Charting the Course of the Global Economy

28:28And so most of the investments are taking place there. But for the developed world, I think there's structural issues and macro issues that have to be addressed once you're in a pursuit phase. the macro issue that has to be addressed is that the household sector are still saving money as before as they used to do for the last 5 ,000 years you know we still worry about our old age so households still continue to save but the corporate sector they used to borrow all the household sector savings to invest in capex during the 50s 60s and 70s they are no longer doing that so developed world have this excess savings problem within the private sector which requires that the government has to come in and borrow and spend those funds but the public debt in most of these countries is already pretty large and this is going to be a very long term issue it's not going to end tomorrow suddenly all the developing countries become developed countries That's not going to happen very quickly.

29:39So this is going to be a long-term issue. So what that means is that government needs to borrow money to keep the economies going. But because this is going to be a long-term proposition, they will have to put those money in those projects that produces a return that is higher than, has the social rate of return that is higher than the interest rates. And you might sound like that's going to be very difficult. Well, the estimate part of the process is that when the economy is in the pursuit phase, there's extra savings in the private sector. So interest rates usually come down to these very low levels.

30:26And when the rates come down to these low levels, it should be much more easier for government to come up with projects projects that has a social rate of return that is higher than those rates. I mean, right now, because of the inflation in the United States, a 10-year bond is yielding 3.8 % or so. But if the inflation rates come down with the Fed tightening, and if it comes down to, let's say, 2.6 % or something, then all we have to find out is those projects that has a social rate of return higher than 2.6%. And that should, that will keep the economy going. And it will not become a burden of future taxpayers because the social rate of return of this project is higher than the interest rates that are being incurred.

31:18So I think that's the way we have to think about pursue the economy on the macro side. And on the structural side, on the structural side, During the what I call golden era, where the return on capital is highest at home, it's usually the manufacturing sector that is doing great. And then, of course, the manufacturing sector absorbs lots of capital for their CapEx investments. Manufacturing workers don't have to have a very high level of education. So in a sense, it raises the income level from the bottom up. So if you have lots of manufacturers, inequality problem that you just raised earlier gets resolved because people from the bottom of the society start benefiting from economic growth.

32:12But once the manufacturers start moving away to lower wage areas, then what's left will require much higher levels of education and that's where I think inequality problem gets worse and worse and worse for those people who didn't study all that hard during the high school or college days and that means we need a much more robust educational programs in perceived economies than we had during what I call the golden era so those are the changes that I think has to take place once you are in a pursued era. Yeah, so in context of the pursuing economies at this point, I've seen you argue that China currently is potentially looking increasingly like Japan.

33:02And so China is obviously, you know, the whole region there, China and India, I'd argue, are, you know, going to be really the growth engines of the global economy going forward for the next 100 years, in large part due to just demographics and the sheer size and scope of the interconnectedness of the globalized world now. And so how do you think of China in the context of all this at present?

33:28Well, China is in the golden era, as I would describe it. And so it should be growing actually much faster than it is growing right now. uh it's export uh its manufacturers are very highly competitive in export markets they're coming out with lots of interesting products innovative products so china has a great potential but what's been happening over the last six seven years is very bothersome in my view because when you look at the flow of funds of the chinese economy you'll notice that the corporate sector has been reducing their borrowings even before the bubble burst 2022. They should be increasing borrowings at the current stage of Chinese economic development, but they're actually reducing it.

34:25And Central Bank brought rates down. Central Bank also relaxed their reserve requirements quite a bit during this period to encourage more companies to borrow. but that has not produced the results they expected. Companies actually reducing their borrowers. But the household sector is still saving money but the corporate sector is now borrowing money and so the government had to come in and keep the economy going. And you can see that government budget deficit, this is general government budget deficit, not the central government. If you put in the provincial governments and so forth, they're already running something like 9 % budget deficit as a percentage of GDP.

35:13And I find that very, very disturbing because China is now entering possibly the Japan-like balance sheet recession because the real estate bubble is bursting. When Japanese bubble burst back in 1990, when the Japanese real estate bubble burst back in 1990, Japanese government was enjoying budget surplus, so they have plenty of borrowing power to support the economy. But the Chinese economy is facing this potential financial recession with the bubble bursting, with the government already running such a large budget deficit. So they have to increase their borrowings from that point on further. And that could mean 10%, 12 % of GDP budget deficit.

35:57And that may cause some problems for the Chinese financial market. And so the number of issues here, why are the companies not borrowing money when their export competitiveness is still second to none? and if the government had to borrow money with this balance sheet recession starting how much can they borrow when the provincial governments have already exhausted their borrowing power because they had to support the economy five years prior to bursting out the bubble so my sense is that the problem Chinese economy is facing is quite substantial. Because if the Chinese companies stop borrowing money or reduce their borrowings because of uncertainty with the West, this geopolitical confrontation, and there's a middle income trap issue, China is right at the middle of the middle income trap where a lot of companies may be moving their factories to cheaper places.

37:06And of course, demographics that a lot of people talk about. and finally the population shrinking on the same year the bubble burst in the Japanese case a lot of people associate Japan a Japanese economic slowdown with population growth but Japanese population was growing all the way until 2009 the bubble burst in Japan at 1990 so there was 19 years when the Japanese population was still growing but the economy was stagnating because of the the balance sheet recession. In the Chinese case, two are happening on the exactly same year, 2022, population declining and the bubble bursting. So if you put all of these together, my guess is that unless something is really done drastically to bring back confidence to these companies that future is much brighter, regulatory uncertainty is no longer an issue, Western markets are completely open you can export as much as you want unless these things are put on the table my guess is that Chinese companies will remain hesitant and if that's the case and the household sector is still saving a lot of money China may begin to look like more pursued economy in a sense that the household sector is saving money but the corporate sector is not borrowing money Yeah.

38:35So Michael Pettis, who's a professor in China, he's a famous macroeconomist as well from the United States, now based in China and sort of an expert in the area. He, I think, listened to your interview recently on Odd Lots where you were explaining this view. And he said that he thought you misunderstood the causation of this in the sense that the The government in China was, in large part, the causality of a lot of the bubble. And so this response that the government then needs to respond to the bubble, he said, could actually exacerbate things. He said that the market value of these assets really needs to come down.

39:15The losses need to be realized. And that intervening in a lot of this has the risk of sort of zombifying, creating these zombie banks and zombie entities. What's your response to that? Well, I really have to understand the logic behind what he said.

39:39If the government is such a large part of the problem, so private sector wants to borrow money, but the government is borrowing money away from the private sector and then spending this money on some useless projects, interest rates should be much, much higher. But the fact that Chinese interest rates have been coming down, even with central banks, even with a large budget deficit, suggests to me that the private sector savings is even larger. Otherwise, you cannot have this 9 % budget deficit, 9 % of GDP budget deficit that China is now incurring. If the private sector also wanted to borrow, rates must be much higher than 2.6 % after 10 years.

40:29That's the 10-year Chinese government bonds. But the fact that it is 2.6 % suggests to me that even the government has borrowed lots of money. The private sector saved even more than that. Otherwise, you know, the math doesn't come out, right? and Michael Pettis and so many other economists get all these kicks out of coming up with these big debt numbers. I'm sure you have heard many of those yourself, but when I look at those debt numbers, I want to compare that with interest rates. And if interest rates are very low, which is the case in so many countries, that suggests that even though the debt might be large, the excess savings in the private sector must be even larger.

41:15And in that case, just looking at the debt and saying, let's cut the deficit because the debt is too large, that will actually make the situation worse. Like 1 ,900, 810, 730, that process can actually happen in China and elsewhere. So if interest rates are very low, but even if government deficit is large but interest rates are very low, my first reaction would be that yes the budget deficit is large but maybe it's not large enough to offset the uh savings generated in the in the private sector so i will not just look at one side i i want to look at both sides to see uh what makes sense under those circumstances Yeah, so that's a good sort of segue into what's going on in the United States these days, where I think at least part of the lesson from COVID and the government response in the USA is that the government fiscal policy can cause big time inflation, and it can cause interest rates to have to adjust.

42:28And so there's been a lot of talk in the United States in the last 36 months about how we've had sort of an everything bubble, is what people have referred to it, where bonds were bubbly, the stock market was frothy. You had a huge boom again in real estate. Do you think there's a risk of the United States having a Japan-like balance sheet recession going forward? Well, the US had one in 2008, and it was a pretty serious balance sheet recession. But I'm glad to note that so many policymakers within the Obama administration that faced this understood that it was a balance sheet recession. Chairman Bernanke,

43:14Janet Yellen, Larry Summers at the NEC, they all understood that this was a balance sheet recession and took appropriate actions, putting in the necessary fiscal stimulus. Chairman Benenke in particular, he used to say that if the appropriate monetary policies are in place, they can solve most problems. Well, during 2009 or so, once he realized that it was a balance sheet recession, he started talking about fiscal cliff, that we cannot afford to fall off the fiscal cliff, the government must continue to borrow money. that was quite different from what he used to say about the effectiveness of monetary policy.

43:54And so same thing will happen again if U.S. ended up in the balance sheet recession. But for the U.S. to end the balance sheet recession on this occasion, commercial real estate prices, house prices will have to fall significantly beyond where they are now. And commercial real estate prices are falling for about 10 % nationwide. But housing prices fell a little bit now. It seems to be picking up again. And so I think the immediate danger of U.S. falling into balance sheet recession, I think, is limited. And when you look at the flow of funds for the U.S. household sector, they do not seem to be all that leveraged compared to the flow of funds data of 2007-2006, 2006 when at that time U.S.

44:49household sector was actually a net borrower. You know, we all learn in universities that household sector saves money and the corporate sector borrows the money. But during the housing bubble back then, U.S. household sector was actually a net borrower. So that's how bad the housing bubble was back then. This time, I don't see that household sector is actually a net saver. not by much but they are certainly not borrowing all that much and so even if house prices start falling it might not have the kind of impact it had back in 2008 commercial real estate I'm not so sure because no one buys commercial real estate with cash so there has to be borrowing behind the commercial real estate and if the commercial real estate prices really loses its bottom or something, then that could push us into a voluntary recession.

45:46How much do you worry about that? The commercial space is interesting, especially with the United States, there's been this big trend of work from home. And there's obviously there's all this empty real estate all over. And this seems to be a very well-known risk. But how risky do you actually think the commercial real estate situation is in the United States?

46:11I think it's quite risky. But now that so many people are watching it, my guess is that if enough people watch it and realize how risky it is, it won't be as risky as it could be. Back in 2008, when there was this housing bubble, people said, this is perfectly natural, this is great, this is fine. And of course, that was not mine. But this time, I think people in the real estate market at least many of them should be aware of the risk because they experienced something similar in 2008. And so I hope it's not going to get to something as bad as what we experienced 15 years ago. And in terms of policy response, it was October of 2009 when FDIC, Federal Reserve and Comptroller Currency, the three banking supervisors in the United States, jointly issued this, what we call it, pretend and extend.

47:18Pretend that everything is fine and continue to extend the loan, even though at that time the value of the collateral was way below the value of the loans because of what happened to commercial real estate market in the United States. And when that pretend and extend was implemented October 2009,

47:46that policy was able to stop the bubble from collapsing. And so I suppose policymakers now know that if the situation really gets bad enough, they can use that tool to provide a flow to the commercial real estate prices. Yeah, and in the sort of broader context of all of this, now that we see the sort of extreme involvement from the monetary policy side and increasingly the fiscal policy side, do you think that looking at the global economy now, do we all need to get used to the potential that fiscal policy is going to be have a much more sustained, larger impact on the global economy going forward.

48:34Now that we're in this world of the pursued economies where we see that monetary policy in the developed world doesn't seem to be having as big of an impact. It's been a big discussion point, especially in the United States and Europe in the last, especially 18 months, where a lot of people have argued that the large interest rate increase, the biggest we've ever seen or the fastest and largest we've ever seen in recent history, aren't having quite the impact because they're not impacting the debt markets to a larger degree. Do you think that fiscal policy is something that's going to become larger and larger going forward?

49:10And is that potentially a problem in certain economies? Well, fiscal policy has to become much larger, has to play a much larger role in these developed economies because they are all in the perceived phase where household sector is still saving money, but the corporate sector is not borrowing as much. So fiscal policy has to fill the gap. In that sense, yes, fiscal policy has to play a much greater role. And because this is going to be a long-term issue, they also have to look at the content of what they do with the fiscal policy, make sure that those fiscal stimulus will produce a social rate of return that is as high as the bond yield that government has to pay.

49:55But on the other side, about the monetary end of it, the reason why monetary policy is not working as much as we expected, that even in spite of this high interest rates that we're already seeing, is, as I explained to you earlier, there's so much excess reserves in the banking system, about$3 trillion US at the moment. And so in the old, in the world that, in the textbook world, where banks do not have that much excess reserves, and central bank raises interest rates to a certain point, let's say 5%, a borrower comes in and says, I'm willing to pay 6%, give me the money. But the bank doesn't have that much excess reserves, so it has to go to the market or try to collect deposits to meet this guy's demand, and that, of course, is a very involved process.

50:57And that's how this tightening of monetary policy worked. But today, if someone walks into a bank, and let's say federal funds rate at, let's say, 5.25 or so, where if someone comes in and says, I'm willing to pay 6%, give me the money. The banks are flooded with excess reserves,$3 trillion worth. So these guys can say, okay, sure, you can have the money. And so even with 6%, where the inflation rates now, the real rates are very, very low. And if these guys continue to come in and borrow money, then monetary policy looks like it's not doing its job. and this index that's published by Chicago Fed, the National Financial Condition Index, it is still in the negative range, minus 0.2 or something.

51:54That means the financial condition is still loose compared to the average of the last 50 years. this number has to be in the positive range before you can expect tightening real tightening of our financial conditions and we didn't get there yet we haven't got there yet i think it's because of this uh qe provided excess reserves in the banking system and so qe during balance sheet recession does nothing but once the economy is out of the balance recession and then people come in to borrow money, then the QE produces all sorts of problems because monetary tightening that is required does not work as well as it used to.

52:40And so I would argue that we should not use monetary policy too lightly once you are in a pursuit phase. I mean, during COVID-19, when government needed money very quickly, only central bank would provide that. So I have absolutely nothing against those QE that Federal Reserve put in to make sure that people have something to live with. But other than those natural disasters and very urgent issues, I think Central Bank should be more careful with monetary policy in this pursuit phase. How do you think that relates to the current environment? A lot of people are worried about, we've had this nice trend in inflation this year where we've had a really steady disinflation.

53:31The headline CPI is down to 3.1 % in the United States. And so it looks increasingly like there could be sort of a soft landing in the United States, which I think has surprised virtually everybody. But there's still a lot of people who are worried about sort of a double bump in inflation, where you get this 1940s or 1970s situation where we had a big jump in inflation early, and then the inflation kind of roars back. And in part, I think a lot of people are worried that that could be caused by the fiscal policy side of things, and especially the large interest rate payments that are being made.

54:10Are you worried about sort of a 1970s-style inflation in parts of the developed world? Well, during 1970s, the option of moving factories to Mexico or to Southeast Asia did not exist. So once the labor supply is kind of exhausted and wages start rising very, very rapidly, and that created the wage price spiral. In this period, that is no longer the case, right? Japanese can always move factories to Southeast Asia, Americans can move it to Mexico, and the Europeans can move it to East Europe. And the globalization is still very much in place, even if China may be a little bit out of the picture.

55:00And so once the initial supply shock from the COVID-19 or reopening after COVID-19 is absorbed, then my guess is that inflation rates will come down to much more reasonable levels. because there's still a lot of emerging economies who love to get into the action of globalization, attract factories from abroad, and ship cheap products to develop the world, which will keep inflation rates down. So I'm not in a camp that says we're going to be returning to the 1970s because I think in the 1970s, Mexico was still very closed. most of Latin America was still following this import substitution model of growth and Southeast Asia was under Vietnam War and Eastern Europe was on the other side of the Iron Curtain.

55:55And so that's a very different situation. How does that fit into your overarching view with the pursuit economy perspective and the way that, especially in the United States, we're seeing a lot of pushback against the idea of globalization. My general view is that globalization is something that is almost naturally occurring in large part because the technological world has made everything really so much more accessible. Like you were alluding to, in the 1970s, you just didn't have the technology to make it even feasible to export work or to manufacture goods in Southeast Asia the way we do today.

56:35hey, my view is that the technology, and this is related to the inequality issue and everything, that I essentially think that the technology is going to make all of this worse going forward, that the world is going to become a smaller and smaller and smaller place, and that we can fight the globalization trend, and that there's no getting around it. What's your perspective on how globalization fits into this? And does it make sense for countries to fight it? Or should countries embrace the globalization trend, even though, as you said, with your pursuit economy perspective, it could potentially cause other problems?

57:13Well, globalization certainly caused lots of problems for a lot of families, especially in the developed world. And even though I would argue that we should embrace globalization, because that's basically natural market forces, I wish U.S. government, my government, to be a lot more careful with the exchange rate. And as I describe in chapter 9 of this book, U.S. has paid so little attention to exchange rates and allow the dollar to be determined mostly by capital flows which is of course the industry we are in and so I'm part of the problem I'm not part of the solution in that sense

58:12but the original position of original idea of the free trade which is of course what made globalization possible, is that if the countries start running these huge imbalances, too much, too large a surplus or too large a deficit, exchange rates should adjust. That was the original idea. But in 1980s, starting literally 1980, that year, all these countries started removing their capital controls, this and that, and the foreign exchange rate lost that function of balancing trade or at least keep the trade imbalance from going totally out of whack. And that created this backlash against globalization.

59:03That made the backlash against globalization much worse than it had to be. And I remember the Plaza Accord of 1985. I was a little bit involved in the sidelines on that issue. At that time, the U.S. dollar was so strong, 260 yen to the dollar, 250 yen to the dollar. And most people in Washington were saying there's only two U.S. companies left who are still for globalization and free trade. One was Boeing and the other one was Coca-Cola. Everyone else was against free trade. With that kind of exchange rate, you can understand that. and of course then President Reagan pushed this dollar down quite sharply using the Plaza Accord but since then and that was good but since then the dollar was kind of allowed to float on its own and recently the dollar is one of the strongest currency in the world again especially on a global straight weighted basis and I'm afraid that this will make many blue collar workers in United States very unhappy again.

1:00:13And that might, of course, add to the kind of movement that Trump was able to lead by saying that our blue-collar workers really need our help. They certainly do need our help, but that should be through our exchange adjustments, not by just giving out money in my view, because even if we help this industry, the steel industry, this and that, another 10 % movement in exchange rate and all the subsidies, all the taxpayers' money to help these industries will be wasted. And then you might ask the question, can we really control the exchange rate now that the capital flows are such a large part of foreign exchange market?

1:01:02and I think we can and I was involved in the Plaza Accord as I mentioned to you earlier that event how did government manage to bring the exchange rate down from 240 yen to the dollar to 120 yen to the dollar and eventually 80 yen to the dollar in the 10 year period simple you just scare the investors sufficiently so that they don't buy too many currencies of the deficit countries. And we saw that most recently with President Trump. He talked about trade deficits almost every day, right, during his four years of presidency. If the U.S. president keeps on talking about trade deficit and how we need to fix it, those people who are buying dollars get a little scared.

1:01:56because with this kind of president, he might tell the secretary of munichin to intervene in the foreign exchange tomorrow. And if that risk is there, many investors will think twice about buying U.S. assets. They may still buy it, but much more carefully than if someone else was the president. And as a result, if you look at, I mean, the yen dollar rate might not be the most representative, But if you look at the yen dollar rate during President Trump's period, it was remarkably stable for the whole four years. Even though during that four years, Federal Reserve raised interest rates nine times.

1:02:39And the Japanese kept the rates very low. So Fed raised interest rates nine times. Japanese did not increase the rates. And the yen dollar rate remained remarkably stable. Because someone like Trump keep on talking about trade deficit. I'm sure many Japanese institutional investors who used to buy U.S. treasuries and so forth got a little scared and they were more careful in purchasing U.S. assets. But Japan was still running large trade deficit trade surplus with the U.S. So that's a natural force to push dollar down and yen higher. And if the Japanese insurance companies did not upset that by buying U.S.

1:03:22treasuries, then that will keep the dollar from appreciating. And so I think we can learn from those experiences of Plaza Gold or during Trump years that there is something government can still do. And I think we need to do it to make sure that this reaction to globalization does not go too far to the point where free trade is put in danger because free trade made so many of us prosperous, both in the developed world and in the developing world. But we have to make sure that it works properly as originally advertised by making sure that the exchange rate really doesn't go totally out. That's interesting.

1:04:17I never thought of all of Donald Trump's talking as being a soft currency peg of sorts. So maybe there was more benefit to all of his talking than some people expected. So anyways, Richard, you've been super gracious with your time. I know it's 10 o 'clock there in Japan. So thank you very much. We could go on and on all day, but we'll let you go. So thank you so much for all your insights. And Richard's new book is The Pursued Economy. me and Richard's, you know, what I've said was, I think one of the great macroeconomic books of all time, the Holy Grail of macroeconomics, you should buy them both.

1:04:59Richard, thanks so much for your time and hope to talk to you again soon.

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