Marieke: So what do you think we get wrong in the West about China? You mentioned deflation, the fact that the banking system is actually not the same. What other examples come to mind, things where there's currently the wrong perspective on what's actually happening?
Michael: I think sometimes people overestimate the power of Beijing to get things done. There is a perception that if Xi Jinping says jump, everybody in China jumps. It’s not really true.
Historically, there has always been a conflict between the power of the central government, whether it’s in Beijing or Xi’an or wherever it has been historically, and the power of local governments. That continues to be a very big issue in China. For example, a few days ago, the South China Morning Post had an interesting article about, I forget which industry it was, one of the industries suffering from involution, where Beijing has made it very clear you have to cut down capacity. And capacity is actually expanding, not cutting down, because local governments want to continue expanding domestic production. So all the yelling and screaming from Beijing doesn’t seem to have had as big an effect as you might have expected.
The other thing that I think people get very wrong is that they have two different stories about China, which they think are in opposition. You can argue that the bear case about China is massive overinvestment, obviously in the property sector, which has started to correct, but also in manufacturing and in infrastructure. And then you have the bull case for China, which is counterposed to that, and the argument there is, no, China is doing great. Look at its infrastructure, it has the best infrastructure in the world. Look at its technology, it’s catching up to the US in many areas and surpassing it in others. So it must be doing very well.
And the point there is that those two stories are not at all inconsistent. They could very well be the same story. When you overspend on infrastructure, you don’t get worse infrastructure, you get better infrastructure. The problem is, is it economically viable? Is it worth the cost? When you overspend on technology, you will get great technology, but it may bankrupt you. We’ve seen this before in the Soviet Union in the 1960s. The Soviets expended an enormous amount of resources on catching up and surpassing the US technologically, and they did in some areas. We all know about the famous Sputnik moment. And yet in the end, it didn’t really provide the productivity boost that Soviet officials were hoping would get them out of their domestic economic problems, I suspect because their great technology was never economically viable.
The same thing happened in Japan. I always tell people that the best way to understand China is to read as much as you can about Japan in the ‘70s, ‘80s, and ‘90s. I’m old enough to remember that in the late 1980s Japan easily had the best infrastructure in the world. Nobody compared to it. It also had some of the best technology in the world. Every cool consumer product in the 1990s was Japanese. And yet it still didn’t lead them out of the economic problems that the economy suffered. So I would argue that great technology is certainly a wonderful thing, but you can bankrupt yourself with great technology just as easily as you can get rich with great technology.
Nicolas: And what about scale in that case? Because China is much bigger than Japan ever was, more comparable to what the US was in the early 20th century compared to European nations. Can scale actually save you when the reckoning comes? Can China overcome the obstacles because its sheer scale makes it possible to impose new terms, a new paradigm onto how the economy works?
Michael: I think the scaling argument is one of those retrospective arguments. When an economy is growing very quickly, we look for reasons to explain that rapid growth. This is why it’s really useful to be obsessed about economic history in general, because scale isn’t as much of an advantage as you would think it is when you look at the historical precedents.
In terms of population, India is bigger than China. Those have been two huge countries basically for the last 100 years, longer of course, but in the last 100 years those are potentially the countries with the best scaling benefits, which they’ve used miserably. That hasn’t really been very successful. But more importantly, the extent of scaling isn’t a function of population, it’s a function of population times income. And Japan was 17% of the world in 1991. That’s what China is today. So when people talk about how massive China is, yes, it’s about as big as Japan was in the early 1990s, and that didn’t resolve Japanese problems. It’s hard to see why it would resolve Chinese problems.
For me, it’s a very simple arithmetic problem. If you take 50 euros of resources and combine it with 40 euros of resources and create 80 euros of value, it doesn’t matter how big you are, you’re losing money. There, I would say the poster child is the province of Guizhou in the south of China. You may know of Guizhou. It’s a beautiful mountainous province, a little bit richer than Cambodia, so it’s quite poor. And it has easily the most spectacular bridges in the world. More than 50 of the 100 highest bridges in the world are in this one little province, and approximately half of the top 10 are in this province. And yet it was the first province to go bankrupt.
The argument there is that there was this belief that infrastructure creates growth, that infrastructure is a source of growth. So because Guizhou is so poor, let’s massively spend on infrastructure and Guizhou will get rich. Well, it’s not that easy. Infrastructure is not a source of growth, it’s a cost of growth. If you could grow without spending money on infrastructure, you’d be better off. But when I say it’s a cost, that cost is only justified if the subsequent increase in productivity exceeds the value of building that infrastructure.
It turns out that more productive countries tend to benefit more from infrastructure than less productive countries, because you can basically say the value of infrastructure is the amount of man-hours it saves times the productivity per worker. In very low productivity countries you can absorb much less infrastructure productively than in high productivity countries. The reason Switzerland has more investment per capita than another mountainous landlocked economy like Bolivia is not because that infrastructure made Switzerland rich. It was because Switzerland was rich and was able to absorb that infrastructure. So the question then becomes, why is Switzerland richer than Bolivia? That’s the question that can win you a Nobel Prize if you answer it. But the simple answer is that Switzerland has the set of institutions, political institutions, legal institutions, financial institutions, that allow workers and businesses to operate at much higher levels of productivity. So what you really need is for infrastructure to keep pace with the growth in productivity, not for growth in infrastructure to replace growth in productivity. In China, you have the case where it’s really been increased spending on infrastructure that has driven much of the growth.
But then you run into a strange paradox, and Martin Wolf wrote about this in the Financial Times about a month ago. He said, how is it possible that a country that invests more than 40% of GDP is only growing at 5%? That’s, in theory, impossible. But that is what we see in China. And the only possible answer is that that investment is not real investment, it’s non-productive.
Just to give you a sense of how much of an outlier China is: investment is roughly 25% of global GDP, and that’s been a pretty consistent number. But it’s not the same in every country. Europe, the US, the capital-rich countries invest much less. They invest around 18 to 20% of their GDPs. Developing countries, poor countries, also invest much less. But there are countries that invest much more. Very rapidly growing developing economies growing at 6%, 7%, 8% might invest 32%, 33% of their GDP. That tends to be the high end. I once saw that South Korea invested as much as 39% of its GDP for one or two years, and that’s the only higher number. But China for the last 40 years, for the last 30 years, has invested between 40 and 47% of its GDP year after year after year.
And as in Japan in the 1980s, as in Brazil in the 1960s and ‘70s, all of that investment created significant economic activity that looked like growth. But we realized in retrospect that much of that investment, the famous bridges to nowhere in Japan, had no economic value. So they actually made the country poorer, not richer. Obviously, if you’re a very big country, there’s probably more room for you to invest in productive infrastructure. But there’s always a limit. And once you pass that limit, then all of this investment is driving GDP growth, but not real economic growth.
Marieke: It's really interesting, because hearing what you were saying, I'm thinking about AI, which is at the same time an infrastructure but also carries the wish that it will increase productivity. And listening to you, I was thinking, well, who is it going to bankrupt? Because when you look at the massive valuations that are floating all around the world, and the very different paths that China is taking from the US in terms of its AI investment and development, I don't know, do you have a view on the role that AI will play in the model you were describing?
Michael: If you look back at these technology bubbles, or, I shouldn’t call them a bubble, stages of the Industrial Revolution, periods when we saw very rapid growth in technology and very rapid growth in productivity, it’s interesting, because I used to track stages of global financial liquidity being driven towards developing economies. You’ve had many bubbles in developing economies, Latin America in 1925, several in the last 200 years. And there was an economic historian at Oxford, I forget his name, who listed stages of the Industrial Revolution where you saw very rapid increases in productivity and technology. I was amazed, because his stages exactly matched my stages. What it suggested to me is that a lot of this is driven by, for whatever reason, a significant increase in risk appetite, perhaps because of a massive expansion in liquidity. Several of these stages were driven by gold discoveries in the 19th century, for example. So risk appetite goes up and money pours into risky ventures, risky countries, risky everything. And then you have the bubble and the bust.
But not all technology bubbles have been bad. The railroad bubble in the 1860s in the United States collapsed in 1873, and yet the US was left with spectacular infrastructure. We’ve seen many cases of this. Remember there was a bubble in the 1990s for companies laying out the framework for the internet, the cables and all that. Most of them went bankrupt too, but they left the world with very good technology, which then presumably boosted productivity growth. So you can have good technology bubbles and bad bubbles. I would say real estate bubbles are almost always harmful for the economy. Infrastructure bubbles can be or cannot be, depending on their extent. And the same thing with technology bubbles. This is sort of a cop-out, because what I’m saying is that we don’t really know. Sometimes these are good things, sometimes these are bad things. I think we have to bear that in mind. But China really is different. The level of investment is just incredible. We’ve never seen so much investment pouring into an economy for such a long period of time.
“Whether you like it or not, your economy will adjust to my industrial policy.”
Nicolas: So the complement of that huge investment effort is low consumption. When people try to understand the macroeconomic situation, they always look for causality, and macroeconomics is difficult to understand for that reason, because it's a complex system of feedback loops, each loop feeding into the others, and we don't really know what started the whole thing. But I would say, after having read much of your work and listening to many of your interviews, that at the heart of it there's this phenomenon of very low household consumption in China. Is it fair to bring it back to that core phenomenon?
Michael: There are two arguments here. To simplify the world, let’s say there are two countries, China and the US. The US has very low savings, and China has very high savings. And globally, savings must equal investment. So by definition, if one country saves more than it invests, the other country must invest more than it saves. That’s definitionally true. It could be just an astonishing coincidence that the world always balances. It’s a little bit hard to believe. So if you don’t believe it’s a coincidence, then you must believe that there is some sort of causal relationship. Either high-saving countries force low savings elsewhere, or low-saving countries force high savings elsewhere.
Now, for many Americans, and I think for many people, it’s hard to believe in a world in which the US doesn’t have agency. As one of my professors told me many years ago, most Americans believe that either everything good in the world is caused by the United States, or everything bad in the world is caused by the United States. In fact, lots of things happen whether the US wants them or not. So for me, the question is, which way does causality flow between China and the US?
Here I’m very Joan Robinson. If I control my external imbalances, my external account, if I control my capital account and my trade account, then I’m able to create domestic imbalances, which are reflected in my external imbalances. Because normally, if I subsidize manufacturing at the expense of the household sector, I should run a trade surplus. That trade surplus should change capital flows in ways that probably will drive up my currency. As my currency goes up, households are better off and manufacturers are worse off, so I rebalance.
Now, if I don’t want to rebalance, I control my capital account, I intervene in my currency. So here’s the thing. If I control my external accounts and you don’t control your external accounts, then which way is causality likely to run? Probably from me to you. So I would argue in that case the source of the imbalances is more likely to be in countries like China that very sharply control their external accounts.
I would add to this that the decline in the household share of GDP wasn’t smooth. It began in the 1980s, when Chinese consumption was quite normal. Chinese savings were quite normal by global standards, and then it started coming down all the way until 2011. Then it went up a little bit until 2019, and since then it’s been coming down again. But the really sharp decline occurred in the 2000s, between 2002 and 2010. That’s when we saw an almost collapse in the household share of GDP.
So what explains that? That’s when China decided to clean up its banking system. In the 1990s, bad loans were such a problem that private sector estimates were that as much as 40% of the loans were bad. And the People’s Bank of China (PBOC) never really disagreed. They didn’t agree, but had they disagreed, they would have said something, and they didn’t. China, because it was initiating the IPOs of its four big banks, a really big political event in China, had to clean up the banks.
The way they cleaned up the banks was by shifting the bad loans to what were called asset management companies, which were themselves funded by the banks. So it didn’t really solve anything. But the way they solved it, if you look at real interest rates in China, they were hugely negative basically from 2000 to 2011. And when I say negative, I mean the GDP deflator in China was 8% to 10% during that decade, the nominal growth rate in China was 16% to 20% during that decade, and the deposit rate was 2.5% to 3%. So if you put your money in a savings account, much of it was confiscated through this hidden tax. The IMF estimated that as much as 5 to 8% of GDP was transferred every year from the household sector to the rest of the economy in the form of this tax. So to me, it’s not at all surprising that the income of the household sector, basically there was a huge tax on their savings, so their disposable income as a share of GDP dropped very rapidly. And as a result, we saw a huge surge in the Chinese trade surplus.
So to me, when people say that that must have been the result of domestic policies in the United States, I find that really hard to reconcile with what China was doing at the time. It was very specifically cleaning up the banking system using financial repression, and that had to have an impact on income distribution, which in turn had to have an impact on its external account, et cetera, et cetera.
So that’s really my big argument with, not argument, but I meet with a lot of European policymakers. In fact, next week I’ll be going to Brussels, and this is what I tell them. Again, it’s a very Joan Robinson argument, and the argument is this: if I am able to control my external account to the point where I can externalize the costs of my internal imbalances, and you don’t control your external account, then whether you like it or not, your economy will adjust to my industrial policy. So not only do I get to decide the industrial policy for my country, I get to decide the broad outlines of the industrial policy for your country. You get to choose whether you absorb it in the form of higher debt or higher unemployment, but you are going to lose manufacturing, whether you like it or not. And that’s something that I think is incompatible with a global trading system.
Marieke: I think it's fascinating, because we talk about repression also a bit at the individual level. But I can't help but look, with a 20-year perspective, at the fact that there's been a massive uplift in terms of poverty in China, and there are fewer people that are very, very poor. There's also a major amount of billionaires and so on. So how do we reconcile both things? Because on one hand, what you were describing does not sound great, but on the other hand, if you go witness it and look at some numbers, people seem better off.
Michael: And that was the story with Japan too. Japan lost 60% of its economy after the war, and by, I think, the 1960s, it had recovered it fully. That was a real recovery. Brazil, the first country I believe to be called an economic miracle, in the late ‘50s and ‘60s and early ‘70s, was growing very quickly and very healthily. It was only in the mid to late ‘70s that we started to see the problems emerge. The Soviet Union: we forget that in the 1960s, most intelligent people, not just in the Soviet Union but also in the US, from President Kennedy down, believed that the Soviet Union was going to overtake the US economically and technologically sometime in the 1980s. You can find it in Paul Samuelson’s first edition of his book on economics. I think he said 1984. So it’s always a bit of a surprise, because there have been real advances.
What I would argue is that a high-investment model, which all of those countries followed, is the medicine that the doctor ordered when you are significantly underinvested. Japan after the war, Brazil as a typical developing country, China, remember, when it began its reforms, had gone through five decades of first the anti-Japanese War, then Civil War, then Maoism. So China’s infrastructure, housing stock, and manufacturing stock was a total disaster. On the social basis, it was not so bad. It was relatively educated, very healthy, with political stability. So China, I would argue, entered the reform period hugely underinvested, in which case very high levels of investment are exactly what you need.
The problem is that when you have a very rapid growth in investment, and in China it was the highest growth rate in history, then at some point you close the gap between what you have and what you need. And that’s when you should shift your growth model. No country, by the way, has ever shifted its growth model in time. One of my favorite economists, Albert Hirschman, this was a problem that really puzzled him in the ‘70s. His conclusion was that a very successful growth model creates a very powerful constituency that benefits from that growth model, and they tend to block efforts to change the model, which is why you always overshoot.
Now, how can you tell if you overshoot? In China, as in Japan, there’s a very easy way of telling. Remember, I said that in China almost all lending goes to investment. So if you are investing productively, your debt can grow very quickly, but your debt-to-GDP won’t grow at all, because presumably that productive investment is creating real growth in the economy. If you look at China before 2008, 2009, debt grew very rapidly, but the debt-to-GDP ratio grew slowly, bouncing around. It really wasn’t a problem.
But it’s precisely around 2008, 2009, probably not a coincidence that that’s the global financial crisis, that you start to see an acceleration in debt and a deceleration in GDP growth. That should really puzzle us. If you saw that in the US or Europe, fine, because a lot of lending in the US and Europe goes to consumption. But in China, almost none went to consumption, it all went to investment. So that’s a real puzzle. And the only explanation I can come up with is that an increasing amount of this investment was non-productive.
Now, that should show up in the productivity data, and it does. Productivity growth has slowed very sharply since then, and even that’s overstated if you believe the GDP growth is overstated. So the story we see in China is a very good model that reached the end of its useful life, but they were unable to shift the model. Every country has had that problem. And they kept it going for far too long.
Nicolas: Before we discuss the deindustrialization and maybe the role of the dollar as a reserve currency, I'd like to embrace the perspective of a single household. If I'm a Chinese household, what prevents me from consuming more? What constraints do I feel that force this behavior on me? And if I'm an American household, what prevents me from saving more? I think it would help people understand better how the macroeconomic situation translates into individual behavior on the ground, both in China and the US.
Michael: Sure. The problem in China is quite simple. The household share of GDP is very low. So if you produce €100 worth of goods and I pay you €80, your consumption will probably be €70 to €75. If I pay you €60, obviously your consumption isn’t going to be that high, it’ll be lower than that. And China has the lowest household share of GDP in the world. So to me that’s pretty straightforward. There are variations in it, because if I’m more optimistic about the future, my saving rate might go down, and so my consumption rate will go up. If I’m pessimistic, which is where people are now, my saving rate will go up. But basically the long-term constraint on my consumption has got to be my income.
Now, why do Americans consume so much more than they should? There, I think it’s easier to look at Europe than at the US, because in Europe you saw a very clear example of what happened. Remember that when the euro was created in 2000, 2001, when the currency came out, a country like Spain, I was born and grew up in Spain so I focus mostly on Spain, but it could be Greece, it could be Italy, it could be Portugal, it could even be France to some extent, a country like Spain actually had a fiscal surplus and a tiny trade imbalance. And then something happened. Spain, Portugal, Greece, even France, Italy, suddenly they all went crazy and started spending like crazy.
If you read the German press in 2009, 2010, the problem with Spain is that they always go to the beach and have siestas and they don’t work. Well, that only started after 2003. And it started in all these other European countries at the same time. So that’s a remarkable coincidence until, and I’m sure you know this, you come to what was probably the real driver of all of this. And that was that in 2003, 2005, Germany implemented the Hartz reforms and the labor reforms.
You can call them labor reforms, but it’s a euphemism for wage suppression. Because if you look at the relationship between wages and GDP growth, before 2003, wages kept pace with GDP growth. And after 2003, GDP growth continued and wages stopped growing. So if the household income share of GDP goes down, something else must go up. And what went up? It was business profits, which surged. And of course, that means consumption will go down. So German consumption went down, not because the Germans became thriftier, but because they received a smaller share of what they produced. And the German savings rate soared.
Now, the reason Europe is so useful is because it’s a small experiment, in the sense that the creation of the euro and the rules governing the single market meant that most of the excess saving in Germany didn’t go to the US or anywhere else, it went to other countries within Europe. Interestingly enough, the countries that entered the euro with low inflation ended up exporting capital to the countries that entered the euro with high inflation, which makes sense if interest rates converge, because they become negative in the high-inflation countries and positive in the low-inflation countries.
So in a country like Spain, money poured into the country, into the banking system. And again, from a personal point of view, as late as the 1990s, getting a credit card in Spain was really prestigious. If you had a credit card, you would brag about it. By the end of the 2000s, if your children didn’t have multiple credit cards, then you were a total loser. Everyone had credit cards. So what really happened? Why did the Spanish suddenly go crazy? I would argue that it isn’t that the Spanish went crazy.
If you assume that Spain, like every country in the world, has a normal distribution of risk-taking, there are people who are too prudent, people who are not prudent enough, people who are overly optimistic, people who are foolish. You can always get the consumption rate to go up, not because the whole culture of the country changes, but because if you loosen liquidity conditions in the banking system, the banks are eager to expand lending, and the way you can always expand lending is by lowering your credit standards. So as money poured into the Spanish banking system, banks were under increasing pressure to do something with it. Some of it they used to fund pretty good infrastructure. Spain has decent infrastructure. Some of it went to fund the worst real estate bubble after Ireland’s. It also helped the Irish real estate bubble. And a lot of it went to fund the surge in consumption. I would argue that that’s the mechanism. When money pours into your country, when there’s a net inflow, by definition you need a gap between investment and savings. And that can happen in many ways. If you are a developing country whose investment is constrained by scarce capital, then money inflows could drive up the investment rate.
But in Europe, there’s no scarcity of capital. A recent ECB study asking businesses in Europe why they aren’t investing, none of them said, or very few of them said, because we can’t access capital. They mostly said because we don’t have demand, or the number two reason, which is the same reason in my opinion, because it’s not profitable. So if you go to these businesses that are not investing because they are not competitive with Asian countries, and you say, here’s money, build more industrial capacity, they’ll say, no, we don’t need more capacity, we can barely sell what we’re producing.
So if investment doesn’t go up, then something must happen to cause saving to go down. It’s got to balance. So what could happen? In the world of Keynes and Joan Robinson, it was very clear what would happen. Unemployment would go up, because as German manufacturers expanded their share of the Spanish market, Spanish manufacturers would close down and unemployment would go up. And remember, conveniently enough, unemployed workers have a negative saving rate. So that’s how you balance it. In the modern world, we don’t like unemployment to go up. So we have two ways of dealing with it. We can expand household borrowing through monetary policy, or we can expand the fiscal deficit. And Spain did both. The fiscal deficit went up and household debt went up. And that’s the way you balance without unemployment.
The problem is that in 2009, when Spain was no longer able to increase debt to balance its trade deficit, how did it respond? It responded in the Keynesian way, with a surge in unemployment. So I would argue that that’s really what drives up consumption. When people say that Americans are addicted to consuming, I would say no. If you have a banking system with very loose lending standards, like we did with real estate in 2003, 2004, 2005, you will get very risky, foolish behavior. So that’s really what matters. Sorry for that very long answer.
“Foreign inflows into the US are bigger than ever”
Nicolas: No, it's very clear, and also very interesting for us as Europeans to reflect on the role of Germany in all of that. So maybe coming to deindustrialization, I think it's pretty clear from everything you've said so far that the excess investment in one country, in that case China, or maybe Germany from when the euro was set up in 2002, triggers deindustrialization in the rest of the world, in countries that don't control their capital accounts. So is that the origin of that trauma, all the factories closing?
