Michael Pettis: The US-China Relationship

This is my transcription of Michael Pettis’s interview with SuperReturnTV.

Interviewer: How has Donald Trump affected US CHINA relationship?

MP: China has a current account surplus, of course. And it needs that current account surplus because China has a big problem with demand. It has insufficient domestic demand so it has to balance that with huge amounts of investment and with the current account surplus. But because investment is, much of it is non-productive, all of that investment is causing debt to go up. So the current account surplus can be thought about as a mechanism that reduces the need to grow debt. My very rough calculations are that every forced contraction of China’s current account surplus by 1% of GDP causes the required amount of debt, required to meet the GDP growth target to go up by roughly one-third. So it’s a huge number. And if the US takes steps that forces a rapid contraction in the Chinese current account surplus, the only way China can balance that is with an increase in already too rapidly growing debt.

Interviewer: What do you mean by “if the US takes steps”? Are there concerns for some sort of trade war?

MP: Yes, basically, I think one of easier predictions to make after the Global Financial Crisis was that we were going to see significant pressure on trade. Because we are in a world in which the most valuable resource is demand. And the way that demand is proportioned around the world is that demand is created domestically by all these different countries. And it’s apportioned through the current account. 
So countries with current account surpluses are absorbing more of global demand than they are producing. Countries with current account deficits are the opposite. 
As long as debt levels were able to grow very very quickly, then countries with current account deficits were able to counter the impact of their deficits with and increase in debt. But the global crisis was really sort of the end of the ability to increase debt very very rapidly. So now that means that current account deficits have an employment impact. And once that happens, I think it was a pretty safe bet to say that we would see significant pressures on international trade, which as you know has contracted for the first time in a long long time. 

Interviewer: With that in place, how tricky is it to have a man like Donald Trump running the US as well?

MP: I think people pay too much attention to Donald Trump. Remember Bernie Sanders said exactly the same thing about trade. And this has been an issue that really became important political issue in the 1980s and it hasn’t really gone away. 

The problem is that it is true that the American role in the global economy is to balance the excess demand or excess supply of savings. 

You could say there’s been roughly 100 years of dollar hegemony. And the first 50 years, that really characterized by the two great World Wars, which cause a destruction in the income and therefore the savings of the rich countries of the world and a huge need for rebuilding. 

So in that period what people needed was savings, so I don’t think it was a coincidence that during that period every single year the US ran a current account surplus. The current account surplus is the flip side of a capital account deficit. The US was exporting a huge amount of savings into the rest of the world.

Since roughly the 1960s when the world was more or less rebuilt. The problem shifted. The world no longer lacked savings, it lacked demand. The way to grow was with additional demand. And [the world] had excess savings. And I think it’s not a coincidence that during that period, countries like the US with very open, deep, flexible financial markets (including Great Britain) were constantly running capital account surpluses. In other words, the excess savings ended up in those countries. And if you run a capital account surplus, you must run a current account deficit. And I’d say that is why the US has run persistent current account deficits since the 1970s.

Because, given the existing global framework, its been forced to absorb excess savings in the rest of the world. So this has been a problem for a long time. During the Cold War, the US was willing to ignore the problem because, by running large current account deficits, it was able to strengthen its relationships with its allies. But with the end of the Cold War, I think it was inevitable that would become an increasing problem. 

Interviewer: So in your view this is so long term.. someone going to have protectionist attitudes like Donald Trump.

MP: I think this was going to happen one way or the other. Donald Trump is not the first person to complain about the US current account deficit. The problem with the Trump administration, I think is that although they are right to complain, they are focusing on the wrong side. They’re focusing on the trade side, when the real problem is on the capital side. What they really should be focusing on is on the US role in absorbing excess foreign capital because that’s what drives the trade deficit. 

Interviewer: So that’s trade, there’s also events that could have a big impact, such as the US implementing a infrastructure program.

MP: Well, that’s one of the few things in the world that actually is a free lunch. The US has huge infrastructure needs which the private sector for a whole bunch of reasons is unwilling or unable to fund. But if the government were to fund infrastructure, I think we all agree, that the US has infrastructure needs, if you spend a trillion dollars on improving or building US infrastructure, you will increase the wealth of the US by more than a trillion dollars. So you actually reduce your debt burden. If the US were to engage in a major infrastructure building spree, in that case running a current account deficit wouldn’t be a problem. Because now the import of foreign capital would go into increasing investment. If it doesn’t go into an increase of investment, it must force a reduction in savings, it must balance. So the best way for the US to have a deficit would be if that deficit was caused by a massive infrastructure building spree. That would be great for the US and good for the world. But without that we are going to see tremendous pressure on the current account deficit. 

Interviewer: That’s the situation with the economy, what’s the situation with the “power void”? With Donald Trump looking more inwardly in the US there is sort of this space for China to expand its global influence. 

MP: “Well, I think it makes sense for the US to reduce it’s global commitments. After WWII US was about 50% of the world GDP, US is now around 23% of world GDP.Now the burden of that is much heavier given relative size of the US economy and the relative size of the rest of the world.There should be a US withdrawal from some of these commitments.If it doesn’t happen now, it’ll happen in the future.It’s better to happen now, when the US is still in a position where it can manage the process, than if the US were forced out of these positions 30- 40- 50 years from now.

The argument that a withdrawal of the US role means an expansion of the Chinese role, is not true. It doesn’t have to mean that, it could also mean that there is no leadership. That would be quite bad. The whole purpose of Bretton Woods was we had no one playing that role in the 20s and 30s and we all agreed it was a disaster. It could happen and in fact, in my opinion, it’s far more likely to happen.

Because the leadership role the US plays, the reason the Dollar is the reserve currency, etc, etc, Is not because the US will invade you if you don’t buy dollars. It is because the US is willing to absorb all of your excess savings and run the corresponding current account deficit.

If China wants to replace the US in that role, it’s very simple, it should open up its capital markets and should be willing to run large current account deficits. — Which it won’t do, there’s simply no way it will do that.

So it’s not as if a US withdrawal will be matched with a Chinese expansion. A US withdrawal simply means a US withdrawal. I don’t think there will be anybody to replace the US.

In that case, I think the best way to do it–it’s not going to happen– but the best way to do it, is for us all to get together and decide what this new world must look like.

For so long the global trade and capital regime worked fairly well, as long as the US and the UK, the other so-called Anglo-Saxon economies always had these very open capital markets, because all of the savings imbalances in the world get resolved in the US financial markets, and as that becomes increasingly difficult, it’s not a surprise people are more and more concerned about what the implications are. I wish I had answers. All I can do is tell you that, I think it gets worse before it gets better.

Interviewer: Question about UK’s Brexit, will there be a China UK trade deal?

MP: The problem is people think all we need are good trade deals. No. All we need is someone willing to run large current account deficits. And the UK has a deficit and if it is willing to allow the deficit to grow, and I think the UK has a limited appetite for that. Then trade deals between the UK and China could probably strengthen, we could probably see an awful lot more. Because China needs those surpluses, remember it has very weak domestic demand and much of that demand is non-productive investment, which is why debt is exploding. And their current account surplus is one of the ways in reducing the pressure to increase investment and to increase debt. That’s really what China needs from the world [surpluses]. I’m not sure that is what the UK wants to give it.

Interviewer: you called yourself a history nut, what could we learn from history in trying to understand the next 5 to 10 years?

MP: Well I think we need to look very closely at the 20s and 30s period. That was a period of tremendous imbalances. And, as has often been argued, the UK’s withdrawal as the director of the system, and the refusal of the US to step in. If we see a US withdrawal as the director of the system and no one else is able to step in. And I would insist, the only way for China to step in would to be willing to run the large current account deficits that the world needs it to run. Then that is the period we should look at. And it’s a very bad period. In fact, as I said, the whole purpose of Breton Woods was consensus–the universal consensus, that whatever it was in the 20s and 30s we don’t want that anymore. Unfortunately, I think that is where we’re going to go.

Interviewer: We need global leadership and there is a bit of a void.

MP: We need even global leadership, which was possible when the US was 50% of the world. I think it’s more difficult now that the US is 23% of the world and there’s no body else to replace it. Or we need a coordinated system that works, with no gaming of the system.

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