Reminder: There's a Solution to the Crisis and It Lies in China

by: David Goldman

Last November, Francesco Sisci and I wrote in Asia TImes Online:

Recovery requires a great change in direction of capital flows. For the past decade, poor people in the developing world have financed the consumption of rich people in America. America has borrowed nearly $1 trillion a year, mostly from the developing world, and used these funds to import consumer goods and buy homes at low interest rates. The result is a solvency crisis of the American household, which shows up as a solvency crisis for financial institutions. If we reckon the retirement needs of households as a liability, the household sector is as good as bankrupt.

No recovery is possible unless American households can save, and they cannot save in an economic contraction when incomes spiral downwards. To save, Americans must sell goods and services to someone else, and a glance at the globe makes clear who that must be: nearly half the world’s population, and most of the world’s capacity for economic growth, is concentrated in China and the Pacific Littoral.

We recommended a firm link between the US dollar and the Chinese yuan, in which the yuan would have full convertibility, with a solemn commitment by the two countries to maintain a fixed exchange rate forever. That would instantly link the two countries’ capital markets.

The demographic problem that creates a Japan-style deflationary bias in the US would disappear, because the demographics of China would be open to the American capital market. A great deal of work (bank branches, credit bureaus, and so forth) would be required to build the necessary infrastructure, to be sure, but linking the two currencies would make the rest of the solution possible.

In effect, the world’s two largest economies would establish a full partnership. As we wrote:

China’s economic problem is the inverse of America’s: China has achieved fast rates of growth at the expense of huge disparities between the prosperous coast and the backward interior, as well as excessive dependence on foreign markets. China’s policy response to the economic crisis is far more radical than Washington’s. Rather than attempting to patch up the situation and restore the status quo ante, China plans to spend nearly a fifth of its gross domestic product on an internal stimulus focused on infrastructure in its interior. Severe execution risk attends the Chinese proposal, and markets remain to be convinced.

China can reduce the execution risk of its great economic shift towards home consumption, and America can solve its savings problem, through a grand partnership. This partnership need not be exclusive to America and China, but it must be founded on America and China, two of the world’s largest economies. India and the other Asian economies should be encouraged to join this partnership. A great deal has been written about prospective conflict between China and the United States, but very little explanation is offered as to what issues might arise between China and the United States. China and America have far more to gain from cooperation than from conflict.

The trouble is that Americans can’t spend. They have to save. The combination of a catastrophic decline in wealth and a sudden bulge in retirements gives America the profile of Japan during the lost decade of the 1990s. The Keynesian approach is a one-country model, which states that if the population wants to save rather than spend, the government should spend for them. America appears to be getting away with this because the dollar is a reserve currency and the world has to hold dollars — but the grumbling overseas might lead to the rest of the world ditching the dollar eventually, making the US like like Britain in the 1960s and 1970s.

The Keynesian stimulus isn’t working very well, as the miserable employment data tells us, and the stock market clearly doesn’t believe Obama’s demurral that it will work later in the year. There’s already talk about another stimulus package. FInanced by whom, and how? The deficit is already approaching $2 trillion.

If we follow Robert Mundell and throw out the single-country model of the Keynesians, it is obvious that Americans can save in another fashion, that is, by exporting. China’s underdeveloped interior is potentially the world’s biggest export market, flanked by similar markts in Asia and elsewhere in the developing world. The transition would still be painful, and the frictions considerable, but America could reorient itself to th global market. There would be a recovery. As matters stand we face a lost decade.

Instead of grandstanding in Ghana–however meritorious it is to help the Africans with their problems–Obama should go to Beijing and have a serious conversation with his Chinese counterpart about how the world’s two largest economies can create a recovery.