Meet the Man Who Predicted the Chinese Economic Collapse

Chris Matthews
Jan 23, 2016

Back in 2012, when oil prices were above $100 per barrel and the Chinese economy was growing at over 10% per year you'd be hard pressed to convince anyone that a commodity price collapse, fueled by a sputtering China, would be the event that finally brought the world back into recession.
Unless, of course, that person followed the writings of Michael Pettis, a former Wall Street trader and professor of finance at Peking University’s Guanghua School of Management. For years, Pettis has been warning of the growing imbalances in the Chinese economy, and he called the commodity price collapse as early as 2012.
Pettis argues that the Chinese economy is following the example of many countries that came before, like the Soviet Union following World War II, the Brazilian economy in the 1970s, and Japan in the 1980s. In each of these cases, national governments put forward policies that artificially boosted investment and suppressed consumption, policies that led to a fast buildup of growth and large trade surpluses. But eventually these imbalances go into reverse, and that is what is happening now. Fortune reached out to Pettis to get his take on what will happen next in China, and how it will affect the U.S. economy. The interview has been edited for length and clarity.

Fortune: At what point did you recognize that China's growth model was unsustainable?
Michael Pettis: Pretty early on—by 2006, it was obvious.
What made you realize that China's growth model was like the failed experiments in places like Brazil?
[Economist] Alexander Gerschenkron argues that there are two fundamental parts to an investment-led boom. First, you have to force up the savings rate, which you do by constraining growth in household consumption. And next you have to direct the investment process. But if you look at all the investment growth miracles, they all did that.
One of the things that really struck me was that during the miracle periods, at first when growth rates are really high, everyone is shocked. And then during the adjustment period, it slows so quickly, we’re all shocked. There’s been no exceptions. It’s always like that. We’re shocked on the way up and shocked on the way down.



This happens to individual companies, too. Take a company like Enron, which is a very common story. Before Enron fell apart, it was just growing spectacularly. I think it was the most admired company in America eight out of 10 years before it went under. When a company or country has an inverted balance sheet [i.e. one with an asset structure that doesn't hedge bets, but amplifies them] it’s really like you have your correct balance sheet with a very speculative overlay on top of it. All you’re doing is exacerbating underlying conditions.
It’s like if you invest in the stock market, but you margin write it to the hilt. If the market goes up, you make more money than anybody else, and you and everyone else start to think you’re a genius. And when the market goes down, you get wiped out. And it seemed to me that these economies were doing something very similar. They were growing much more quickly than we had any right to expect. And then suddenly they were slowing much more quickly than anyone believed possible.

For years, you have been predicting a collapse in commodity prices. Most economists don't see the crash infecting large economies like the United States. Why are they wrong?
In places like China and Germany, we're seeing high income inequality while the household share of GDP is quite low. The inequality has the same impact. It pushes up the savings rate because the rich save more than ordinary people. Is that good or bad? Supply siders tell us that it’s always good to increase the savings rate. Keynsians will tell us no, we have to increase demand.
The truth is they are wrong, or that they are both right only under very specific conditions.

For much of the 19th century, there was a huge “problem” of income inequality in England, and so the savings rate was too high. But you had ... the United States, which was credible and urgently needed excess savings from England to fund productive investments. That’s where the excess savings went, and the English got richer, and we got richer.

If you have productive investment that’s credible and that’s being constrained by the lack of savings, then income inequality is actually good for the economy. But if you don’t, then you have the problems that you saw in the 1930s, where excess savings forced down the savings rate in the middle class by forcing up consumption. The savings go into speculative markets. Stock markets go up, real estate goes up, we all feel richer, just like during the real estate bubble. But once that game stops because of debt, then you still have to balance savings and investment. But because nobody is investing, then you’ve got to bring savings down. And the way you bring savings down is firing workers.
And that’s what we’re seeing around the globe, with job losses beginning in the commodity sector
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http://fortune.com/2016/01/23/china-collapse/