The Great Rebalancing - it is all about savings

Michael Pettis has written what may be one of the most important economic books for 2013. He is a former Wall Street analyst, economics professor in China, and an excellent blogger through his China Financial Markets site. What he does is smash a number of myths concerning China and the rest of the world with respect to the international financial system. Policy talk has been all about the huge trade surplus in China and the opposite trade deficit in the US as if this is a war that is fought on the factory floor through cheap labor and undervalued currencies. There are a growing number of stories on currnecy wars when in reality the war is on savings imbalances. What Pettis does is place the main focus back on the imbalance in the current account through looking at the accounting identities associated with trade. 

The trade imbalance is related to the savings and investment imbalance through the simple identity that 

X-M = S-I. 

Exports minus imports have to equal the difference between savings and investments. This has been a focus of discussion by many leading economists. Ben Bernanke wrote about this issue well before the crisis, but for all of the economists who have focused on the identity, there are still many who get it wrong. There is the idea that China may threaten the US through ending the purchase of Treasuries. There is the idea that the US can get out of this problem through simple domestic policies. There is the view that tariffs can be used to solve the imbalance problem. All are wrong. 

Pettis pushes the identities of international trade and finance to the extreme, but he makes the excellent point that to solve any trad problem you have to go back to what is happening to savings and investment. The issue of one country cannot be isolated relative to the rest of the world. This is a global problem that needs correcting or we will have a huge global recession. 

This is not an easy book. The concepts are easy, but Pettis works through the mechanics of the adjustment process quickly and without a formal model. These models exist, but Pettis focuses on story-telling. This requires careful attention by the reader; however, the effort is well-paid for in the end with a clear idea of the problems the global finance system faces.