12/13/2016 Internal and External Balance - Carnegie Endowment for International Peace

InternalandExternalBalance
MichaelPettis
ChinaFinancialMarkets June09,2015 China Financial Markets

Summary:Adeepgroundingineconomicandfinancialhistoryisimportantformoderneconomicanalysis.

IwasrecentlyaskedbyanAustralianeconomicsjournaltowriteareviewofabookIhadalreadyread, e
Leaderless Economy,byPeterTeminandDavidVines(publishedin2013).Becausethebookisagreatplace
fromwhichtostartadiscussiononthelinkswithintheglobaleconomy,Idecidedtobasethisessayonthe
book.IhadalreadyreadPeterTeminsLessons om the Great Depression(1991), e Roman Market Economy
(2012),andPrometheus Unshackled(2013),andIknowhisworkfairlywell.

ThereissubstantialoverlapbetweenthewayTeminandVinesviewtheglobaleconomyandthewayIdo.I
amaregularreaderofDianeCoylesblog, e Enlightened Economist,inwhichshereviewsbooks,usuallyon
economicsrelatedtopicsbutalsoonanythingelsethatmightcatchherattention.Besideshavingsaidvery
nicethingsaboutmybook, e Great Rebalancing,andincludingitinhershortlistoftopbooksfor2013(Iam
braggingalittle)shehasalsoreviewed e Leaderless Economy,andhasnotedthesimilaritiesinthewayboth
booksapproachthebalanceofpayments.

Sheisright.Bothbooksanalyzetheglobaleconomyinprettymuchthesameway,asaneconomicsystemin
whichanycountrysdomesticeconomyisinextricablylinkedtoothereconomiesthroughthebalanceof
paymentsmechanisms.Theabilitytoplaceeventswithintheirglobalcontextisconsequentlycrucially
importantinunderstandinganycountryseconomicperformance,butactuallydoingsotendsmoretobethe
exceptionthantherule.

Totakeoneexample,Irememberintheearly1990sIreadabookaboutthePanicof1873,inwhichduring
SeptemberandOctoberofthatyeargoldreservesinNewYorkplummeted,banksfolded,andthestock
marketcrashed,withtheNewYorkStockExchangeactuallyclosing,onSeptember20,fortendays.Itwasin
manywaysanexcellentbookabouttheeventsleadinguptothecrisisandthevariousfactorsthatcaused
it,butexceptforabriefmentionoftheimpactofthecrisisontheBritishbankingsystem,youcouldhave
easilyassumed,asIdidthen,thatthe1873crisiswaspurelyanAmericanaffair,andthateventsintherestof
theworldbarelymattered.

Itwasonlyafewyearslater,whileIwasreadingCharlesKindlebergersA Financial History of Western Europe

thatIlearnedthatthe1873crisisactuallybeganwithastockmarketcrashinViennainMay,fourmonths
beforetheNewYorkmarketsfell,whichspreadtoGermany,Englandandothercountries,andthe
subsequentdepressionwasperhapsthefirstglobalpanicanddepressioninhistory.ItwasinKindlebergers
bookthatIalsofirstlearnedabouttheimpactoftheFrancoPrussianWarof187071andthesubsequent
reparationspaymentsonglobalfinancialmarkets(whichIdiscussextensivelyinaFebruaryblogentry)andin
unleashingthefinalstageofagloballiquiditybubblethatendedwiththevariouspanicsof1873.

ThePanicof1873,inotherwords,wasclearlynotonly,overevenmostly,anAmericanaffair.Itwasglobal,
anditscausescouldnothavebeenlimitedtoAmericancauses,asthebookseemedtoimply.Onthe
contrary,Iwouldarguethatitisimpossiblefullytounderstandthecrisis,whetherthefocusisontheevolution
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ofthecrisisintheUS,theUK,continentalEurope,orLatinAmerica,withoutunderstandingthefullglobal
context.

e Leaderless EconomymakesthesamepointItrytomakein e Great Rebalancing:theeconomicanalysisofany

countryislargelyuselessifitignores,ortreatsasaminorissue,linkswiththeexternalsectori.e.other
countriesandthisisevenmoretruetodaythaninthepast.Evensomethingasimportant,andasseemingly
domestic,astheUSsavingsrate(whichformostpeopleisassumedlargelytoreflectculturalpreferences
towardsthriftamongAmericanhouseholds)isnotdeterminedprimarilybyAmericanhouseholdsbutratherby
itslinkswithsavingsdistortionsabroad.

Thismightseemaprofoundlycounterintuitivestatement,butinfactyouonlyneedtounderstandtwoorthree
accountingidentitiestobeabletoworklogicallythroughtheexplanation.Ishowedwhyonecountryssavings
rateisaslikelytobedeterminedbydomesticdistortionsasitisbydistortionsabroadinablogentryon
whetherasavingsglutmustcauseglobalsavingstorise.Inanotherblogentry,Iexplainedwhyalowsavings
rateincountrieslikeSpainwasanecessaryoutcomeofpoliciesinGermanythateffectivelyrestrictedwage
growth.AndfinallyIshowedhowbecauseoftheroleofthedollarinreserveaccumulationand,more
generally,theunrestrictedabilityofforeignerstobuyUSassetstheUSsavingsrateisdeterminedlargely
asaresidualneededtobalancenetcapitalflows,inablogentryonthesocalledexorbitantprivilege,andin
afollowupblogentry.

Global balancing mechanisms

IntheirbookPeterTeminandDavidVinesdontdiscusstheUSsavingsratebuttheydoalotofthesame
thingbychangingthefocusslightly.InmybookIarguethatbecauseglobalsavingsandglobalinvestment
mustbalance,ifanycountryssavingsexceedsitsinvestmentbysomeamount,investmentintherestofthe
worldmustexceedsavingsbyexactlythesameamount.TeminandVinesexpressthesamerelationship
betweenconditionsinonecountrywithconditionsabroadinawaythatcanbesummarizedintwosentences.
First,thedomesticimbalanceinanyeconomyi.e.highlevelsofunemploymentordemand,largegaps
betweensavingsandinvestment,andsoonmustbeconsistentwithandequaltothatcountrysexternal
imbalanceatalltimes.Second,thatcountrysexternalimbalancemustbeconsistentwithandequaltothe
externalimbalanceoftherestoftheworldatalltimes

Thesetwowaysofseeingcountrieswithintheirglobalcontextsarebasicallyidentical.Anycountryscapital
accountofcourseissimplythegapbetweenitsdomesticsavingsanditsdomesticinvestment,andbecause
thecapitalaccountmustbalancethecurrentaccount(thetwoalwaysaddtozero),tosaythatthegap
betweensavingsandinvestmentinanycountrymustbeequaltoanoppositegapbetweensavingsand
investmentabroadissimplytorestatethefarmoreintuitivelyfamiliarclaimthateverycurrentaccountsurplus
intheworldmustbematchedbyacurrentaccountdeficit.Untilwebegintradingwithextraterrestrialsthe
totalmustadduptozero.

Thisshouldallbeobvious,butifanimbalanceinonecountrymustbematchedbyanoppositeandequal
imbalanceabroad,thereareonlytwopossibleexplanations.Eithertheimbalancesineverycountryareset
endogenously,and,bysomemiracle,ateverypointintime,theybalanceoutperfectly,oranimbalancein
onecountrycanforceimbalancesontoothercountries.Thefirstexplanationisobviouslyabsurd,sothegap
betweentheamountacountrysavesandtheamountitinvestsisaslikelytobedeterminedbyexternal
conditionsasbyinternal.Thisiswhyitispossibletoarguethatacountryssavingsrate(oritsunemployment
rate,oritsinvestmentrate,etc.)isdeterminedbypoliciesabroadasmuchasbypoliciesathome.Thisis
whatitmeanstoliveinaglobalizedworld.

Mostanalyststendautomaticallytolookatthecurrentaccountasthebalancingmechanism,butIthinkthisis
perhapswhyitissoofteneasytogetconfusedaboutthebalancingprocess.Byexplainingtheadjustment
processintermsofthecapitalaccount,asIdo,Ithinkitbecomesmucheasiertounderstandhowthe
directionofnetcapitalflowsdeterminesthebalancingmechanism.Italsohelpsanalystsavoidfallingintothe
trapoflookingatbilateraltradebalancesasmeaningfulwheninfact,andverycounterintuitively,theyare
almosttotallyuselesswhenitcomestounderstandinghowdistortionsinonecountrymightcausedistortions
elsewhere.Forexample,lastyearStephenRoach,oneofthemostknowledgeablecommentatorsonthe
Chineseeconomy,fellintothesameconfusionwhenhewrotethefollowing:

e US trade de cit is a multilateral imbalance with many countries 102 in all not a bilateral problem with China. It
arises not om the alleged manipulation of the renminbi, but om the simple fact that America does not save. Lacking in
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domestic savings and wanting to grow, the US must import surplus savings om abroad, and run massive current-account
de cits to attract the foreign capital. And that leads to Americas multilateral trade imbalance

IfChinarunsacapitalaccountdeficitandtheUSacapitalaccountsurplus,andtheseareroughlyequalto
netpurchasesbythePBoCandotherChinesegovernmententitiesofUSgovernmentbondsandUSassets,
Chinawillrunacurrentaccountsurplusexactlyequaltoitscapitalaccountdeficit.TheUSwillrunacurrent
accountdeficitexactlyequaltoitscapitalaccountsurplus.

Thismayshowupintheformofcorrespondingbilateraltradesurplusesanddeficitsbetweenthetwo
countries,butitisnotnecessary,andinfactextremelyunlikely,thatitwould.Whilewecannotsayjustfrom
lookingatthenumberswhetherlowUSsavingsrelativetoinvestmentforcedtheChineseintosavingmore
thantheyinvest,orwhetherhighChinesesavingsrelativetoinvestmentforcedtheAmericansintosaving
lessthantheyinvest,wecansaythatthesavingsrateinoneofthecountrieswasdeterminedinlargepartby
distortionsintheother.

ThemainpointisthatifyouwanttounderstandthecausalrelationshipbetweenChinesesurplusesandUS
deficits,orbetweenGermansurplusesbefore2009andperipheralEuropeandeficits,youhavetolookatthe
directionofnetcapitalflows,andnotatbilateraltrade.Iwillreturntothis,buttogetbackto e Leaderless
Economy,thisbookisunderpinnedbythesamedeepfamiliaritywithfinancialhistorythatPeterTeminbringsto
allhiswork,andperhapsthisiswhythebookshouldleaveeveryoneterriblyfrustratedontwocounts.First,
theauthorsshowthatwhilethe200708globalcrisisanditsaftermathwereunquestionablylargeand
complexaffairs,therewasnothingaboutthecrisisthatwasunprecedentedwehaveexperiencedsimilar
eventsbeforeandweunderstandfarmoreaboutwhatmightormightnothaveworkedthansubsequent
policymakingmightsuggest.

Theauthorsshowforexamplethatanyonewhohadareasonableunderstandingofthecurrentandcapital
accountpressuresofthe1920swhoseinconsistenciesdoomedGermanyshouldhavebeenableto
understandwhydownwardpressureonGermanwagegrowth,intheseveralyearsbeforetheglobalcrisis
wassetoffin2007bytheUSsubprimecrisis,wouldultimatelyforcehugeinternalimbalancesontoEurope
duringthattime.Moreimportantly,thisunderstandingshouldhavebeenenoughtoconvinceEuropean
policymakersthatunlessGermanyrespondedtothecrisisbyreflatingdomesticdemandsufficientlyto
generatelargecurrentaccountdeficits,itwouldbeallbutimpossibletopreventadecadeofanemicgrowth
andextraordinarilyhighunemploymentinperipheralEurope.

ItsnotthatGermanyinthe1920swasanythinglikeGermanyinthe2000s,oreventhatGermanysufferedin
the1920sfromthekindsofpressuresitforcedontoperipheralEuropeinthe2000s(althoughthisiscloserto
thetruth).TheproblemwasthatGermanyinthe1920swasrequiredtoexportlargeamountsofcapital,
becauseofextremelyhighreparationsdemands,whileitsabilitytoruncurrentaccountsurpluseswas
constrainedbyEuropeanpostwarpolicies.

Nocountrycanrunacapitalaccountdeficitunlessitrunsacurrentaccountsurplus,andtheseenormous
countervailingpressuresforcedGermany,amongotherthings,intoanunsustainableborrowingpath.
Similarlysince200809peripheralEuropehasbeenunderpressuretoruncapitalaccountdeficits(itmust
repaysubstantialborrowingsandfundflightcapital,butithastroubleborrowingwithoutimplicitECB
guarantees).Itsabilitytoruncountervailingcurrentaccountsurpluses,however,isconstrainedwithinEurope
byBerlinsrefusaltoallowareflationofdomesticdemandanditisconstrainedoutsideEuropebyGermanys
enormouscurrentaccountsurplus,whichpreventsacurrencyadjustment.ThisforcesperipheralEuropeinto
bothrisingdebtandhighunemployment,anditisonlybecauseEuropeasawholehasforcedtheproblemof
weakGermandemandontotherestoftheworldthatconditionsinEuropearenotevenworse.

Are trade surpluses virtuous?

BeforeIexplainthesecondsourceofgreatfrustrationthatthisbookprovides,Iwanttomakeaquickdetour
onthesubjectofcurrentaccount,ortrade,surpluses.AnysuggestionthatGermanystradesurplusistoo
largeandhasbecomeasourceofglobaldistortionselsewhereseemstoinfuriatealotofpeople,formanyof
whomtheideathatatradesurpluscanbetoolargeisthemoralequivalentofcastigatingpeopleforworking
toohardandbeingtooprudent.Atradesurplus,theybelieve,istherewardacountrygetswhenitspeople
workhardandsavetheirmoney.

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Butwouldanationofproductiveandhardworkingpeople,letscallthemants,normallyruntradesurpluses?
Theconsensusseemstobethatitwould.Runningatradesurplusmeansthatacountrysellsmoreto
foreignersthanitbuysfromthem,andthereseemstobeanimplicitbeliefthatexportsarewhatahard
workingcountryproduces,andimportsaretheequivalentofitsconsumption,sothatatradesurplusmeans
thatthecountryearnsmorethanitspends,andthelargerthesurplus,themorelikelytheantsinthatcountry
areespeciallyproductive,thrifty,morallyupright,andperhapsfondofsensibleclothing.

Countriesthatrunlargeandpersistenttradedeficits,ontheotherhand,buymorefromforeignersthanthey
sell,andbecausethisseemstosuggesttheyarelivingbeyondtheirmeans,weusuallythinkofthesepeople,
letscallthemgrasshoppers,aslackingdisciplineandprudence.Grasshoppersexciteourscorn,evenifwe
sometimesenvytheircarefreewaysandtheirbohemianmorals.

Ifhouseholdsthatarecarefultospendlessthantheyearn,makingsuretosavepartoftheirearnings,are
seenasadmirablythrifty,whilehouseholdsthataretooquicktopullouttheircreditcardstobuythingsthey
cannotaffordareseenasfoolish,andwillintheendimplicitlyrequirethattheirprudentneighborsbailthem
out,thesame,weassume,shouldbetrueofcountries.Itisunfairthatantshavetobailoutgrasshoppers,
andsonaturallywetendtoabhorpoliciesaimedatfavoringgrasshoppersoverants,andbyextensionwe
alsoabhorpoliciesthatseemtofavortradedeficitsovertradesurpluses.

Butcountriesarenotatalllikehouseholdsand,moreimportantly,acountrysearningsarenotequaltoits
exports.Acountryearnsthetotalamountofgoodsandservicesthatitshouseholdsproduce,ofwhich
exportsareonlyapartandusuallyasmallpartexceptintradingentrepotsandinmercantilistcountries.
Therichestandmostproductivecountriesarenottheonesthatexportthemost.Theyaretheonesthat
producethegreatestamountofgoodsandservices,andweusually,althoughnotalwaysaccurately,
measurethisnumberasgrossdomesticproduct(GDP).

Acountryofhardworking,productiveants,inotherwords,willnotberewardedwithahightradesurplus,but
ratherwithahighGDP,whichshouldtranslateintoahigherqualityoflife.Theymightexportagreatdeal,but
thereasontheyexportissothattheyexchangetheirexportsforforeigngoodsthateithertheycannotmake
athomeorthattakemoretimeandmoneytoproduceathomethantoimportfromabroad.Thisshouldbe
obviouswhenweconsiderthatwhileitispossibleforeveryhouseholdtoworkharder,producemore,andso
consumeandsavemore,itisimpossibleforeverycountrytoworkharder,exportmore,andimportless.

Acountryofantscouldruneithertradesurplusesortradedeficits,dependingonconditionsthathavenothing
todowithhowhardworkingitis,butifitdidrunsurplusesformanyyears,itscurrencywouldeventuallyrise,
allowingantstoexchangetheirproductsforevenmoreforeignproductsthanbefore.Thiswouldcausethe
tradesurplustodisappearastheantsconsumedalargeramountofforeigngoodsthattheycouldacquirefor
lessworkthanbefore.

Soifantsarenotrewardedwithtradesurpluses,whatexplainsthefactthatsomecountriesrunpersistent
tradesurplusesyearafteryearwhileothercountriesrunpersistentdeficits?Thereasons,itturnsout,hasto
dowiththerelationshipbetweensavingsandinvestment.Countriesthatsavemorethantheyinvestmust
exporttheseexcesssavingstoothercountries,throughthecapitalaccount,becausethesavingscannotbe
investedathome.

Butsomethingelsemusthappen.Theantsmusteitherworktoproducegoodsandservicestobeconsumed,
ortheymustbuildroads,factories,airports,andotherkindsofinvestmentthatarefundedbytheirsavings
i.e.theshareoftheirproductionthatisnotconsumed.Thisstatementisusuallycharacterizedas:

Consumption+savings=Consumption+investment

Iftheantssavemorethantheyinvest,thenbysimplearithmeticthetotalamountofgoodsandservicesthey
produceastheyearntheirincomesmustbegreaterthanthetotalamountofgoodsandservicesthey
produceinordertoconsumeortoinvest.Putdifferently,thetotalsupplyofgoodsandservicestheyproduce
mustbegreaterthantheirtotaldemandforgoodsandservices,andsotheymustexporttheexcessby
runningatradesurplus.

Acountrystradesurplus(moreaccuratelyitscurrentaccountsurplus,whichincludesthingslikeroyalty
payments,tourism,returnsoninvestmentabroad,andotherthings,butwewillpretendtheyarethesame)is
exactlyequaltoitstotalsavingsminusitstotalinvestment,whichisequaltotheamountofsavingsitexports.
Thisiswhywerefertothebalanceofpayments.Thetotalmoneythatantsreceivefromtheirtrade(current

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account)surplusisperfectlybalancedbythecapitalaccountdeficit,whichissimplytheamountofsavings
theysendabroad.

Why save more than you invest?

Countriesruntradesurpluses,inotherwords,notbecausetheircitizensarehardworkingants,butrather
becausetheysavemorethantheyinvest.Ofcourseantsaresupposedtosavemorethangrasshoppers
becausetheyareprudentlywillingtomakesomesacrificetodayinorderobtainabetteroutcometomorrow,
butthismeansthattheyalsomustinvestmorethangrasshoppersbecausetheonlywayasacrificetoday
resultsinabetteroutcometomorrowisifwesavepartoftodaysproductionandinvestitinsomethingthat
willincreaseourproductivitytomorrow.Thenaturalthriftinessofantsexplainswhytheysavemore,butit
cannotexplainwhycountriessavemorethantheyinvest,andsoruntradesurpluses,yearafteryear.There
arethreereasonsthatexplainmostcasesoflarge,persistenttradesurpluses.

Thefirstreasonisagoodoneinthatitresultsinhighergrowthandabetteroutcomefortheworldoverall.
Thesecondtworeasons,whicharereallyvariationsofthesamereason,resultinlowergrowthfortheworld
overall.

Inthefirstcase,thereisahugeinvestmentopportunityabroad,perhapsbecauseagroupofforeignants
haveidentifiedagreatopportunitytoincreaseproductivity,andthisopportunitypersistsyearafteryear.The
returnsonthatinvestmentaresomuchhigherthantheyareathomethatantsathomearewillingtosave
morethantheynaturallywouldtoinvestathome.

Becausetheysavemorethantheyinvest,theyexporttheexcesssavingsabroad,whereitearnsanoutsized
return.Totalgrowthinproductionfortheworld,consequently,ishigher,andifthatincreaseinproductionis
sharedbetweentheantsathomeandforeignants,everyoneisbetteroff.Noticehoweverthattheforeign
antswillbeimportingsavingsbecausetheirinvestmentneedsexceedtheirsavings,andsoinspiteoftheir
hardworkandrapidlyrisingproductivity,theywillruntradedeficitsformanyyears.Inthe19thCentury
EnglandandtheUnitedStatesplayedthesetworoles,withexcessEnglishsavingspouringintotheUnited
Statestofundgrowthinhistorysmostsuccessfulemergingmarket,andwhiletheBritishranpersistenttrade
surpluses,andtheUSranpersistenttradedeficits,bothcountriesgotricher.

Thesecondreasonacountrymightsavemorethanitinvestsisbecauseofhighlevelsofincomeinequality.
Richpeopleusuallysavemoreoftheirincomethanordinarypeople,sothatthemoretheykeepofthetotal
amountofgoodsandservicesproducedbyhardworkingants,thehigherthatcountryssavingsrateandthe
loweritsconsumptionrate.Becauselowerconsumptiondiscouragesbusinessesfrombuildingnewfactories
orotherwiseexpandingproduction,highersavingsoftencomewithlowerinvestment,andsocountrieswith
highlyunequalincomedistributiontendtorunlargetradesurpluses.

Theotherreasonhastodowiththesharethathouseholdsreceiveofeverythingtheyproduced.Acountrys
totalproductionisdividedbetweenhouseholds,businesses,andthegovernment.Althoughgovernmentsdo
makepurchasesthatwecanclassifyasconsumption,almostallconsumptioncomesfromhouseholds.This
matters,becauseincountriesinwhichhouseholdsareallowedtokeepaverylargeshareofwhatthey
produce,whethertheyareasthriftyasantsorasspendthriftasgrasshoppers,theirtotalconsumptionwillbe
ahighshareoftotalGDP,andtotalsavingsalowshare.Iftheirhighconsumptionencouragesbusinessesto
opennewfactories,lowsavingsandhighinvestmentmightevenleadthemtoruntemporarytradedeficits,
althoughonlyuntilthefactoriesbegintoproduce.

Butifhouseholdsretainalowshareofeverythingtheyproduce,withgovernmentsandbusinessesgettingthe
rest,thenagain,whethertheyareasthriftyasantsorasspendthriftasgrasshoppers,theirtotalconsumption
willbealowshareoftotalGDP,andthecountrystotalsavings,whichisequaltoGDPminusconsumption,
willbeahighshare.Onceagainiflowconsumptionactuallycausesinvestmenttodrop,theywillrunlarge
tradesurpluses.Noticehowever,thatthecountryhasahighsavingsratenotbecauseantshavesavedalot
oftheirearnings.Ithasahighsavingsratebecausebusinessesandgovernmentsareabletosavethe
moneythatwasnotgiventohouseholds.

ThisiswhathappenedinGermanyduringthepastdecade.WhileEuropeboomed,anumberoffactors
allowedcompaniestoreducewagegrowthinGermanysharply,leavingGermanhouseholdswithadeclining
shareofwhattheyproducedandbusinesseswithmorethanever.Asincomeinequalityalsoroseduringthis
time,Germanhouseholdconsumptionratesdroppedandsototalconsumptionratesdropped.Meanwhile,
GermancompaniesdecidedtoreducetheirinvestmentinGermany,perhapsbecauseGermanhouseholds
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werenotabletobuywhattheyproduced.HighersavingsandlowerinvestmentcausedGermanystrade
surplustosoar.

Soascounterintuitiveasitmayatfirstseem,tradesurplusesarenottherewardforhardworkorthrift.Trade
surplusescanhavemanycauses,toooftenjustthelowshareofGDPthatordinaryhouseholdsareallowed
tokeep,buttradesurplusesordeficitsthatpersistformanyyearsarealwaystheresultofsignificant
distortionsathomeorabroad.Risingproductivityandhardworkcanleadtostrongexportgrowth,butonly
netcapitalexportswillleadtoatradesurplus(or,morecorrectly,acurrentaccountsurplus).Ifcountrieslike
Germany,whosesurpluseshavecausedsomuchdamagetoEurope,weretoarrangeincomemorefairly,not
onlywouldEuropebenefit,butGermanyshardworkingandthriftyantswouldfinallygettheirrewardsa
higherincome,ratherthanalargernationaltradesurplus.

The value of history

Isaidthatformethereweretwogreatfrustrationsthatcomefromreading e Leaderless Economy.Thefirstis
thatwehavethetoolstounderstandmuchofwhatwentwrongbeforethe200708crisis,andtounderstand
whydistortionsinthecurrentandcapitalaccountscanleadtoabuildupofdebtandasubsequentdisruptive
adjustment.Wedidntusethesetoolsbecausewefailedtoworkthroughthelogicofthebalanceof
payments,tothepointwhereinsomecountriesweactuallyapplaudmeasuresthatreducetheshareof
productionallottedtohardworkinghouseholdsonthegroundsthattheirrealrewardisahighernationaltrade
surplus.

Thesecondfrustrationiscloselyrelated.Byshowingushowusefulhistoryisinunderstandingcurrentevents,
theauthorsalsoreveal,indirectly,howlittlevaluethereisinthevastliteratureofeconomictheorizingthat
emergesfromtheabstractanddistortedworldofacademia,bereftasitisofhistoricalcontext.

Formosteconomists,historyisusuallylittlemorethanadatasequencewhosevaluesarepluggedinto
mathematicalmodelswhoseimplicitassumptionstoooftenthesesameeconomistsfailtounderstand.But
asTeminandVinesshow,historyismuchmoreusefullyseenastheevolutionofoftencomplexinstitutions
financial,political,legal,cultural,andsoonthroughwhicheconomicbehaviorismediatedandwhichaffect
thewaysinwhichrecurringpatternsoffinance,commerceandtradeunfold,andthatwithoutan
understandingofhistorywelosesomuchcomplexityinourmodelsthatweoftenendupmakingveryobvious
mistakes.

CharlesCalomiris,aprofessoratColumbiaUniversitywhoseworkonbankingsystemsandbankingsystem
riskisamongthebestintheworldmademuchthesamepointatapresentationattheFederalReserveBank
ofAtlantalastmonth:Youhavetothinkhistoricallytothinkusefully.Traditionaleconomicmodelsdont
incorporatehistoricalanalysis,despiteitsusefulnessinexplainingfactorsbehindcrisesorfindingholes.

The200708globalcrisisanditsaftermatharesomucheasiertounderstandiftheperiodisplacedfirmly
withinhistory,whichtheauthorsdo,especiallyfocusingoneventsinthe1920sand1930s,twodecadesthat
havegreatresonancewiththepastfifteenyears.OneoftheirgoalsistoexplaintheinsightsthatJohn
MaynardKeynesprovidedontheworkingsoftheglobalbalanceofpaymentsastheyworkthroughthe
developmentofKeynesthinkinginrealtime.NotonlydoesthisfleshoutthelogicbehindKeynesevolving
theories,butitalsomakesiteasiertounderstandtheeventsthatinspiredKeynesultimatelytoovercome
RalphHawtreysobjectionsinafamous1930debatetohisintuitivesensethatexcesssavingsand
unemploymentwererelated,althoughthedebateitselfisnotdiscussedinthebook.

Whydoesthismatter?ItisimpossibletooverstatetheusefulnessofthereasoningKeynesprovidedthatlinks
savings,investment,unemployment,andtrade.JohnHobsonhadalreadyshownnearlyhalfacenturyearlier
howinstitutionaldistortionsthatforcesavingslevelshigherthanthelevelofdesiredinvestmentwillaffectan
openeconomy,butKeynescreatedaformallylogicalwaytothinkaboutit.Byusingthismodelweareableto
understandtodaywhyinaworldwithoutanearinfiniteamountofcredibledemandforinvestment(therole
theUnitedStatesplayedinthe19thCentury),highlevelsofincomeinequality,ordownwardpressureonthe
householdshareofGDP,mustleadalmostinevitablyfirsttorisingdebtandlatertorisingunemployment.*

Thesesavingsimbalancesareoftenattheheartofthegreatimbalancesinglobaltradeandcapitalflows,and
in e Leaderless Economytheauthorsclarifyimmenselythetransmissionofsavingsimbalancesfromone
countrytoanother.Domesticimbalancesinanyeconomymustbeconsistentatalltimeswiththatcountrys

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externalimbalancesor,putdifferently,anygapbetweenacountrystotalsavingsanditstotalinvestment
mustresultinacurrentaccountimbalance.

Soifhouseholdsconsumeadecliningshareofwhattheyproduce,eithertheymustincreaseinvestment
commensurately,sothatsavingsriseandGDPremainsthesame,or,ifinvestmentcannotrisefastenough
(infactinmostcasesitislikelytofall),unemploymentmustrisefastenoughtokeeptotalsavingsfrom
exceedingtotalinvestment.Ofcourseiftheyforcethedemandshortfallontotherestoftheworld,theycan
keepunemploymentdownbyexportingtheirexcesssavingsandrunningacurrentaccountsurplus,the
counterpartofwhichisacurrentaccountdeficitsomewhereelse.Thesearejustaccountingidentitiesthe
internalimbalancebetweenacountryssavingsandinvestmentisatalltimesconsistentwithandequaltoits
externalimbalance,andacountrysexternalimbalancesisatalltimesconsistentwithandequaltothe
externalimbalancesoftherestoftheworld.Tounderstandwhichcountrywillrunthecorrespondingexternal
imbalancedependsonthenatureoftheinstitutionsthroughwhicheconomicbehaviorismediated,andthisis
whyadeepgroundingineconomicandfinancialhistoryissoimportant.

*IexplainthemodelformallyintheAppendixto e Great Rebalancing: Trade, Con ict, and the Perilous Road
Ahead for the World Economy(PrincetonUniversityPress,2013)

ThiswasfirstpublishedatChina Financial Markets.

Endofdocument

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