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November 07, 2011

Michael Pettis says Germany Must Bail out Europe, Not China

Michael Pettis (professor at Peking University’s Guanghua School of Management and a Senior Associate at the Carnegie Endowment for International Peace) agrees with Arvind Subramanian (Peterson Institute) that China should use current events to play a bigger and more decisive role in global finance, and I certainly agree that as a surplus nation it is very much in China’s interest provide financing to the eurozone, I am not sure it makes sense for China to do anything that actually helps Europe.

[The concept of China bailing out Europe accord to Pettis is a] little bizarre, but not at all out of step with the thinking in Europe. I think the request for assistance from China and other developing countries shows how confused Europe’s leaders are and reinforces the claim made by Beth Simmons in her book (Who Adjusts) on the politics of the 1930s European debt crisis. Simmons argues that one of the problems with a debt crisis is that when debt levels are perceived as being too high, major stakeholders are forced into behaving in ways that reinforce credit deterioration and exacerbate the debt problem.




As political horizons get shorter (in a crisis, governments tend to be unstable), leaders choose short-term fixes at the expense of medium-term solutions. Since they are unlikely to be in office to benefit from the medium-term improvement, they discount its effect at much higher rates than they discount short-term policies. The result is that the crisis gets worse, not better.

This seems to be what is happening in Europe. In order to postpone the crisis, perhaps because of upcoming elections in a number of important countries, European leaders are choosing quick fixes at the expense of long-term European growth, and of course this will simply increase the probability and cost of a crisis.

Europe is capital-rich and in fact is a net exporter of capital. The reason peripheral European governments cannot get financing is not because there is a lack of capital or liquidity but simply because their solvency is questioned by investors, and correctly so in my opinion. They don’t need Chinese capital. They need someone foolish enough to lend money to countries that probably won’t repay.

If European leaders hope that China will lend large amounts of money directly to those borrowers, I say good luck to them but they shouldn’t expect too much. Why should China lend to someone who won’t repay? But if Europe is asking China to lend into a fund that is effectively guaranteed by Germany, then there shouldn’t be much Chinese reluctance. In that case however I would have to wonder why Europe needs help from foreigners. Germany has little difficulty in borrowing on its own.

But the main issue is the sheer silliness of Europe’s asking for foreign money. Any net increase in foreign capital inflows to Europe must be matched by a deterioration in Europe’s trade balance. This will probably occur through a strengthening of the euro against the dollar. And given weak domestic European demand, this means that either Europeans will buy from foreign manufacturers what they would have bought from European manufacturers, or it means Europe will export less. Europe, in other words, is trading medium-term growth and employment for short-term financing for borrowers that should not be increasing their debt levels.

This is absurd. Europe needs growth, not capital, and importing capital means exporting demand, which is now the world’s most valuable resource. Increasing unemployment cannot possibly be the solution for Europe – especially when Spain just announced yesterday that unemployment was up to 21.5%. But I guess postponing the crisis is more important than medium-term growth if you are looking to get reelected in the next year or so.

In the end this is Germany’s crisis to resolve, not China’s. Germany has benefitted tremendously from the euro. Nearly all of its growth in the past decade can be explained by its rising trade surplus which, given monetary policy driven almost exclusively by the needs of slow-growing and consumption-repressed Germany, came at the expense of the rest of Europe.

If the Germans want to save Europe, they must reverse their polices and start running large trade deficits even if that comes with slower growth. If not, the euro will break apart and peripheral Europe will almost certainly default on its obligations to Germany. Either way Germany loses.

And why do I say that Germany benefitted from the euro at the expense of peripheral Europe? For one thing, take a look at the table below provided to me by Chen Long. It shows the top ten trade deficit countries for each of the indicated years. I have colored each of the spendthrift, deficit-loving countries of peripheral Europe red, and all the thrifty, deficit-hating countries green

Ernst and Young forecast of China's economy at $29 trillion in 2020

Ernst and Young’s astonishing fact was presented this way: “Fact or fiction? China’s estimated economy will reach $29 trillion by 2020.”

Pettis assumes that they mean constant dollars otherwise the whole exercise is pointless. China’s nominal dollar GDP in 2020 is inordinately sensitive to dollar inflation between now and then.

Pettis did the math, and it turns out that China has to grow by roughly 16% a year in constant dollar terms to reach $29 trillion in 2020. If you think China will grow in real RMB terms by 9% a year, and that inflation in China will be more than 5% a year, and that the RMB will appreciate by 4% a year, and that dollar inflation will be around 4% a year, you can get to the $29 trillion, but it seems a stretch – especially the assumption of real RMB growth of 9% a year while inflation and the RMB are appreciating together by 9% a year.

Pettis would like to make a $100 bet with Ernst and Young. He bets that in constant dollars China’s GDP will be much closer to half that number.

My published forecasts for China are about $28 trillion for China and Hong Kong in 2020. It is for with an estimate of inflation differential with the USA and exchange rates. It does not look at inflation in the US so it is constant US dollars.

I would be willing to have a $100 bet with Pettis for an over/under bet around $21 trillion for China's constant dollar GDP for the full year of 2020 (based on converting RMB with the exchange rate on Dec 31, 2020) based on the official China reported GDP numbers later in 2021.

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