Where I disagree with Michael Pettis

Recently, Michael Pettis has written a book on Chinese rebalancing and published an article at Foreign Policy on the euro zone crisis. While I have read through the first chapters of his book and will publish a critique at a later stage, I want to take issue with his article. While his Saldenmechanik (balance of payments mechanics) is the right approach, his neglect of endogenous money leads to the wrong causalities and therefore the wrong conclusions. Take this paragraph:

In the 1990s, Germany saved too little. It ran current account deficits for much of the decade, which means it imported capital to fund domestic investment. A country’s current account deficit is the difference between how much it invests and how much it saves, and Germans in the 1990s did not save enough to fund local investment.

The major issue here is that of financing – or, as Pettis calls it, funding – investment. The neo-classical view is best expressed by the loanable funds theory. Savings finance investment, and if there is not enough savings you must seek funds from abroad. With this in mind, Pettis concludes that “Germans in the 1990s did not save enough to fund local investment.” I disagree with this view.

In my view, investment is financed by loans, not by saving. As Marc Lavoie has written: loans create deposits. Banks create money by giving loans to households and firms, but not to governments (which issue bonds). A loan created leads to a new deposit created for the lender at the bank. Also, governments have the power to deficit spend and by this issue new deposits (and bonds).

So, if you do not need savings to finance investment, why the negative current account in Germany in the 1990s? The answer is very easy. Germany had its own sovereign currency, the deutsch mark (DM). So, German banks could create the loans it wanted to create. Of course, German banks were prudent and only issued loans to those that had sufficient collateral and a good history. So, Germans did not save too little. They saved just the amount the wanted to save since nobody forces people to spend their income. The only problem might have been that some people had an income which was low, and therefore saved less than the would have wanted to had they been in employment. Well, there is only one reality and Germans saved whatever they wanted to save, given employment and income.

So, how does the negative current account arise? What might have happened (and I can’t find the data now) is that international investors thought that buying German financial assets would be a good idea so that foreign currency went into the country more than it went out. Since the government engaged in fiscal spending to build up the east and offered relatively high interest rates, many speculators went after them. The foreign money was then partly used by German firms and households to buy imports so that a negative current account resulted.

Did Germans in the 1990s save too little? I don’t think so. Did they not save enough to fund investment? Again, I don’t think so. In a financial system with a sovereign currency, investment is financed by loans. So, in Ireland, Spain and China you can finance huge investment programmes in either public or private sector. If the financial assets you create by doing this are attractive either compared to other assets – like low-yielding government bonds in the euro zone or low-yielding deposits at Chinese banks – than you might be able to sell those assets on financial markets. With that money you can finance a consumption binge, like in Spain and Ireland, or give it as subsidies to entrepreneurs, like in China.

While I agree with Michael Pettis that balance of payments is the right place to look to get a grip on how an economy fundamentally works, our disagreement over the nature of money puts us in two different places when it comes to causality. This might make for an interesting debate.