Stock markets continue to roar higher on better global economic data and expectations for pro-growth policies from the US. Beneath the surface, however, it appears that capital is herding in a manner similar to prior market booms that didn't end too well.
This time on FS Insider, we spoke with Michael Pettis, a finance professor at Peking University and senior associate for the Carnegie Endowment for International Peace, about his views on capital flows, trade imbalances, and what they mean for the world economy in the future.
Trade imbalances, particularly in Europe, have worsened since Pettis wrote his book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, a few years back.
The reason for the current imbalance is because Germany has been running huge surpluses, and because of the rules of the Euro, countries such as Spain, Italy, France, and Portugal, have been prevented from adjusting. As a result, these high-inflation countries with converging interest rates ended up with negative real interest rates.
“Those negative real interest rates set off, as they always do, the real estate booms and the stock market booms that led to this insane consumption binge and a rapid increase in debt,” Pettis noted.
Here's a partial clip of his recent interview where he explains how US markets are acting as a “shock absorber” as the trade environment, he predicts, will continue to get worse:
Capital Flows Dominate Cycles
The reality is, this flow of capital is one of the main reasons we’ve seen the US stock market continuing to head higher.
“When you get those major capital flows, the first reaction is always to set off stock market and real estate booms,” Pettis said. “Those always go too far. They lead to soaring debt, and they lead to misallocated investment, particularly in the real estate sector, until you reach the point where you have a debt crisis. Then that aspect stops, and you get the other aspect, which is soaring unemployment.”
For developed countries running a deficit, there are really two responses. Either we allow debt to surge, perhaps by lowering interest rates, or we see unemployment surge.
In the former case, when credible central banks lower interest rates, we always see a surge in debt. In the latter case, unemployment is inevitably the result, Pettis stated.
“It’s just such a regular pattern,” he said. “We always see it that way. It’s something we’ve known about for a while, but for some reason, people keep forgetting it.”
Listen to this full interview with Michael Pettis on our website by clicking here. Become a subscriber and gain full access to our premium weekday interviews with leading guest experts by clicking here.