What Rebalancing of Chinese and American Consumption?

I am leaving to New York and DC for a week, so this may be my last post for several days since my schedule will be pretty hectic. Of course most of my trip will involve meetings with bankers, investors and some government officials, but the timing of my visit was based on the three-week tour of a group of my favorite Beijing musicians. For those who live in the northeast and are interested, check out the tour schedule and by all means come and see the shows. The work of these artists is, in my opinion, among the most interesting in the music world and will give a very different idea of what Beijing’s hippest youth are thinking about than most people assume. I will be attending most of the performances until November 11, when I return to Beijing.

But on to grayer topics. When the US economic data for the third quarter of 2009 came out last Thursday judging by the market reaction it seemed much more mixed to me than it apparently did to others, especially as far as it relates to China. It is true that after four quarters of negative growth, with GDP contracting 3.8% in the year to July, we finally got positive GDP growth of an annualized 3.5%. This was above expectations, and given China’s reliance on US overconsumption, the increase certainly seemed to be good news.

Even better, much of that growth was powered by a 3.4% increase in personal consumption, which was itself powered by the rather astonishing 22% increase in durable goods consumption – or perhaps not so astonishing if we chalk it up, as most experts do, to the “cash for clunkers” program. Americans, it seems, bought a lot of cars in the third quarter of 2009.

As I (and many others) see it, however, this surge in auto sales in the US isn’t likely to represent new and sustainable purchases, and so undermines any optimism generated by the growth in consumption. The surge in car sales may simply be Americans taking advantage of temporary government subsidies, and to that extent represent not new purchases but rather an anticipation of future purchases. If that is the case, whatever we get this year in new car sales will result in a reduction next year.

Why am I so negative about the good consumption numbers coming out of the US? Because the rise in personal consumption was accompanied by a 3.4% decline in household disposable income. If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption. Consumption and household income must move in the same direction over any reasonable time period to be sustainable.

As if on cue, this was at least partly confirmed by the subsequent release of September numbers. As Friday’s Financial Times put it:

US consumer spending stalled in September after climbing in each of the prior four months, dampening spirits, as the effects of government stimulus programmes started to wane. Personal consumption expenditures fell by 0.5 per cent, or $47.2bn, last month, commerce department figures showed on Friday. The data were in line with the predictions of Wall Street economists, who expected that the expiration of the popular “cash for clunkers” car rebate scheme would hit spending.

In September, spending on durable goods, which includes cars, fell by 7.2 per cent after jumping by 6.7 per cent the previous month. Incomes were flat in September, slipping by just 0.1 per cent, after ticking up by 0.1 per cent in August. Companies are continuing to freeze pay or cut salaries as they wait to see the shape of the economic recovery.

So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending. Both China and the US are dealing with their imbalances either by slowing down the rebalancing or by exacerbating the very things that caused the imbalances in the first place. Slowing down the adjustment makes good political and social sense, of course, but it shouldn’t blind us to the fact that US households cannot continue leveraging up to absorb the excess production that Chinese companies are leveraging up to produce. We will rebalance, one way or the other.

By the way, and speaking of not rebalancing, net new lending in October might be up. According to an article in Bloomberg:

China’s four biggest banks granted 136 billion yuan in new loans in October, higher than the previous month, Caijing magazine reported, citing industry data. Bank of China Ltd.’s new loans in October were 44 billion yuan, the most among all the banks, Caijing said. China Construction Bank Corp. lent 36 billion yuan, Industrial & Commercial Bank of China Ltd. granted loans of 33 billion yuan and Agricultural Bank of China lent 23 billion yuan, the magazine said on its Web site.

Resolving the imbalances

The same day the economic numbers were released Tom Holland had an interesting piece in the South China Morning Post on two “new” proposals for solving the Asian side of the destabilizing imbalances at the heart of the global economy – one from the International Monetary Fund and one from Barclays Capital. The first:

As the IMF points out in its regional economic outlook published yesterday, household savings have actually declined across much of Asia over the past 10 years. Even in China, the personal savings rate has remained more or less constant, which means it cannot be ordinary individuals who are responsible for the explosion in the region’s excess savings.

What’s actually happened…is that saving by Asian companies has ballooned since the crisis of the 1990s. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Asian companies have made bumper profits in recent years. And because of weak corporate governance, they have been able to retain a large portion of those earnings rather than paying them out to shareholders as dividends, feeding the savings glut.

The answer, according to the IMF, is to strengthen corporate financing options, so companies no longer need to hang on to earnings, while beefing up corporate governance standards to ensure a better dividend payout. The IMF estimates that raising emerging Asia’s financial market development and corporate governance standards to rich-world levels would lower the region’s corporate savings by 7 per cent of gross domestic product, wiping out the savings glut and going a long way towards rebalancing the world economy.

I think it is widely agreed that there should be a more robust mechanism for forcing SOEs and other large corporations to disgorge their profits and return them to shareholders, including the government, but I wonder if it isn’t a little more complicated than that. As I see it, SOE profits are not the result of their value creation but are rather more than 100% explained by various subsidies delivered from the household sector. Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which may be the currency undervaluation, SOE profits in the aggregate would be negative.

In that sense SOE profits are simply part of the transfer from household income to the state sector, and the most efficient way to return the money to households is likely to be to raise deposit and lending rates rather than dividend them back to shareholders. If the shareholders gain access to those profits via increased dividend payments, as I see it we are still seeing a transfer of income from Chinese households to the state sector.

The state may spend it more wisely than the SOEs (something that I would have to see to believe), but unless that money directly or indirectly was sent back to the household sector, perhaps by paying for health care or lower taxes, it doesn’t really address the fundamental problem. If it goes into state-favored investment projects, there will have been no rebalancing. I am convinced that Chinese households need to receive a larger share of national income, or their consumption growth will always lag growth in production and high savings rates will persist.

The second new proposal described by Holland:

The emerging-Asia economics team at Barclays Capital have come up with a different solution to the problem. In a report also published yesterday, they argue that the way to get rid of the region’s excess savings is not for Asian countries to save less but for them to invest more. Barclays’ analysts argue that Asia’s problem is not low consumption. Across much of the region, with the exception of China, household consumption ratios are similar to those in the European Union. Instead, the source of the glut is the low level of investment, which has declined since the Asian crisis.

Given Asia’s heavy need for infrastructure, Barclays recommends that governments should use the region’s excess savings to ramp up investment in order to promote future economic development. That certainly appears to be China’s preferred solution. The problem, however, is ensuring that investment is channelled into productive projects rather than misallocated to building excess capacity. Barclays’ answer is to finance more projects with private, rather than government, capital. That, however, would need financial reform and stronger governance in order to work.

I can’t speak for the rest of Asia, but I doubt that what China needs is a lot more investment. We seem to have forgotten all the lessons of the overinvestment crises of the 19th and early 20th centuries (and perhaps Japan in the 1980s) in favor of the mantra that increasing investment is always a good solution to whatever the current problem is. Although there is no question that much of the world probably invests too little (e.g. the US), the idea that there is infinite scope for additional investment is simply not true, and I worry that so much of China’s investment is already non-viable that increasing it significantly can only make matters worse. Building yet more stuff, if it does not repay the cost of the investment, means reducing future consumption, and it is consumption growth that powers economies over the long term.

Perhaps I am sounding like a skipping CD, but for rebalancing to occur in China we need households to grab a larger share of income. Any other solution, I think, misses the point. China entered the crisis with the highest investment rate in history, and probably also one of the highest rates of misallocation of investment in recent times, and then grew it sharply and quickly. This probably isn’t the solution to low Chinese consumption.

What the 1930s tell us about the coming protection

Finally, Barry Eichengreen and Douglas Irwin have a July 2009 NBER paper out with the title “The Roots of Protectionism in the Great Depression” which examines the relationship between protectionism and monetary conditions. According to the very helpful abstract:

Previous research has shown that countries that remained on the gold standard tended to endure sharper and longer downturns than those that allowed their currencies to depreciate. Eichengreen and Irwin offer an important trade-policy corollary: without the flexibility to depreciate their currencies, many gold-standard nations turned to trade restrictions in hopes that these would boost their domestic industries and curb unemployment. Thus, the 1930s’ rush to protectionism was not so much a triumph of special-interest politics as it was a result of second-best macroeconomic policies, the authors write. Their study “suggests that had more countries been willing to abandon the gold standard and use monetary policy to counter the slump, fewer would have been driven to impose trade restrictions.”

This was a fascinating paper that covers a lot of the ground in Eichengreen’s magisterial Golden Fetters. I think the paper (like the book, incidentally) has a lot to say about the current crisis, and the political implications are, I think, a little worrying. When they argue that countries that were tied to, or late to abandon, the gold standard were the ones most likely to employ protectionist measures, they could also be arguing that countries whose exchange rates are forced untenably high are also more likely to use protectionist measures to achieve adjustment by other means.

In that sense the refusal of Asian central banks to permit the needed appreciation of their currencies against the dollar may end up having the same impact on the adjustment process of the overvalued currencies. The 1930s seemed to show, according to the authors, that when their currencies could not adjust, countries became protectionist. So if the overvalued dollar cannot adjust except against the euro, and if the already overvalued euro has to bear the brunt of any further adjustment, will American and European politicians be forced into the “second-best” option of trade protection? No prizes for guessing what I think. By the way the chorus of complaints over the currency regime seems to be getting louder. After Paul Krugman’s piece in the New York Times last week I saw the Financial Times had a pretty strong piecetoday by Alan Beattie called “Renminbi at heart of trade imbalances.”

By the way, Douglas Paal, Taiya Smith, Michael Swaine and I will be speaking at a Carnegie Endowment event, on President Obama’s trip, to China on Thursday, November 5 from 12:15 to 2 p.m. I have been told that it will be live-streamed and there will be opportunities for questions. If anyone is interested he can find it here.

Comments

[Mad Hedge F...:]

lks Zachary Karabell, president of River Twice Research, is one of the few original thinkers out there who also has a sense of humor. So there’s more than one? Zach has brought his considerable talents to bear on the current state of the Chinese-American relationship in a new book, Superfusion: How China and American became One Economy and Why the World’s Prosperity Depends On It. International trade has fused the two countries into a single economic unit that accounts for a quarter of the world’s population and a third of its GDP, despite wildly different cultures, much like the loose confederation that makes up the European Community. The Middle Kingdom now has reserves of $2.3 trillion, which is overwhelmingly invested in the US. Where else can it go? That enabled them to step up and play an important role in the bail out of the US financial system this year. But it is an imbalanced agglomeration, with Americans over consuming and under saving and the Chinese doing the reverse. This has to stop, lest the symbiotic relationship tears itself apart. The tit for tat, storm in a tea cup, where the US imposed punitive import duties on Chinese tires and the they retaliated with a ban on American chicken feet (yes, they eat them, yuk!), is a recent example. The reality is that old, boring industries that once might have fought tooth and nail for protection are now migrating to China en masse and finding new life. Bet you didn’t know that General Motors sells more cars in China than in the US, some 1.6 million this year? Don’t hold your breath waiting for China to float the Yuan, as it is one of the few tools that give the Mandarins in Beijing direct control of a huge, disparate economy. Chinese military spending is so parsimonious that it won’t remotely comprise a threat to the US. What little they have is directed at potential regional aggressors, like Japan, India, and Russia. The greatest risk to the existing relationship is that Chinese growth continues so rapid, that it pits them against the world in resource bidding wars, which could get ugly. With crude at $82 and copper at $3, has that already started? The book is well worth a read for some excellent “out of the box” analysis. Does anyone have any good recipes for chicken feet?

Nov 03 11:03 AM

[ObjectiveFu...:]

Sir, any idea what venue the bands are playing at Hampshire College (13 Nov)? The link just takes you to the college site and the show doesn't appear on any of their calendars. Thanks!

Nov 03 11:27 AM

[derryl:]

It's not just China that needs a more balanced distribution of the national income. Since 1982, the "Great Moderation" era, virtually all of the gains of globalization have concentrated into corporate profits. Poor workers do not own stocks and earn dividends. It is disproportionately people who already have significant savings/investable 'excess' incomes who share in the corporate profits.

So as Mt. Pettis says of China, a better distribution of dividends merely puts more money in the hands of people who already consume as much as they want to. To revive the consumption levels that ultimately drive economic production a nation needs a large portion of its population earning enough money so that they can save what they feel is prudent and still consume enough to absorb their nation's productive capacity. The alternative is trade imbalance where you have to export the 'excess' production, which is just another way of saying workers are not paid enough to buy what they produce.

Henry Ford had the right idea, the idea that built America's middle class--the people who built American prosperity. Ford wanted his workers to be able to afford the cars they built. It's the right goal if you want a sustainably balanced economy.

Ford's workers could afford cars on their earned incomes. Great Moderation middle class Americans could afford cars only by taking on debt and spending more than they earned. They borrowed that 'excess' consumption from their own future, the future where they have to consume less than their income as they devote more of their earnings to repaying their debts. That future is now.

I have no sympathy for people who leveraged their lifestyle to include an Escalade in the driveway of their McMansion, and who are now suffering the inevitable paying of the piper. But in our credit driven monetary system SOMEBODY has to keep taking on new debt or else the system seizes up, due to leakage of money out of the borrow and spend, produce-and-consume economy and into financial markets and other monetary eddies that absorb but do not release trillions of dollars of 'investment' money. Savers end up with all the money, spenders end up with all the debts, and money ceases flowing which seizes up the economy.

An alternative solution would be a monetary policy innovation by which debt-free money is released into the system at whatever rate is found to be beneficial via a program of naked money creation by the Fed and Treasury. From "lender of last resort"--creator of even more debt to add to the already unpayable debt levels; the Fed would become free money creator of last resort. As long as the money was directed towards people who would spend it--poor people and the overindebted middle class--it should stimulate the real economy and allow for significant household debt deleveraging.

Of course this money would also ultimately end up in the hands of people who save and invest rather than spend it, which would merely exacerbate asset inflation and lower interest rates due to "excess savings", but Mr. Pettis has touched on some of the fiscal measures that are capable of dealing with that aspect of the imbalance problem.

Nov 03 06:04 PM

[Al-USA:]

Derryl wrote:
"
To revive the consumption levels that ultimately drive economic production a nation needs a large portion of its population earning enough money so that they can save what they feel is prudent and still consume enough to absorb their nation's productive capacity.
"

Well said by writer Derry above. If I may extend it further, what we have here is, fundamentally, a crisis of capitalism, or, a crisis of over-production.

This is obvious to the serious strategists of capital, and it should be also obvious to you, the "little" investor and predominant reader, so that you're not taken up and swept away by all the propaganda talk of "green shoots", or Chinese growth, etc....

The policies and practices that led to the present crisis can be traced back to the coming to power of Margaret Thatcher in Britain in 1979 and the election of Ronald Reagan in 1980. Their dual victories led to a repudiation of the managed capitalism advocated by John Maynard Keynes and the introduction of the free-market “fundamentalism” of Milton Friedman.

However, this change itself occurred as a response by powerful sections of the ruling class in Britain and the United States to an already far-advanced crisis of the capitalist system. If you recall, or care to reference, as far back as 1967, there were growing indications that the mechanisms devised by Keynes to stabilize and rebuild capitalism in the aftermath of World War II were breaking down.

The system of dollar-gold convertibility adopted at the Bretton Woods Conference of 1944, came under increasing pressure and eventually broke down as a result of three inter-related factors:

1) The first was the gradual erosion in the course of the 1950s and 1960s of the dominant economic position that the United States had enjoyed in the aftermath of the Second World War.

2) The second was a general decline in the rate of profit in the mid-1960s that placed considerable pressure on American, European and Japanese corporations and intensified global competitive pressures.

3) Finally, the militancy of the working class, throughout the world, frustrated efforts by the capitalist class to find a way out of the crisis through reduction in wages and benefits of the working class. What is now called "restructuring".

The three factors above, or advanced crisis of the capitalist system, were eventually resolved by three events that signaled the beginning of a successful counter-offensive by the ruling class against the previous decades' concessions won by the masses of the working/middle class. This also planted the "seeds" which directly lead to the present crisis of over-production now some 30 years later.

1) The counter-offensive began with the appointment by President Carter, a Democrat, of Paul Volcker as chairman of the Federal Reserve. Volcker immediately set about to break the back of working class militancy by raising interest rates to unprecedented levels, thus provoking a severe recession and driving up unemployment.

2) The second event was the announcement by Chrysler that it would shut down a major production facility in Detroit, the famous Dodge Main plant in Hamtramck that employed several thousand workers. This decision was accepted by the UAW bureaucracy by deciding to grant Chrysler major concessions on wages and work rules. Thus began a pattern of union-management "collaboration" that cleared the way for subsequent attacks on the jobs, wages, working conditions, and benefits of all sections of the American working/middle class.

3) Finally, Reagans' accession to the presidency in January 1981 accelerated and intensified the war on the working/middle class that Carter had begun in 1979 with the appointment of Paul Volcker. The defining event of the Reagan presidency—the firing of 11,000 striking air traffic controllers, members of PATCO—sent a signal to all corporations that strike-breaking and union-busting was legitimate and would enjoy the support of the government.

However, Reagan’s destruction of PATCO would not have succeeded had he not received the support of the AFL-CIO bureaucracy, which opposed any action in defense of the victimized air traffic controllers. In the years that followed, the AFL-CIO bureaucracy sanctioned a wave of government and corporate strikebreaking following the pattern of union-management "collaboration"

In practice, the alliance of the trade union bureaucracy with the Democratic Party kept the mass movement within the confines of capitalist politics and capitalist economics. This provided the ruling class with an opportunity to reverse its retreats of the previous decades and go on the offensive. In summary, under conditions in which social conflict is suppressed, by the destruction of the labor movement in the USA, wealth accumulation increases rapidly along with the level of social inequality which has now led us to the present crisis of over-production and another still unfolding, in my opinion, Greater Depression...

Get your shorts ready because fortunes will once again, be made on the downside.

Nov 04 06:51 AM