By coincidence I had two OpEd pieces that came out last week, one in the WSJ and the other in the Financial Times. The latter came about because about a month ago Martin Wolf asked me to write a piece based on my June 20 entry. The former came about on the previous Friday when I was thinking about last week’s SED meeting and why I wasn’t expecting much to come from it. Although they are very different pieces, both of them build on this idea that the inversion of the consumption/GDP growth relationship in the US has important implications for China’s future GDP growth.
For the WSJ piece I start by pointing out that when the Japanese and German currencies soared in value against the dollar after the Plaza Accords were signed in September 1985, many analysts thought that at long last their trade surpluses with the US would decline. They were partly right in the sense that the German trade surplus with the US did indeed decline. But in spite of the fact that the value of the yen doubled, Japan’s trade surplus nonetheless surged.
I don’t think this should have come as a surprise. There is a tendency to think that the value of the currency and the level of import and export tariffs are the main policy tools affecting the trade balance, and so absent a change in tariffs, any increase in the value of a country’s currency will automatically lead to a decline in its trade surplus.
In fact the trade surplus reflects the gap between what a country produces and what it consumes, and so anything that affects that gap is implicitly a trade policy. I discussed this in some depth in my June 3rd entry.
In the case of Japan in the post-Plaza Accords environment, the Ministry of Finance and the Bank of Japan responded to the currency agreement by directing a flood of low-interest credit into the manufacturing sector while informally guaranteeing borrowers, so assuring lenders that profitability was irrelevant in determining the flow of credit. Sound familiar? As a consequence Japanese manufacturers increased their production even as the flow of funding into the manufacturing sector and traditional constraints on household consumption forced an increase in the gap between Japanese production and Japanese consumption. The result: a rising trade surplus.
By the way I have been reading Akio Mikuni and R. Taggart Murphy’s Japan’s Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance, an interesting book that covers a lot of this ground. I recommend it to China watchers, although I am no expert on Japan and I did have a big problem with the often-repeated assertion (and one that often pops up in discussions about China) that because Japanese trade was not denominated in yen the Bank of Japan was forced to accumulate dollars. In fact it doesn’t matter what currency your trade is denominated in – if you run a net current and capital account surplus, your central bank must accumulate foreign currency. Had trade been denominated in yen foreign buyers would still have had to convert dollars to yen with the Bank of Japan in order to make their purchases.
But that is a digression, and aside from a few irrelevant disagreements I think the book is quite illuminating. In China, like in Japan during the 1980s, there are a number of factors besides the value of the currency that affect the country’s trade account, and even if the value of the Chinese yuan rises, it will not automatically lead to a decline in China’s trade surplus commensurate with the contraction in global trade, especially if it is matched by a significant credit expansion to the manufacturing sector.
Several policies are aimed at boosting production besides the undervalued currency. As I have discussed before, these include very low lending rates enforced by the People’s Bank of China, energy and commodity subsidies, and probably most importantly, a flood of credit aimed at investment both in infrastructure and in the manufacturing sector. At the same time very low deposit rates, constraints on consumer financing, and low wages, among other factors, prevent consumption from growing at nearly the pace necessary to absorb everything that China produces.
As an aside MacQuarie’s Paul Cavey has a very interesting OpEd piece in last week’s Wall Street Journal, based on a longer research piece which I am not able to link. Among other things he argues that although China has run negative interest rates for much of recent history, until last year there was no credit bubble because credit was rationed – and credit rationing implicitly raises the cost of capital for the system, even if interest rates are nominally low. Recent conditions, however, are different, and all rationing has disappeared with the explosion in credit of the past eight months. Cavey concludes:
It’s not impossible for Beijing to take away the punch bowl of credit. There is plenty of room to defy the skeptics and in the next few months and push through structural reforms. For instance, some of the privileges state-owned enterprises continue to enjoy in terms of the ability to provide domestic services like banking and telecoms could be dismantled, allowing the country’s more productive private sector to thrive in local markets rather than just overseas. But without such changes China will be relying on growth financed by cheap domestic debt. This means China will be decoupling itself from the U.S. consumer, but at the cost of a credit bubble.
China’s consumption will rise
So to return to the main story, with the credit expansion and other measures aimed at boosting production, will China’s trade surplus soar? Probably not. Every trade surplus requires a trade deficit elsewhere, and as the leading trade deficit country, policies in the US that affect the gap between consumption and production will also determine the size of the US trade deficit. If the Obama administration is successful in forcing a rise in US savings levels, and even if it is not (since in the short term US households have no choice but to increase their savings rates), US consumption must grow more slowly than US production and the US trade deficit will narrow, except in the very unlikely case that US investment soars – investment would have to grow faster than savings to keep the trade deficit from contracting.
For China this almost certainly forces the country into either of these two outcomes
1. The government continues the current fiscal expansion forever, in which a huge expansion in government-led investment pushes growth forward.
2. The consumption rate in China must rise as a share of GDP.
There are at least three problems with the first option. First, a significant portion of the fiscal stimulus (and almost certainly a higher share than reported) is directed into manufacturing in the tradable goods sector, which needs anyway to be absorbed by rising consumption, either in China or globally. Second, given the inefficiency of the current fiscal and credit expansion, and the concomitant rapidly rising direct and contingent government debt, there is a real question as to whether this program can be sustained for more than one or two years.
And third, and this seems to be the most confusing point for some, the economic purpose of investment is to increase future production, and even if the fiscal stimulus turns out to be hugely efficient (it isn’t), without a surge in future domestic consumption to absorb the additional Chinese capacity we will still be stuck with the need for a massive return to US profligacy, and Chinese funding of that profligacy, to absorb the increased production.
The first option, in other words, is at best possible for a very short time, and ultimately we are forced into the second option: Chinese consumption must rise as a share of GDP, or to put it another way, Chinese GDP must grow more slowly than consumption.
So why should the US care what China does to rebalance its trade if changes in US consumption will force a rebalancing anyway? Isn’t discussion and coordination pretty much unnecessary if a rising savings rate in the US must ultimately force an adjustment on China?
No. US and Chinese policies matter because there are many ways that international trade can rebalance. In the US we will see consumption grow more slowly that production, just as in China we will see consumption growth outpace production growth.
Both will happen, but in both countries there is a good scenario and a bad scenario. The good scenario for the US would see some growth in consumption buttressing healthier GDP growth. But the bad scenario would involve a contraction in GDP driven by even faster contraction in consumption. For China a good scenario would involve surging consumption driving slightly slower GDP growth, and a bad scenario would consist of slow consumption growth dragging down GDP growth.
If China continues to pump out capacity and tries to export this excess abroad, and if US household savings rise much more quickly than US fiscal dis-saving (borrowing), we will almost certainly see the bad case scenario occur, at least in China, and especially if it leads to trade friction around the world. The nightmare scenario is that in the US a still-high trade deficit prevents a slowdown in consumption from nonetheless causing a sharp slowdown in economic growth, which leads to rising unemployment, which causes consumption to slow down even further. Meanwhile in China rising inventories eventually lead to cutbacks in production, which also lead to rising unemployment.
As fewer Chinese get jobs, the unemployed consume less, and the employed also try to increase their savings because of rising uncertainty. Since net Chinese savings must decline if net US savings rise (note I am assuming the rest of the world, including sustained investment levels, is constant, but I suspect the impact of the rest of the world will actually be adverse), the only way for this to happen if the Chinese savings rates rises is either for a burst of inefficient and unsustainable debt-fueled investment by the government, or for GDP growth actually to slow sharply.
I know all this sounds drastic, but the imbalances have to be worked out one way or the other. Rising savings in one part of the world, even assuming no change in global investment, requires declining savings somewhere else, and although it may be unrealistic to expect no change in global investment, the plausible prediction is that global investment will actually decline, which increases the pressure. This is just another way of saying that changes in trade deficits in one part of the world require equal changes in trade surpluses elsewhere. This is also just the obverse of saying that declining consumption in one part of the world requires rising consumption elsewhere (or sharply rising investment, which since it represents future production only postpones the need for consumption growth) or else global GDP must contract.
What will determine whether or not the two countries follow the good scenario or the bad scenario? Clearly fiscal and monetary policies in both countries will matter because they will set the speed of the adjustment and they may or may not speed up the adjustment process.
In the US, fiscal expansion is aimed primarily at slowing the pace of demand contraction. This may be necessary since I expect US GDP will grow slower than US consumption for many years, but it comes at the expense of a rising fiscal debt. I am not as worried as many others seem to be about US fiscal indebtedness and I am certainly not worried about the ability of the US to fund its debt, especially since the stock of debt in the US is declining (private debt is dropping faster than public is rising). As I have argued many times, I also think all the fear-mongering about whether or not China and other foreigners will continue to fund the US fiscal deficit is totally muddled thinking and among the least important things to worry about. Foreigners will and must fund the US current account deficit, and the bigger the deficit the more they will fund – so really we actually want foreigner to reduce their funding.
But there are reasonable limits to how much debt we want to see in the US, and we certainly don’t want to see a continuation of the global imbalances in which the debt-fueled consumption binge of US households is simply replaced by the a debt-fueled consumption binge by the US government, especially since as long as the trade deficit is high a large part of the job-creating aspect of US fiscal deficits will leak abroad, requiring even larger US fiscal deficits. In addition, the US fiscal program should be accompanied by specific measures aimed at increasing US household savings – I am not able here to go into much detail on how to do this (and I am no expert on the subject), but for example perhaps we can eliminate taxes on interest income, raise consumption or gasoline taxes, and so on.
Of course forcing an increase in US savings means improving the long-term US outlook while hurting short-term prospects for employment. Rising US savings means declining consumption growth, and remember that US GDP growth will be less than growth in US demand for the next few years as US debt levels decline.
I think China will face an even more drastic version of this trade-off, and this is because, as I have been arguing for two years, contractions in global demand force the most difficult adjustments not on the “sinful” low-savings trade-deficit countries but rather on the “virtuous” high-savings trade-surplus countries. China needs to cut capacity drastically and put into place the factors that will lead to a rise in net consumption, but most of these policies will actually hurt employment in the short term. I have already discussed what these policies are likely to be in my June 3rd entry, and almost all of them will almost by definition force a contraction in the tradable goods sector.
China’s problems will be made much worse if it is forced to cut capacity very quickly, which will happen if trade disputes get worse. Already disputes with Asian neighbors are pretty nasty, and they are likely to get worse with the US and Europe. There has been a lot of discussion recently about China turning to other developing countries as sources of net demand to replace the US, but this is unlikely. Aside from the fact that no one is large enough, none has the ability to run persistent trade deficits. China can fund these deficits for a while, but it will learn, as many have before it, that funding persistent current account deficits for developing countries eventually leads to defaults on the debt.
So after all the premable on what do I think the SED discussions should focus? Since this entry is long enough already I will postpone that part of my discussion for a couple of days.