What Should Have Been Discussed During the SED Meetings (Part II)

In my last entry I tried to set out the necessary shifts over the next few years as the world, and especially China and the US, works out its imbalances. These shifts will take place, I am pretty sure, but they can do so under a “good” scenario and a “bad” scenario.

So what does all this have to do with the SED? It means that the best hope for the two countries, I think, is a well coordinated set of policies acknowledging that the US savings rate must rise, and with it the Chinese must decline, but also recognizing that if this happens too quickly, or is accompanied by a collapse in trade, it will be bad for the US and terrible for China. These coordinated policies must also acknowledge – and this becomes much more difficult – that the current Chinese stimulus may be making the adjustment more difficult, and much of it will have to reversed at the same time as the “appropriate” measures aimed at spurring consumption may cause a short-term rise in unemployment.

Finally, the while the US commits to keep fiscal spending high, to turn a blind eye to trade disputes, and to run large trade deficits for several years more, China must commit to the financial sector and currency liberalization that will effectively reduce subsidies to producers and constraints on consumption. The SED might also discuss the ability of workers to demand and enforce wage increases, since there is a wide consensus in China and abroad that among the main reasons for low household consumption in China is that wages are rising too slowly relative to GDP, and household savings are “taxed’ too heavily via interest rate policies. Of course discussing workers right in a bilateral context is politically difficult, even without the irony of this particular discussion, so it will probably not happen.

When I discuss these issues, I am often confronted by the “aha!” crowd who point out that my analysis must be wrong because if China does what I think they should do that would cause a rise in unemployment. How can a policy be the right one if its implementation leads to a bad outcome?

That’s easy. It can be the right policy if the alternative leads to a worse outcome. That’s the problem. There is no silver bullet here that can kill all the demons and leave us living happily ever after. As I see it, the imbalances of the past decade were real and must be addressed, and we have broadly speaking three possible ranges of outcomes:

1. The US returns to its consumption orgy, the US trade deficit surges, and we’re back to the wonderful days of 2005. China can continue pumping out production and funding US consumption. The problem of course is that this cannot be a permanent solution. It just postpones the resolution of the global imbalances while fueling another asset bubble and saddling the US with even more debt and China with even more excess capacity.

2. China begins a long – five or six years at least – process of forcing the necessary structural changes that will permit a shift from a production-led economy to a consumption-led economy. The changes necessary involve liberalizing interest rates and the banking system, allowing workers higher wages, and a number of other measures to boost SMEs, the service sector, and household consumption. In the short term, however, nearly all of these measures will involve closing down unprofitable production facilities. This must be done in conjunction with the US, so that the US adjustment is slowed down to a pace which China can absorb. The US would do this by keeping fiscal expansion high enough to counteract the contraction in US household consumption.

3. Everyone does what they want to do anyway with no attempt at serious coordination. US savings rise. Chinese production rises too. These two forces are globally incompatible and eventually lead to a sharp contraction in global GDP growth. The effects on China might include, but are not limited to, an explosion in Chinese inventory, a sharp and nasty contraction in international trade, or a brutal rise in Chinese NPLs and an unsustainable government debt burden.

High savings in China is not an accident. Chinese trade and industrial policies that were aimed at generating employment growth by directly or indirectly subsidizing the cost of production, including currency and interest rate policies, nearly all effectively created forms of income and consumption taxes that constrain consumption even as they boost production (and a rising savings rates just means that production is growing faster than consumption), and to remove the latter you need to remove the former too.

It’s not so easy to increase consumption

So they have a dilemma: Remove the producer subsidies so as to allow consumption to grow, but cause subsidized producers to go out of business. Or keep them in place, and perpetuate the production/consumption imbalance.

One way or the other Chinese policymakers are destined to be “successful” in raising the consumption share of GDP, because as the US reverses its earlier relationship between consumption growth and production growth, the rest of the world, which ran the opposite position, must also ultimately reverse.

Now for the next few years China’s savings rate will almost certainly decline and its consumption rate rise – it has no other choice except to inflate a major, debt-fueled overinvestment boom – but will that happen because of high growth in consumption or low production growth? That is where policy matters very much, and the longer they wait to address the imbalance, the worse the outcome gets, I think.

Clearly Beijing wants to raise consumption quickly. Not too long ago a group government economists were reported to have reported on their website (sorry, but I lost the link): “The new policy measures and initiatives will be the latest effort to shift growth from focusing on capital investment to a more sustainable model that gives domestic consumption a more important role in boosting economic growth.”

But they’ve been wanting to do this for a several years – as they explicitly acknowledge by calling this the “latest” effort – but the fact that it is harder to this now then it might have been three or four years ago doesn’t inspire me with much confidence. It seems to me that most policies that will boost consumption in a stable and efficient way fall into one of two camps. Measures like building the medical and social safety net, gradually getting banks to direct lending to service industries, loosening the one child policy, and so on can be very successful, but will take years before they have much impact on real consumption.

In that camp I might add measures to force banks to increase consumer lending, because I think the last time they tried that (with car loans), nearly half the loans went NPL, suggesting that at first consumer lending will simply consist of free consumption financed indirectly by the government, when it bails out the NPLs. This is a form of “consumption” I guess, but it is not really what the doctor had ordered.

Bad or worse

On the other hand reversing the policies that might have repressed consumption in the past will probably work more effectively within a shorter time horizon. These would include liberalizing interest rates and allowing them to rise (which reverses the implicit transfer from households to producers), allowing workers to organize to demand higher wages, raising the value of the RMB, and so on. Unfortunately nearly all of these measures would hurt manufacturers, especially in the export sector, and would cause an initial rise in unemployment. I am not sure it is possible to manage the transition without a sharp, short-term rise in unemployment caused by the downsizing of the export sector as its implicit subsidies are removed, and it isn’t clear to me that any country that has managed a similar transition has been able to avoid this. My guess is China will have to do this, but will wait until they have no choice – building up in the mean time even more excess capacity and bad debt. And bad debt, as I have argued before, must be resolved at some point in the future, and unfortunately usually in a way that constrains consumption growth.

One of the things that worries me is that the trajectory of rising US savings and increased investment in Chinese production is likely to squeeze the tradable goods sector in most countries around the world as China increase its market share. This will lead to accusations that China is behaving in a predatory way, and will almost certainly lead to increased trade tensions as policymakers around the world try to protect their tradable goods sectors form “unfair” Chinese competition.

But I don’t believe that China should be considered predatory. China desperately wants to raise its consumption rate, because it is highly likely that for the next few years Chinese GDP growth will be limited to something below Chinese consumption growth. Beijing would love to find the magic policy that transforms Chinese consumption overnight and turns China into a continental economy driven by internal demand. It would love to see the trade surplus reduced not by a collapse in exports but rather by a shifting of exports to domestic consumption and a rise in imports (this last maybe).

The problem is that there is no such magic policy. I cannot find any historical precedent of a country that was able to make the transition quickly and painlessly, and because of its own domestic problems – especially the employment effect of the contraction in the export sector – China is facing a difficult set of policy choices. The fact that the fiscal stimulus may be exacerbating China’s reliance on the export sector was not the plan. The fiscal stimulus is aimed at arresting a sharp and probably politically unacceptable rise in unemployment, and the fact that so much spending has gone into investment, rather than consumption, reflects rigidities in the economic and financial structure. China would love to see explosive growth in domestic consumption, but there is no way they can easily engineer such growth.

So we are stuck with policymakers, in China and elsewhere, making the best of a bad situation. They can be criticized for not beginning the adjustment process when conditions were much easier, but that is a criticism that can be spread around pretty thickly to policymakers in quite a few countries. Anyway it is too late.

In these circumstances policy coordination matters a lot, and I see too little of it to have much optimism. Beijing, Washington and Brussels must recognize that China and th world is still in a more vulnerable position than anyone seems to realize, and that rising US savings and rising Chinese investment create conditions for two seemingly irresistible forces to go head to head, and without coordination the consequences could be much worse than we expect.

Comments

[Crispus:]

I tend to disagree with your assertions “China desperately wants to raise its consumption rate” and “The problem is that there is no such magic policy.”

Hundreds of millions of Chinese workers work excessively long hours with few days off for very little money. However, a reading of China’s labor laws will show there is an eight hour work day, a 44 hour workweek, premium pay for work in excess of 8/44 hours, a required day of “rest” each week, and a minimum wage.

These “laws,” despite official claims China has “the rule of law,” are generally ignored unless you are KFC, McDonald’s, Metro, Carrefour, Pizza Hut or HP.

Not being an economist, I am only a simple accountant, I cannot help but wonder at the effect on universal enforcement of existing labor laws on aggregate income, job creation, and increased consumption. Clearly, there would also be higher production costs, both in manufacturing and infrastructure development. Savings would also increase as would demand for consumer goods. Further, increased leisure spending would increase.

If “China desperately wants to raise its consumption” she ought to take a hard look at increasing disposable income by enforcing the fairly decent labor laws on the books. I suggest, this would also create a heightened sense of goodwill toward the government thereby promote social stability.

This is as “win-win” as it gets. The propaganda value is immense. Think of it, the party of the worker could actually improve the lot of the worker.

Naw…. Never mind, its just a silly Socialist idea.

Aug 10 10:13 PM

[James Lewis:]

The Chinese government does not want to raise wages of the people because it will create a loss of control over a large % of the population. They fear the people will start to have more power and then question the policitical reality of the 'one party system'.

The Chinese government also does not want to raise the wages of the people because it will make acheiving 'state objectives' harder. There are many many facets to 'state objectives' (not all negative)

Lets also be clear that if the minimum wage was raised significantly. This would lead to higher unemployment, corporations/restaurants etc have far too many workers as it is. Very in-efficient. Raise the wages, people will be laid off.

I have observed over the last 4 years, as wages have started to rise. That restaurant waiters have been getting younger and younger to circumvent wages rise by employing younger cheaper workers. If it was mandated for higher wages, there would be a whole host of ways to circumvent the new rules.

Also there is a far more important dynamic here. On every level of social order in China; there is a very steep hierarchy with all the power/wealth concentrated at the top. In order to create a consumption economy, there needs to be a flatter social hierarchy. Which those at the top of the hierarchy will not allow. Regardless of new legislation being passed.

This is a typical alpha-male social dynamic, very evident in nature.

It will take at least 30-60 years and a lot of social/spiritual development for this dynamic to change.

Aug 11 09:47 AM

[Crispus:]

I have observed over the last 25 years, significant changes in the lot of the common folk of China. Not only have wages increased, but the goods available have markedly changed. Clearly, these changes have been largely urban but most of the population has benefited.

2008 saw minimum wages increased in China in various provinces and municipalities. Guangdong raised minimum wages by about 18% in some cities. Wages were raised in the major cities of Shanghai and Beijing. Tibet raised minimum wages by nearly
50% at the beginning of 2008. Note, the China minimum wage regulation stipulates minimum wage control is in the hands of provinces and municipalities.

The minimum monthly wage in Beijing was raised to 730 yuan ($105USD or so) without massive layoffs. Chinese do not begin to pay individual income tax until their monthly cash wage exceeds 2,000 yuan.

My point goes to the hours worked by the minimum, or near minimum, wage earners. Typically, ten to 12 hour days, with one or two days off each month, is required, in Beijing, to earn 730 yuan. If the owner were to pay according to existing labor law, which is, over 8 hours a day pay is paid at 150%, over 44 hours a week is paid at 150%, and not allowing a day of rest, the seventh day is paid at 200%, the minimum wage worker would earn about 1,300 yuan a month.

Enforcing labor laws would effect a redistribution of incomes from the wealthy to the masses. The owners would have the choice of increasing headcount to avoid higher per hour costs, or, continuing to overwork current employees. Foreign firms, foreign owned or foreign branded, are monitored closely and do follow Chinese labor law profitably.

Clearly compliance with law would increase cost. An owner paying 730 yuan with typical working hours to ten workers will have a cost of 7,300 yuan a month. If she followed the law her labor cost would be about 13,000 yuan. Should she hire additional workers and avoid any premium pay her labor cost would be about 10,800 yuan.

It is also clear income would be redistributed from the owner to the workers but she has the option to raise prices and does get the income tax benefit.

Lastly, I do not doubt that control and retention of power are significant motivators in Chinese government policies. But given the changes I have seen over the last 25 years, most of them recent, the CPC and government are becoming more responsive to public dissatisfaction and is taking action. Keeping people poor and hungry is of no benefit in the long run.

Aug 12 02:36 AM

[HeF:]

Yes Crispus, but over the past several years wages as a share of GDP haved dropped sharply, even during periods of flaming growth. That seems evidence that there are real constraints on workers' abilities to get their fair share. When this happens in the US, as it has during the same time period, we have no problem criticizing bad policy, and why not in China?

Aug 12 10:00 AM

[Crispus:]

Prof. Pettis, I quite agree with you. Wages in China are shamefully low and workers are truly exploited in both the Marxist and conventional usages of the word. To me the existence of decent labor laws and the the near universal lack of enforcement is something the government needs to face. Working conditions in China, and the treatment of workers, can easily be labeled Manchester like.

It is difficult to criticize policies when the law sets out a reasonable and fair policy with regard to workers. Seems to me enforcement of labor laws would enhance CPC respect and ease social stability concerns.

On the other side of the coin, :-), enforcement of labor laws would effect a redistribution of income, promote consumption and savings, wages would gain share of GDP, more production would be utilized domestically and China can continue on her merry way extolling the merits of Chinese characteristics.

Dude, China has been fun to watch. Us that live here can see the nitty gritty not represented in stats like GDP or the Marxist words. I am an American Capitalist but I love the Chinese, maddening though they can be.
I like your economic writings Mike, the music not so much.

Aug 12 08:57 PM