A Fragile Bond

A thought-provoking piece in the Financial Times yesterday by Michael Pettis on the balance sheet adjustment challenges facing China prompted some wider thoughts. The chief policy challenge Michael identified was how China policymakers can apportion losses in the system. The less explicit focus of his article was how societal trust in the system can be maintained in the face of that adjustment. But let’s be clear, his analysis is relevant globally and societal trust in the West is significantly more brittle than in China.

source: Nightcafe.ai

As the IMF table quote in Michael’s article shows, the growth in debt has occurred everywhere. For 60 years, debt has increased steadily at every level of society and every industry, both public and private – at a global level. Total liabilities = total assets. As an accounting fact, the current and future values of global assets have increased to match, approximately, the additional debt – either in capital value or income value – with a balancing, and essential, residual item. Namely, the inherent ‘equity’ or ‘franchise value’ which in relation to a financial system includes what is colloquially termed ‘trust’.

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This ‘trust’ was implicit in Michael’s analysis and is of central importance to Chinese policy makers. However, it seems even more relevant to policymakers of the West.

It was never clear that overall system trust increased in line with the expanded global balance sheet. China’s is probably considerably better off in this regard, given the obvious material benefits that have accrued over the last 30 years. Elsewhere the store of trust has been depleted, in large part precisely because of China’s ascendency. The shift of the ‘workshop of the world’ from Europe and the United States has increased income insecurity and eroded trust. Trust was marked down first by the Global Financial Crisis, then by the disruptive (and authoritarian) effects of the COVID19 pandemic. Although you won’t need it, here are three examples of the problem: a populist take (Rich Get Richer), a more mainstream take (The Economist), and an American version.

To be fair, some long-term capital improvement may have occurred to bolster real asset values everywhere – through efficiencies (principally informational) and globalisation. However, a good part of these benefits on the asset side have been concentrated. And challenges to future expected cash flows and asset values (if they arise) threaten not just the asset values but also the trust (equity) in the system.  And since 2020 there have been plenty of challenges.

Faced with these challenges, Chinese policy makers appear better placed than those in the West. It is by no means clear the asset values of China are any more inflated than those of the West – as recent real estate transactions in San Francisco or St Louis attest.

A societal harmonising preference, given the apparent erosion of trust, implies future adjustments in the West be allocated in a progressive fashion and demonstrated as such. That is already apparent in the political narrative across Europe and the United States. But while the narrative is comforting, the evidence does not support it. To date information asymmetries (aka network effects) have tended towards regressive allocation of gains, and where they have occurred losses often appear to be socialised. That is a recipe for further erosion of ‘trust’. Given the paucity of equity/trust in the Western system as a starting point, a progressive response seems a more pressing imperative than in China.

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