The urgent debate earlier this year about the establishment of a binding debt ceiling for the U.S. government implicitly (and sometimes quite explicitly) assumed that rising debt is a measure of Washington’s profligacy, and that if only policymakers were a little more frugal or a little less irresponsible, the American debt burden would stop rising. The purpose of the debt ceiling, by this logic, is to impose discipline on lawmakers.
There is a similar debate within China about the surge over the past ten to fifteen years in local government debt. The press is full of stories about regulators attempting to clamp down on hidden local government debt and fraudulent borrowing practices, suggesting that once the regulators impose borrowing discipline on local governments and state-owned enterprises, rising debt will no longer be a problem.
But in both cases, this is confused thinking. In the United States and China, rising debt is structural, and necessary to the way in which their economies currently operate. While it is indeed likely that part of the debt in both countries is due to profligacy, irresponsible behavior, and even fraud, these do not explain the bulk of the increase in debt. Even with the strictest controls, until more fundamental changes are made to the two economies, either debt must continue to rise or growth must slow to politically unacceptable levels—levels that cause unemployment to rise.
Rising debt, in other words, is baked into the current structures of both the U.S. and Chinese economies, with similar causes for rising debt and mirror images in the ways in which rising debt occurs. In the United States, rising debt is how the economy balances the impact of conditions—including most importantly high levels of income inequality and the large U.S. trade deficit—that automatically reduce the demand available for American businesses. That is because high levels of income inequality, as I explain below, force a contraction in sustainable demand in the U.S. economy.
The same is true of China, but for slightly different reasons. China suffers from two forms of income distortions that limit demand for Chinese businesses. The one most discussed is income inequality: rich Chinese individuals (like rich Americans) retain a disproportionately high share of household income. But the second, more important form of income distortion is the very low share Chinese households retain of the country’s GDP—roughly 60 percent versus the roughly 80 percent typical in the United States. The low household share of GDP has the same effect on demand as income inequality.
Suppressing Domestic Demand
The ways in which these distortions in the distribution of income reduce demand are key to understanding the structural reasons for rising debt. In any economy, all income is either consumed or saved. Businesses, the government, and wealthy individuals save a much larger part of their income than do working- and middle-class individuals, so a lower share of income is retained by the latter group. These distortions reduce overall consumption by effectively transferring income from high consumers (working- and middle-class households) to high savers (wealthy households and, in China’s case, the government).
If the higher resulting savings were used to fund productive investments by American or Chinese businesses, this would be a good thing for their economies (and for the world). Lower consumption would be matched by higher investment, so that total demand would remain the same in the short term and would rise in the long term as more productive investment caused growth to accelerate. Workers would keep their jobs, only now these jobs would accommodate more investment rather than more consumption. This is in fact what happened in China in the 1990s and early 2000s
Must higher savings necessarily lead to higher investment? The belief that it must is at the heart of supply-side economics in the United States and seems to be a key belief—at least implicitly—of China’s leaders.
But while it used to be true many decades ago that increases in U.S. investment were often a function of an increase in available (domestic or foreign) savings, this hasn’t been true since the 1980s. U.S. businesses now often hold huge amounts of cash, which they have little interest in using to expand production. The main constraint on U.S. investment is not scarce savings but rather weak demand, which is why making more foreign or domestic savings available to American businesses has little to no impact on their decision to invest.
There is a similar problem in China. Until the mid-2000s, the level of productive Chinese investment was very sensitive to the level of Chinese savings. Before that time, China exported a very low share of its domestic savings and mostly did so as a function of central bank intervention and the perceived need to raise central bank reserves. Policies that increased savings—mainly by reducing the share of income directly or indirectly retained by ordinary households—tended to be matched by higher investment in the property, infrastructure, and manufacturing capacity that China needed.
Since the mid-2000s, however, Chinese businesses have not increased their investment in line with increased savings. In fact, in more recent years, they have actually reduced investment in response to stagnant domestic consumption. In both the United States and China, the biggest constraint to productive investment by private businesses is weak domestic demand.
How to Balance Rising Ex Ante Savings
This creates a problem for the economy. If lower consumption isn’t balanced by higher investment, total demand will decline and, in response, businesses will cut back on production and fire workers to accommodate the decline in demand.
To prevent this from happening in the United States, policymakers in Washington typically do one of two things. First, the Federal Reserve, determined to prevent the economy from slowing and unemployment from rising, can loosen monetary policy, encouraging households to increase their borrowing to fund additional consumption. In that case, the reduction in the share ordinary Americans retain of GDP is balanced by an increase in their borrowing, and so through rising consumer debt, the same level of consumption can be maintained.
Second, Washington can itself borrow money and spend it directly or indirectly to replace the demand lost due to lower household consumption. Borrowing is the opposite of saving, and by increasing the fiscal deficit, the United States can reverse the adverse consequences of rising savings among the wealthy.
Policymakers in Beijing respond to weak demand in a different way. While the country’s central bank, the People’s Bank of China, encouraged a surge in household debt over the past several years, much like the Fed did, Chinese household debt rose so quickly and is now so high that Beijing doesn’t want to encourage more household debt. Because the private sector isn’t willing or able to bridge the gap by increasing investment given the weak demand it faces, Beijing forces state-owned enterprises and local governments to borrow increasing amounts to fund spending on infrastructure, property, and government-owned projects.
The problem is that around the mid-2000s, investment in infrastructure, property, and government-owned projects in the aggregate began to create less economic value than it cost. The result was that China responded to the high savings of wealthy individuals and the government with a surge in nonproductive investment, which led to a surge in the country’s debt burden. This is the reason that China is forced to encourage a rapid rise in debt as the only way to prevent a rapid rise in unemployment.
Rising debt in China is therefore a mirror image of rising debt in the United States. In both cases, severe distortions in the distribution of income have resulted in downward pressure on domestic consumption and upward pressure on ex ante savings. The United States has resolved the resulting decline in demand by forcing up household debt or fiscal deficits to increase consumption and reduce ex post savings. China has resolved the resulting decline in demand by forcing up nonproductive government investment, so that rising savings is matched by rising investment—however unsustainable and economically useless this investment is. In both cases, the country’s debt burden must rise in order to accommodate the demand consequences of a highly distorted distribution of domestic income.
The Role of Trade
There is another way for countries to respond to an unwanted surge in domestic savings. If a country’s savings rise faster than its investment—or if demand declines relative to production, which is the same thing—it can export the excess production in the form of a trade surplus to countries that have high investment needs and insufficient domestic savings.
But while China can do this, the United States cannot. Because of the United States’ open and well-governed financial markets, the rest of the world prefers to direct its own excess savings and excess production into the country. Even though the United States doesn’t need foreign savings for its domestic investment needs, nearly 40 percent of global excess savings are nonetheless exported into U.S. financial markets, as foreign central banks, businesses, oligarchs, and owners of financial assets use their savings surpluses to acquire American stocks, bonds, factories, and real estate.
These net inflows push up the value of the dollar and make U.S. manufacturing less competitive, so that rather than run trade surpluses to manage its excess ex ante savings, the problem is exacerbated, and the United States must run large trade deficits to absorb excess foreign production. In order to keep unemployment from rising, either the Fed must encourage even more household debt or Washington must run even larger fiscal deficits.
This is one of the main differences between the way China manages debt and the way the United States does. China’s trade surplus allows it to externalize a part of the domestic demand deficiencies caused by low consumption, and so reduces the amount of nonproductive investment (and debt) needed to balance Chinese supply and demand. The American trade deficit forces it to absorb foreign demand deficiencies and so increases the amount of debt needed to balance American supply and demand. But while the countries’ different trade positions exacerbate U.S. debt and reduce Chinese debt, it leaves China overly sensitive to changes in external demand and to trade conflicts, while the United States actually benefits from trade conflict.
Rising Debt Is Structural
The great mistake U.S. lawmakers make is to assume that rising debt in the United States is mainly the consequence of irresponsible behavior on the part of American households and the federal and local governments, and that it can be brought under control by better audits and careful spending. In fact, rising debt is a structural problem, and the choice Americans face is not between more debt and less debt, but rather between more debt and more unemployment.
Lawmakers in China make a similar mistake. They are cracking down on fraud and inefficiency as the source of local government debt, when the real source of China’s surging debt is Beijing’s GDP growth targets—which, for political reasons, exceed the real growth capacity of the economy and can only be met by further increases in nonproductive investment and, with it, the country’s debt burden.
The point is that both China and the United States have, in different ways, highly distorted distributions of domestic income that leave them no choice but to encourage rapid growth in debt (as do, by the way, Japan, Spain, the United Kingdom, and many other countries). Until they resolve their respective distortions in income distribution, both countries have structural reasons for their expanding debt burdens.
It is these structural reasons, and not irresponsible behavior, that explains surging debt in both countries. Until the distortions in income distribution are addressed, both will be forced to choose between rising debt and slowing growth, which means that both countries must choose between rising debt and rising unemployment.
For those interested in reading more on this topic, see also “Wealth Should Trickle Up, Not Down”, “Why U.S. Debt Must Continue to Rise”, and “The Only Five Paths China’s Economy Can Follow” on the Carnegie website. I also write a monthly newsletter that covers similar topics as this blog. Those who want to receive a subscription to the newsletter should email me at chinfinpettis@yahoo.com, stating their affiliation. I’m also on Twitter, @michaelxpettis.
