Posted by: Dirk | June 3, 2013

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.



  1. Normally I do not disagree with you, but today I disagree with your disagreement. –:).

    I dont think Pettis´s statement contradicts the “loans create deposits” adagio.

    Regardless of who finances the saving-investment deficit, even if these are German banks, the consolidated financial position of Germany worsens, while the rest of the world´s FP will improve.

    From the moment that savings are not enough to cover desired investment, arises a liability to a non-resident in the balance of the great germany.

    In my opinion, what Pettis is trying to explain is how the consolidated balance sheet of a country changes, not who gives the loan.

    i don´t think Pettis’s article is for the general public. I’ve read it a couple of times and slowly. I think that he assumes that anyone reading his article knows how and who manufactures the money we use every day.



    • Thanks, Iñigo. I think that you (and Michael) create confusion by assuming causality in a way that is not justified by the balance of payments. Your “saving-investment deficit” is nothing to be actively financed. If you have net capital inflows because of whatever, this will cause a “saving-investment deficit”. Maybe the cause is that domestic firms have to borrow from abroad (because they need dollars which they cannot get from domestic banks), maybe the cause is that international investors really, really like your sovereign bonds. Ex-post you know what happened, but not why. It is here where I disagree with Michael.

      Take this sentence, for instance: “In the 1990s, Germany saved too little.” What do you mean by “too little”? To little for the current account deficit to be zero? Why should it be zero? There are very interesting questions behind this and the “fact” that Germany saves too little hides all these very important discussions. If Michael thinks that Germans saved too little to finance investment – and this is how I read him – than he apparently thinks that investment is financed by savings, and not by loans.

      I hope that my amendment has helped to clarify my position. I agree with you that Michael aims at country balance sheets, like he did in his “Volatility Machine” book which I find very enlightening. However, going from ex-post identities to explanations of causality is something very delicate and this is what I want(ed) to stress.


  2. “The foreign money was then partly used by German firms and households to buy imports so that a negative current account resulted.”

    A decision to import is not the result of a foreigner willing to hold more of residents’ liabilities. A decision to import by the citizen rather says something about the competitiveness of the foreign producer relative to the domestic producer. Financial account balances do not cause current account imbalances. So the CAB depends on things such as import and export elasticities of demand at home and abroad and demand and home and abroad.

    In fact, Pettis also assumes that incorrect causality many times.

    Also saving can finance investment. It is not inconsistent with investment creating saving. So a firm may initially borrow from the bank to finance investment and later issue bonds/equities to households (and then reduce the loans) who can then be said to be financing the investment. In literature this is called initial finance and final finance. Or it can directly issue bonds to households to finance investment expenditures.

    Of course the sectoral balances identity as usually interpreted by Pettis is a bit vague. It is more appropriate to say that foreigners are financing the current account deficit.

    • “A decision to import is not the result of a foreigner willing to hold more of residents’ liabilities. A decision to import by the citizen rather says something about the competitiveness of the foreign producer relative to the domestic producer. Financial account balances do not cause current account imbalances.”

      I did not make that claim which you write about in your first sentence. You can assume that imports depend on consumption and consumption depends on income. That gives you the total amount of imports. How are these financed? If banks can lend from abroad, it is either that, or use of foreign means of payments acquired by liquidating financial assets and exchanging the proceeds into the currency needed. Alternatively, the exporter accepts payment in your currency or any domestic financial asset. I never said that financial balances cause current account imbalances and I agree that changes in demand drive the current account.

      The distinction between initial and final finance is interesting, I like that. Nevertheless, savings cannot finance investment in a modern monetary economy. There is no direct link between savings and investment. Loans are given by crediting a bank account, not by handing over money that a saver had deposited with the bank before. This does not mean that the position of liquidity of a bank has no effect on its credit creation. A firm that initially borrows from a bank receives a deposit at that bank, which receives a loan on its asset side. I cannot see how issuing bonds and repaying the initial loan can be seen as “savings financing investment”. What has the initial loan to do with it? What you get is a destruction of money/credit (a loan is repaid) and an increase of debt for the firm with a parallel increase in assets for the savers. Do note that the savings must come from somewhere! That somewhere is either deficit-spending by the government or endogenous money creation by banks. So, loans create deposits, which you move somewhere else (paying bills of your investment project) and then you call them savings. Then those savings can “finance” investment (like an IPO), if I understand you correctly. Nevertheless, your savings are really deposits and these have been created by loans (or government bonds) in the first place. So, loans finance investment by creating additional deposits, and savings don’t. Deposits can be used to buy financial assets, but this is a zero sum game in the short run. For every buyer there is a seller. During an IPO, the bank sells you stock and you buy it. This is about ownership of the asset, not financing. In most IPOs, banks promise to hold stocks not sold to the market at some price agreed upon before. If demand for stocks is too weak, the IPO is off. Only later movements in asset prices have consequences for the economy (i.e., issuance/repayment of debt).

      Consider the following case: all new shares during an IPO are bought by an investor who borrows the money from a bank to finance this. Clearly, the investment if financed by a loan. If that investor gives all his money to his daughter as a present and she buys the very same shares, would then the investment be financed by savings? If you believe that the answer is yes, what if the daughter is technically bankrupt? The value of her assets – the money she uses to buy the shares – is a lot below the value of her liabilities. Why do you call her cash holdings savings and not deposits? If you acknowledge that they are deposits you will also understand that a loan (by the father) was what created them in the first place. Without that loan these deposits would not be there. Loans finance investment. Sometimes, indirectly, but they do.

      • I said you assigned a causality because you started with the sentence

        “So, how does the negative current account arise? ”


        “Nevertheless, savings cannot finance investment in a modern monetary economy. ” ….

        I did mention firms issuing equities, so this is primary issuance, not a change of shares in the secondary markets in my scenario.

        It is true an investor can borrow money from a bank to purchase shares in an IPO, but the investor can purchase shares even without borrowing from the bank. Saving is financing investment.

        In fact firms finance a lot of investment with retained earnings – meaning saving is financing the investment. Again, it isn’t inconsistent with investment bring forth its own saving.

  3. OK, then we disagree, but more on choice of words then on substance. What you call “savings finance investment” I would call “deposits, created by loans, buy financial assets”. I note that you did not reject my explanation that deposits are the result of loans. So, loans create deposits that can buy something. If you buy investment goods we call that investment. If you transfer the money to someone else and that somebody buys investment goods the source of the deposits is still the loan.

    If you cannot explain where money is coming from you will not be able to understand what “saving” really is: deposits used for saving. If you decrease the amount of loans (by banks but also through government surpluses) you decrease the amount of deposits, which makes it harder to save for everybody. This is called the paradox of thrift in Keynesian economics, and you can see it at work in Spain, Greece and other countries effected by austerity policies.

    • I know things such as loans create deposits and so on.

      “If you cannot explain where money is coming from you will not be able to understand what “saving” really is: deposits used for saving.”

      Saving is disposable income minus consumption. Deposits is one form in which the saving can be allocated into.

      The reason I pursued the argument is that in the United States a lot of investment is financed out of retained earnings in addition to being financed by borrowing. (Retained earnings is firms’ saving).

      You can find the usage of the phrase “investment financed by retained earnings” in books such as Godley/Lavoie.

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