Given my constant harping on the "deficits don't matter" theme, it is no surprise that someone who constantly raises my hackles is Michael Pettis. Usually considered as an authority on Chinese financial markets since articles by the International Herald Tribune and others regularly ask him for commentary about the subject matter, he also maintains a popular blog. What we share in common is that we have both been guest writers on Brad Setser's blog--but not much else! It is there where I had a previous debate with him on Bernanke's "global savings glut" hypothesis, which is of course that "deficits don't matter because there's a global savings glut." You can see my more recent thoughts on the matter here.
Pettis has long been sanguine on the US running huge deficits, for example writing in the WSJ in 2004 about the existence of a "Deficit Attention Disorder." More recently, though, it seems that Pettis is becoming less sanguine on this state of affairs. In a recent blog post, he now admits the possibility--not the reality, mind you--that "the reason for the recession is that US households and businesses have found themselves overleveraged after years of excessive consumption." To me it's simple: the US has become overly dependent on consumption fueled by foreign borrowing and negligible household saving. Now that easy consumer credit is gone, America's consumption-driven economy is suffering.
That Pettis is at least making concessions to the idea that deficits do matter is welcome. However, he again makes another questionable remark about the financial relationship between the US and China. A post of his was inspired by this op-ed by Fareed Zakaria on how China's help will be necessary in financing America's record fiscal deficit. Pettis believes Zakaria does not understand the balance of payments identity:
...US fiscal expansion, in other words, will occur to offset the economic impact of a rise in US savings.Is Pettis right in saying an increase in US household savings will compensate for a larger fiscal deficit? Let us return to the basics. The balance of payments identity for an open economy is:
But if there is a rise in US household savings, don’t these increased savings need to be invested? Where will Americans put their savings? In fact almost all of it is likely to be invested in the US, and therefore the increase in savings is going to offset the need to finance a higher deficit [my emphasis] (by the way, even if Americans decide to invest their incremental savings abroad instead of in the US, the net impact is the same). This is just another way of saying that the money that used to go towards financing private US consumption will now go to finance public US consumption, and we all hope (I think) and expect that overall US consumption declines from its clearly excessive levels of recent years, so the total financing will be smaller.
S - I = CA
Given that we are talking about household savings and government budgets, we should expand this equation as follows:
(Sp + Sg) - I = CA
In plain English, private saving (by US households as well as corporations in the form of retained earnings) and government saving (revenues less outlays) less investment is equivalent to the current account balance. What Pettis says is that household savings will compensate for the larger budget deficit the US will run in fiscal year 2009. One of my gripes with Pettis is that he usually doesn't give figures to back up his assertions. Same banana here. Looking at the numbers should help illuminate matters.
The US Bureau of Economic Analysis (BEA) puts out its report on Personal Income and Outlays every month. Here, you will find the most up-to-date data on household savings. What we are concerned with is the line "Personal saving as a percentage of disposable personal income," better known to us as the personal saving rate. Based on this data, we can make some projections about whether Pettis will be proven correct. In particular, what we need to solve for is the personal saving rate at which household savings compensate for the increased federal deficit. To do this, we need to make assumptions about (a) US disposable personal income in 2009 and (b) the size of the additional US financing requirement.
To demonstrate that I am not stacking the deck, let us make some very optimistic
assumptions here in the favor of Michael Pettis:
- disposable personal income will increase in 2008 and 2009 by the same rate it did in 2007 (5.5%) despite the US entering a recession in December 2007;
- the additional deficit financing requirement will amount to *only* $700 billion despite Paulson already having spent $350 billion of his TARP allocation just two months into fiscal year 2009 and the US having managed to run a $273B deficit in the first month of FY2009;
- there will be no appreciable change in corporate savings affecting private saving despite dwindling corporate profits set to be hit even more by a stronger dollar.
Plugging in more realistic assumptions, the required savings rate figures I come up with are all in the double digits. I am thus at a loss as to why Pettis makes bold claims like this:
The net impact is that the US doesn’t need foreign savings to finance the fiscal expansion unless the expansion is so great that the US economy surges and Americans (private and public) spend more than ever, in which case the problem is not a recession but a boom.While it's welcome that deficits are starting to matter for Pettis--at least those on the household side--it's still unwelcome that he doesn't recognize the magnitude of the US funding requirement using the BOP identity he keeps citing. It is not at all guaranteed that personal savings will return to trends of wayback as he believes. And, these simulations suggest that even a highly improbable savings rate of 10% will not likely be enough to obviate the need for foreign financing based on the BOP identity. Additionally, he doesn't seem to appreciate that the level of disposable personal income is as necessary as the savings rate in determining personal saving. And, of course, disposable personal income will be affected by dwindling interest income via lower deposit rates and lower dividends as companies try to conserve cash.
While the basis for some arguments cannot admittedly be simulated by using data, this particular one can. Armchair theorizing is all well and good, but I believe that it's important to, well, do the math if possible. When Fareed Zakaria writes, I shut up and read as his observations typically get the larger picture right. When Michael Pettis writes, I tend to reach for the calculator first ;-)
12/19 UPDATE: An astute commentator has questioned why I haven't considered investment, and what the effect of including it would mean for the above calculations. My reply is "not much." Turning to US GDP data, it is remarkable how private investment has not fallen considerably in recent quarters. While residential investment has fallen off a cliff as you'd expect, non-residential investment has picked up quite a bit of the slack. See table 3 in the most recent GDP report. At most, I would dock investment by $130 billion--not much by US standards.