“The most striking real economic fact of the past several months is not continued U.S. economic weakness, but that China’s economy has slowed much more quickly than anyone had forecast,” Australia’s central bank Governor Glenn Stevens said this week.
Not quite “anyone”. Quite a few people who read this blog, some of them quite prominent, have been forecasting very grim numbers for China all year, and much of our discussion in the comments section has revolved around how bad the slowdown would be – above 7%, some of us said, or much lower, others have argued. I still say that we haven’t seen the end of downward revisions. By the way, I was just told by a friend two minutes ago that Goldman Sachs has just reduced their projection of 2009 Chinese GDP growth to 6%. I don’t have the citation so it might not be true, but it wouldn’t be surprising to me, and eventually lots of other banks will do the same.
As I have argued for a long time, if you think about China as being one of the two main players, along with the US, deeply linked within the overall global balance of payments, it cannot possibly come as a surprise that the US adjustment was going to require a Chinese adjustment which, given the relative size of the two economies, almost inevitably meant that China was going to get hit harder than the US. Here is a quote from as far back as September, 2005, in an interview with Hamish McDonald of the Sydney Morning Herald, in response to widespread belief at the time that the US was the most vulnerable to a breakdown in the balance of payments relationship:
“My money says the US could survive a disruption in the dependency relationship much more easily than could China,” says Michael Pettis, professor of finance in Peking University’s management school.
I know this sounds like I am tooting my own horn, and I don’t mean to, but the belief that China was protected from a possible crisis affecting the US trade deficit always struck me as weird. Perhaps American paranoia requires a sense of helplessness in the face of a powerful threat, and clearly the rest of the world takes its intellectual clue (and often cluelessness) from the US, but it couldn’t have been such a surprise that a sharp US slowdown would create trouble in a country so reliant on US consumption for its employment growth. Things have always been this way – why should they have suddenly changed?
Because last night I was invited to be a guest on the CCTV current events show, Dialogue, I tried to get my arms around an easier way of thinking about the adjustment so that I could explain it on TV. Let us assume that the US trade deficit will decline by 50%, from 6% of GDP to 3% of GDP – there are some who have argued that it will go to zero next year and others who have even argued that the US will soon be forced to run a small surplus, but I will assume nothing quite so dramatic. I will also ignore any contraction in net demand from Europe and elsewhere.
Since the Chinese trade surplus is equal to up to 2/3s of the US trade deficit, this suggests that within the overall global balance China should, ideally, absorb about 2/3s of this contraction, roughly equal to 2% of US GDP. This is also equal to about 7% of Chinese GDP, which means that either
a) Chinese consumption is going to have to expand by 7% of GDP faster than production,
b) Chinese production is going to have to contract by 7% of GDP more than any contraction in demand, or
c) both will have to happen so that the sum is equal to 7% of GDP.
Clearly the first cannot happen very quickly. The second would mean economic chaos for China, so that leaves the third. In the best of cases China would be given enough time to get as close as possible to the first of the three adjustments, but without a very strong international framework and coordinated action the most likely outcome is for at least some contraction in production.
The problem with all my scenarios is that the numbers are so big it is not easy to make the case for a smooth adjustment, except under the assumption that the rest of the world will do everything it can, including suffer rising unemployment, to pull China out of the crisis. That is unlikely.
That brings us to the terrible trade numbers. Last night, as I was on my way to CCTV to do the show, I got a call from Shang Ning, my Peking University student, about the data release. He told me exports were down 2.2% – terrible news given that economists were confidently predicting a 15% increase as recently as a week ago, but no longer unexpected. By the way Tom Holland in the South China Morning Post claims that in RMB terms, the more relevant measure if you want to judge the pain, exports were actually down 10.1%.
Shang Ning also told me on his phone call that imports were down 17.9%. I immediately called my friend Logan Wright from Stone & McCarthy and asked him about the import numbers. According to Logan, only a part of that decline can be accounted for by lower commodity prices. There was a real contraction in import volume.
This is frankly much more worrying to me than the decline in exports because it suggests that demand in China is contracting quickly. I have no idea what the retail sales numbers are going to say, but last month I complained that it seemed inconsistent to me that imports were contracting while retail sales were implying a healthy expansion of consumer demand. Unless the marginal propensity to import is collapsing, I think I trust the import numbers more. Demand in China is looking very bad.
Finally, and most shockingly, Shang Ning told me on the phone call that the trade surplus was $40.1 billion. At first I thought he was saying $30 billion, and I was surprised that it was so high – it would have been the second-highest monthly trade surplus ever recorded. When I finally understood him to say $40 billion, I couldn’t believe it. That is the main reason I immediately called Logan, to see if my student had made a mistake just before I was going to go on TV to debate the economic outlook.
He hadn’t made a mistake. In October China’s trade surplus was $35.2 billion, the highest every reached by any country at any time in history. In November that record was smashed. In the last three months China’s trade surplus has been $96 billion, nearly equal to the $100 billion from the first six months of 2008.
The headlines in China and around the world have been dominated by the contraction in Chinese exports, and this certainly is a bad number, but it cannot be a surprise and it is not the number on which we really should be focusing. The trade surplus is much more worrying, and soon enough that is what all the headlines will be reporting. Remember that the trade surplus is the measure of Chinese overcapacity that is being exported onto the world economy, but the world economy is looking for ways to increase net consumption, not net production. While demand in the rest of the world is shrinking, China is providing even more overcapacity, which means effectively that not only is China not absorbing its share of the demand/supply adjustment, it is exacerbating the imbalance. Other countries are going to have to withstand a faster decline in production than otherwise.
I know that China is facing a real problem of economic slowdown, one that seriously worries policy-makers. The other guest on the CCTV show last night was the chief economist of a large local securities firm, and he accomplished the not-inconsiderable feat of making me sound like an optimist. But still, it is wholly unrealistic to assume that the rest of the world will accept that they must bear more than 100% of the adjustment in order to pull China out of its trouble.
As a related aside, one of my former Columbia students, currently a government official in Vietnam, just told me an hour ago that Vietnam’s exports are awful. Declining exports are going to be a real problem for a lot of developing countries. With the collapse of the part of the capital markets that financed developing countries, and the resurgence of capital flight, developing-country trade-deficit countries will be forced suddenly to run trade surpluses (via, almost inevitably, a sharp contraction in domestic demand). If that happens, anti-China feelings are inevitably going to rise. If these result in anti-trade acts, China will suffer far more than it would under even the worst of current economic scenarios.
The chief economist who was on the TV show with me last night clearly understood this, as do many others in China (there is a even rumor that one reason the RMB depreciated before the SED meeting last week was that some people in the PBoC wanted to bring the matter to a head), and it is really important that US, Chinese, European and Japanese policymakers fully understand the problem. The major economies must work out a plan in which they provide for a three or four year period during which China can adjust its overcapacity problem, but if China tries to go it alone and allows the trade surplus to remain at anywhere near these levels, it is hard to see how we can avoid trade trouble. To repeat ad nauseum, the Chinese economy absolutely cannot tolerate a world of trade protection.
By the way I talk mostly about the US and China as being fundamental to the current global imbalance, but there is another pair that is also suffering from some of the same problems. Germany is running a huge trade surplus while the rest of Europe is running huge deficits. Already relationships in Europe are fraying. Paul Krugman, in Sweden to collect his Nobel purse, writes about it:
Everyone here seems to be talking about…the German problem. At a time when expansionary policies are desperately needed, the leaders of Europe’s largest economy seem to have their heads in the sand. This is a huge problem: there are large spillovers in fiscal policy among EU nations — that is, a significant fraction of, say, French fiscal expansion ends up promoting employment in Germany or Italy rather than France. So there’s a crying need for a coordinated policy. But the Germans aren’t participating.
The Financial Times explains it a little more colorfully in an article today (“Berlin hits out at ‘crass’ UK strategy”):
Germany’s finance minister has launched a stinging attack on the “crass Keynesianism” pursued by Gordon Brown, the British prime minister, fuelling tensions on the eve of European economic crisis talks in Brussels. Peer Steinbrück accuses Mr Brown in a magazine interview of “tossing around billions” and saddling a whole generation with a bill for paying off British debt.
His comments come as the European Union’s 27 leaders meet in Brussels to debate a proposed €200bn fiscal stimulus package, designed to stop a protracted economic slump. Mr Steinbrück, a Social Democrat in chancellor Angela Merkel’s grand coalition, has previously accused other European leaders of acting like “lemmings”, borrowing billions to fund tax cuts or higher spending. His irritation has been heightened by efforts by Mr Brown to construct a coalition to put pressure on Germany to follow suit.
…Germany has insisted the summit communique, while endorsing a €200bn stimulus package, should include the need to maintain fiscal discipline. A draft statement says the goal of long-term budgetary sustainability “implies a swift return to the reduction of deficits which have been temporarily increased.” Mr Steinbrück, speaking to Newsweek, questions whether Mr Brown’s £12.5bn (€14.2bn) cut in value-added tax will work. “All this will do is raise Britain’s debt to a level that will take a whole generation to work off,” he said.
He added: “The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking.” He said British policy would simply repeat mistakes of previous years in fuelling credit-financed growth.
I don’t want to wade into these very deep waters, but I think Steinbrück is right to warn Britain and France against excessive fiscal spending to get their economies going. Given their trade deficits a lot of their spending is going to be used to pull non-British and non-French workers out of unemployment, as Krugman notes. But on the other hand they are right to insist that German do more to expand fiscally. It is German overcapacity that is now the European problem. Perhaps Germany, like China, should be doing more to rebalance its excess capacity and foist less of it on the rest of Europe – struggling as they are with rising unemployment.
As distressing as it is to say this, I think few things are going to raise more irritation and anger next year than global trade.
Very interesting – I certainly concur, Michael. Indeed, the more I read your commentary, that of some of your posters and people like Russell Napier (who also saw the writing on the wall), the more clearly I recognise the issues!
What I find absolutely fascinating is that the markets in which I trade are, at this very time, simply throwing the news of what appears in reality to be a RAPIDLY deteriorating Chinese economic situation with extraordinary global implications into the Santa sack, and merrily moving on-wards and up-wards! Further, I imagine the recent ‘positive’ movements in the financial markets are making the matter of forming and negotiating a reasonable solution quite challenging for governments e.g. imagine what PRC politicians and business leaders must be saying -> ‘we need to save ourselves…press on with pushing our exports as fast as possible on our international (over)consumers – after all, their market commentators/experts keep saying things are now getting better and that they’re on the road to recovery!’
Forgive me for being opportunistic, but it certainly looks like a very interesting trading opportunity and one a few others are clearly (and publicly) on to as well e.g. Jim Chanos, in a recent interview, mentioned China looked like the next domino to fall and was looking at specific opportunities.
As I said before, China must increase import to reduce the imbalance. What can China buy? Luxury goods? Commodity? Education/Healthcare? Or technology? I guess there got to be a balance between the demand and supply for import goods/services to China.
Michael.
No one is winning here, and the fact that EVERYONE is squeezing rocks for a few drops of water through incentives only worries me more.
I am looking at FDI as a real sign of concern as well. If you remember, a lot of decouplists last year were saying that China’s investment could offset the dropoff in the export economy… the problem is that a large portion of investment from the government sector has supported the foreign economy (i.e. factories for export and foreign factories for domestic).
Entire cities – Suzhou, Nanjing, Tianjin, Chengdu, Shantou, and so on – have developed zones, ports, fiber networks, roads, power plants that are to support these groups.. and when local economies fear a drop in this investment, they will stop investing.
the questions I have on your analysis above are:
1) How can the US/ other economies support China if their consumers are bust, and the banks are no longer willing to extend credit?
for me – this is THE issue. US is an economy of consumers, and right now consumers have no means to buy anything. 700bn for the banks does nothing to change this
2) How can China adjust and absorb all the excess? I think it was Andy Xie that said the fact that Chinese don’t have basements or attics means they don’t have enough space to buy all the crap we need them to
3) On what timeline do you think leaders should be approaching this? Does China have 6 months or 3 years to adjust.. or more?
4) Does anyone believe that through the RMB, VAT, and some incentives, that China can turn this around – or push off the inevitable. Is there money out there, and are cash players willing to put their money in at the current perceived level of risk?
5) Is there in the economic sense a tipping point?
R
http://www.allroadsleadtochina.com
Goldman revised down their GDP forecast globally, China to 6% for 09 and 9% for 10, but also said LONG China A share market is the number 1 trade of 2009.
Hi Michael,
Great blog!
I wonder if China will really have to absorb 2/3 of the contraction of the US trade deficit in the end. I think it will rather be the oil-exporting countries who will take that burden.
Of course the effects may propagate globally and finally cause the estimated 7% contraction in China, but this may or may not happen. Some analyses (e.g. World Bank) even forecast that China’s market share will rise.
JLD
Mr. Pettis, what are your thoughts regarding how this crisis will affect the rest of developing Asia? As I understand, Korean and Taiwanese exports were both down double digits and I am not quite sure how Japan is doing though it cannot be good in light of the strength of the Yen and collapse in Chinese import demand. The Indians in particular seem oddly upbeat, perhaps irrationally so, thinking themselves insulated from the global recession and still expecting 7.5% growth next year (though the World Bank and Merril Lynch are much more sanguine).
Dr. Pettis:
Interesting times – in danger of getting more interesting. The global trading system seems in danger of breaking down due to the accumulating imbalances and the resentments they create. Historical precedent is not necessarily a source of optimism.
BW2 will be remembered not as a stable system, but as a perverse optima where external deficits are allocated (mostly) to those countries most able to finance them (US, UK, etc), while surpluses are allotted (mostly) to those countries most willing to pursue the necessary policies to obtain them (China, Japan, Russia, other Asia).
It is small comfort to know that as the system shakes, the US may be less harmed than China et al. The fact is that for several years now the US has been the loser in a great currency game which it doesn’t even acknowledge is being played, and has witnessed a massive outflow of financial wealth and production capacity to the rest of the world. To some extent, this may be considered poetic justice for the terrible IMF policy advice during the Asian crisis, etc. But I believe it has gone far enough.
For reasons I don’t understand, Anglo-Saxon economists as a group seem to fail to recognize a very important normative truth – it is better to run trade and financial surpluses than to run deficits. The drawbacks to deficits are clear – less local production, declining wealth, etc. Taken to extremes, deficit countries become dependent on external financing, vulnerable to sudden collapses, and (usually) exposed to painful “balance sheet effects”. Moreover, countries with large external deficits face conflicting policy objectives – a weaker currency would help the economy as a whole and obviate the need for continued borrowing from foreigners, but at the same time a stronger currency is seen as facilitating loan repayment. And if you have to raise interest rates to defend the currency, so be it. Very strange.
I try to understand the justification for willfully ignoring the problems associated with external deficits. Perhaps there is some confusion from balance of payment accounting, where financial deficits are mis-named “financial account surpluses”. Perhaps there is danger to being labelled a “neo-mercantilist”. Perhaps economists envision some ethereal substance – “capital” – flowing to deficit countries, making them stronger. Perhaps economists believe that trade imbalances correct themselves through some quasi-Humian mechanism price-specie mechanism. But this is simply not true – while there is some convection taking place, most winners remain winners, and most losers remain losers. Until a crisis like the great depression comes along and the losers decide they prefer autarky.
It is clear that many other countries do not make this Anglo-Saxon error. China obviously ensures trade surpluses through reserve buildup. Japan has graduated to using carry trade outflows (although they did slip – recently Japan experienced its first monthly trade deficit in something like twenty years). Russia achieves surpluses through its export revenue fund largely for realpolitik gains. Brazil, while not pursuing surpluses, has boosted reserves in an attempt to retain balanced trade despite high internal interest rates. Etc. Etc.
The decline of the British Empire was capped by a period of bad economic policy – a pointless attempt to return to the Gold Standard at pre-war pricing levels after WW1. It is entirely conceivable that the US will de-throne itself through a similar commitment to bad economic policy. The Washington Consensus may yet become the Washington Curse.
If one acknowledges that trade surpluses are good and trade deficits are bad (except in special circumstances) then it becomes clear that the global system needs to move away from a covert competition for surpluses. Instead, the objective should be BALANCED TRADE with negotiated exceptions. In the long run, this may be the only way of securing the benefits of long-term trade without creating winners and losers.
Whaddaya think?
Which country will be first to install trade barriers? I suspect it will be one of the Asian countries. This will be followed by a lot of talk against Germany. By the time US gets around to it, protectionism will sound like a self evident truth.
Steinbrück is right. Alas he is.
There is little that can be done. And certainly neither crass Keynesianism nor interest rates manipulation à la Greenspan-Bernanke will get us of this trap.
Steinbrück does not want the Euro to be killed.
In view of the difference between a Spanish household (one or many houses, Euribor-based 30-to-50-years leverage loans) and the German one (Cash-denominated savings to put it simply), I can understand why he wants to save the “Eurozone” saver and why Zapatero has a distinct agenda.
Mr Steinbrück is certainly not in charge of the Spanish and Greek situations.
Eurozone will have to wait till the first Eurozone sovereign signature run into the wall. Possibly in 2009. Possibly later. I just hope that it won’t be a big one.
I’m confident on the social and political answer. But the financial cost will certainly be very high. There is no escape.
On the Spanish case, the information is absolute limited and partial and I can only recommend Edward Hughes Blog which is getting better by the day. For some reason:(
http://spaineconomy.blogspot.com/
Prof. Pettis I have a question related to the conversion of USD CNY as a disguised protectionist barrier. You said that:
_____________________________________________________________
He told me exports were down 2.2% – terrible news given that economists were confidently predicting a 15% increase as recently as a week ago, but no longer unexpected. By the way Tom Holland in the South China Morning Post claims that in RMB terms, the more relevant measure if you want to judge the pain, exports were actually down 10.1%.
Shang Ning also told me on his phone call that imports were down 17.9%.
______________________________________________________________
It would be very interesting to know what was the decrease in imports in RMB terms.
Mike – reading that title, I think you’re channeling Krugman a little TOO MUCH…
Six months ago everyone was talking about inflation and the threat of skyrocketing commodities prices. I wouldn’t be surprised if nine months from now it turns out that we have done too much stimulus and the Chinese economy is overheating.
This also goes for analysts forecasts. I find it somewhat amusing that people revise their forecasts after the earthquake has hit rendering them rather useless for anything other than as a measure of consumer sentiment. The amount of GDP growth that both the US and China have next year will be highly dependent on policy decisions, and if you don’t know if GM will still be in business next March, it’s sort of absurd to think that you can predict GDP growth in December. The danger comes in if you have an asset whose value is dependent on expectations of future growth, in which case that asset is likely to be highly volatile.
I don’t see any particular reason to think that the US trade deficit will go down by 50% next year with the dollar strengthening as much as it has.
I still think the problem of unbalanced trade has to do with an issue, that you mentioned a while back: demographics.
As of 2009 a large part the Chinese work force consists of workers in the age group 35-50, which in China equals to the high end of the saving profile, the age-saving profile curve starts falling around 55-60.
This means that no matter what the central goverment does there will be no real change in the saving and thus spending profile within the next 5 years, but then it starts changing.
Given the one-child policy we should see a lower savings rate, because of a lower fertility rate and thus in theory a lower return to capital.
This means that the imbalance, that has been build up during the last 6 or 7 years could be corrected slowly over the next 20 years. Its a long time to wait, but I don´t see any change, the Chinese demographics just isn’t gear to big time consumption yet
what role do capital goods have in the drop-off in non-commodity imports? without knowing the numbers, it seems to me that you could reconcile the export figures with surprisingly benign retail sales if it was explained by a collapse in investment (which after all does take up a very bloated share of chinese aggregate demand, and would be the first to collapse in the face of a global recession). not to say that retail sales won’t collapse as recession feeds through to the wider economy..
btw, re trade war dynamics, i would expect the first overtly protectionist moves to come from europe aimed at china, particularly if the recent dollar weakening (breaking the 1.30 resistance level) becomes a trend and rmb follows usd down. europe has its own ugly internal dynamic between france and germany, so collectively taking aim at china would be a handy way to restore unity. i agree with other posters that the usa would use european protectionism as cover for introducing their own protectionist policies, especially when you look at obama’s voting record on nafta, etc.
There are a lot of things China can buy, Fatbrick, like there are a lot of things that other countries with mercantilist trade policies can buy but don’t. It is not at all impossible for poor countries to consume imports, and many poor countries, some even poorer than China, import a lot of things and even run large deficits. In fact countries with as much income inequality as China – Brazil for example – often have a tendency to import too much.
The problem is that domestic currency policies make imports too expensive, financial policies place more emphasis on creating capacity than on creating consumption, and there is all sorts of hidden protectionism – for example SOEs are discouraged from buying foreign, and today China banned Belgian chocolates in retaliation for Belgium’s banning of melamine-tainted milk.. Some people will start talking about cultural impediments to consumption, but of course that is mostly nonsense. The same thing was said about Asian countries until the early 1990s, after when changes in domestic monetary and exchange policies suddenly resulted in such an explosion of imports that all the countries that suffered from the 1997 crisis were running huge trade deficits, after which everyone changed policies once again and suddenly imports collapsed.
All Roads, to try to respond, I don’t think the US and Europe can continue consuming when the financing of consumption has been cut by the banking crisis. The problem with growing Chinese consumption is not the lack of attics and basements (again, many poor countries have no problems running large trade deficits) but policies that constrain consumption. If you stach countries by amount of consumption, China, the world’s third largest economy, would come probably come in somewhere near Switzerland. In that case boosting Chinese consumption sufficiently to make up for US and European demand is probably as unrealistic as asking Switzerland to do it.
As for timing, I think the problem needs to be resolved very quickly, perhaps in the next six months, and I think the solution will require major economies to agree to boost demand fiscally to give China three or four years to bring overcapacity down. China cannot do it in one year without economic chaos.
JLD, the oil exporters will definitely absorb part of it, but remember that I am assuming that only the US contracts demand, which is unreasonable. I am sure there will be demand contraction elsewhere. For example, Spain’s deficit is much greater than that of the US in GDP terms, and I don’t know if you have been watching, but it is approaching crisis conditions. By the way China’s market share is already rising, but I think that is politically unpalatable for other developing countries and they will fight back.
Jing, I think Asia faces a real problem. I discuss why in a piece that will come out in Monday’s Financial Times.
Brain, I am not sure I agree with you. Trade deficits are not necessarily or always bad. The US ran trade deficits for most of the 19th Century but it would be hard to argue that they underperformed their trading partners. It depenes on many things. By the way I think the US trade deficit until very recently was quite sustainable in the long run because it was easily fimnanced and would reverse once the demographic crisis kicks in in Europe, Japan and China. What was not sustainable in my opinion was the composition of the deficit and the way it was financed with a collapse in household savings.
Francois, thanks for the blog link. Very interesting stuff. I grew up there and my mother and one brother still live there, so I follow it closely. Not good at all.
CLN, I am hoping some smarter friends will do the work and let me know. I will write about anything interesting I find.
Anders, the demographics and their implications for trade are fascinating. A lot of very interesting work will be done there, although the changes are pretty unprecedented so we can only guess at the consequences.
Bena, I think capital goods imports may be part of the answer to the discrepancy between the retail consumer proxy 9albeit not a very good one) and the import numbers.
Dr. Pettis:
Thanks for your comments. Tough issues. But I do think you may be over-estimating the ability of trade imbalances to correct themselves.
Under the classic gold system, the UK initially ran large surpluses, until it was eclipsed eventually by the US and Germany, due to their increasing competitiveness. Over the period, things roughly balanced out because of this “convection” in competitiveness (plus ever-changing terms of trade), making the gold standard appear to work over the period. But many other countries ran consistent deficits during the period and were happy to opt out when they got a chance.
Another example: persistent US trade deficits led to the collapse of BW1.
Only in the case of a superior developmental trajectory can you argue with confidence that trade deficits will self-correct. In other cases, you are left to chance. At best, the system does not self-correct but rather continues to evolve. More pessimistically, the winners remain winners and the losers remain losers.
You can see the same effect within currency zones if you look. Even with labor migration and pork barrel spending, West Virginia and Iowa have a tough time competing with New York and Florida. Things change over time, but the system certainly does not mean-revert.
The beauty of flexible exchange rates is that you can put all countries on a level playing field in the global trade arena. If forex rates are allowed to approach “trade balance parity” (equivalently, if investment flows are neutralized (or minimized)) then international trade will not result in the gradual drainage of wealth from some countries to others.
I disagree with those who try to make a demographics argument out of this. There is nothing about demographics which suggests that a country should run an external surplus or deficit. Households can accumulate wealth for retirement via accumulating government debts and corporate equities just as well as via foreign assets. Of course countries have to realize that for every creditor there must also be a debtor somewhere in the economy. Perhaps the best way to accomodate demographics is to steer government debt levels higher as retirement savings demand grows.
A better case could be made for investment flows to developing markets without adequate internal capital markets. Certainly large projects will require foreign investment. This would be one grounds for a negotiated exception from the principle of balanced trade. But obviously it behooves countries to develop internal financial systems to finance smaller investments.
One convincing argument for allowing external surpluses would be trade surpluses as a form of developmental assistance. Certainly Africa and other impoverished countries should be allowed to run trade surpluses.
You are correct that small and temporary trade imbalances don’t matter much, but we’re quite a bit beyond that point now. Like it or not, there is an aggressive competition for surpluses under way.
Either the US can join the fray, or the US can push for a balanced trade framework to stop these beggar-thy-neighbor strategies. I think the latter is the better alternative.
But clearly the US should do one or the other. The days of laissez faire forex policy are over, at least until this current round of neo-mercantilism is contained.
Let’s hope it ends well.
Michael: Some people will start talking about cultural impediments to consumption, but of course that is mostly nonsense.
I don’t think they are, but what people get wrong is that cultural impediments to consumption are highly generational and can be explained by a “rational expectations” model. Germany is more of an inflation hawk than England is because of the hyperinflation of the 1920′s.
Michael: The same thing was said about Asian countries until the early 1990s, after when changes in domestic monetary and exchange policies suddenly resulted in such an explosion of imports.
But a person arguing for a cultural explanation would argue that 1) this also corresponded to a generational shift and 2) monetary and exchange policies would be influenced by culture.
Michael: All Roads, to try to respond, I don’t think the US and Europe can continue consuming when the financing of consumption has been cut by the banking crisis.
But if consumption in the US and Europe is constrained by financial factors, won’t these financial factors also constrain China? One thing I don’t get is that I hear a lot of people talk about China encouraging consumption as if there were this big button in Hu Jintao can press saying “CONSUME”. I haven’t heard very much about actual policies intended to encourage consumption.
Also encouraging consumption seems to assume that the Chinese banking system is sound. If the Chinese banking system is really a mess (and I don’t think it is) then China can’t safely increase consumption without first cleaning out that problem, because in that situation increasing consumption will cause latent problems to appear causing an even bigger mess.
Michael: As for timing, I think the problem needs to be resolved very quickly, perhaps in the next six months, and I think the solution will require major economies to agree to boost demand fiscally to give China three or four years to bring overcapacity down.
If there is overcapacity, then the thing to do is to boost demand by any means possible. If the US won’t buy Chinese goods, then if you can’t think of anything better to do, the Chinese government can buy these goods and then dump them into the ocean (which is what I think is going to end up more or less happening with cars built by GM.)
Maybe China does have more steel mills than it needs, but are you arguing that the solution to too much steel is to dynamite the steel plants, rather than write off the cost of building the plant, and think of things to do with cheap steel? When an industrial firm undergoes bankruptcy, the point is not to reduce industrial capacity but rather to restructure the finances to preserve as much wealth as possible.
Thanks for the excellent blog, Professor Pettis.
By the way, do you guys realize that twofish is GOD? When everybody else speaks their opinions, he speaks the TRUTH.
Mr. Pettis,
I find your blog informative and insightful. Thanks for sharing your thoughts.
There are a couple of areas that I perceive to be inconsistencies:
1). The notion that the US will dramatically decrease foreign trade doesn’t quite fit with the actions of US monetary and fiscal authorities. The US has a huge fiscal stimulus looming on the horizon and the Fed is very close to monetizing consumer credit by directly purchasing securitized consumer loans. If we are to judge the likelihood of protectionism based on the bureaucrats’ perceived political imperatives at the moment, it seems to me that protectionism is as likely to appear (or in this case unlikely) as politicians allowing a plunge in consumer spending to continue.
2). The extent to which US fiscal authorities are able to implement any spending programs in the next few years is directly dependent on the availability of foreign credit. Without foreign trade, how do you see the US gov’t funding domestic services such as health care?
Imports are down due to China’s active protectionist policies using non-tariff barriers. Ask a foreign importer how customs officials and regulatory agencies are making their businesses die. Of course, it doesn’t help that Chinese companies are not paying for their orders either. Importers are giving up.
Observer, in response to your first point, Brad Setser says international trade is already declining. At any rate as Dani Rodrik pointed out the US fiscal stimulus is actually undermined by the trade deficit because demand created domestically leaks out via the deficit (I think about it as the trade deficit’s effectively increasing the savings rate implicit in the investment multiplier), so if the fiscal expansion does not lead to rapidly rising employment, I expect that the focus will shift to trade. As for your second point, I addressed that several times, most recently in my November 23 entry – I think the idea that the US government needs foreign financing to fund the fiscal deficit is completely untrue, and based on a misunderstanding of the balance of payments adjustment.
Mr. Pettis, thanks for responding to my post.
I’m still confused about a couple of issues. First is the issue of short-term employment numbers in the States. With the vast majority of Americans employed by in service industries of which consumer retail is a big part, is it materially relevant to discriminate whether these distributors are selling foreign or domestic goods? In other words, even if we are to have a complete leakage of the fiscal stimulus going towards the purchase of foreign goods, wouldn’t that still help jobs numbers, especially in retail and banking?
Regarding the point about the US being able to finance its own spending, would Americans save that much seeing how the US monetary authorities are drawing massively on global savings to finance American credit? We are seeing indications of lower mortgages already with the purchase of agency-issued MBS and there are also signs that the government may invest in consumer credit loans as well.
More importantly from the standpoint of domestic politics and public policy, will it be sustainable or desirable to rely on domestic credit to fund $50 trillion worth of unfunded government liabilities over the next 75 years? Even if it is fully possible to fund that amount, which is mostly composed of entitlement spending on Medicare, would it advisable to take such a course given the ramifications of the ‘crowding-out’ effect?
Excellcent post. As a first tip off I’d like to point out 3 fascinating numbers:
China aluminium cash cost: $2500-$2800 USD
LME Spot: $1500ish
World 1st quartile cash cost cutoff: $1600
Now, check how much capacity China has cut off. Hint: its a lot less than 100%. They are also still producing their own bauxite from crappy deposits and smelting with high cost power. I doubt Obama is going to let Alcoa and Rio’s Alcan go belly up because Chalco is unwilling/under pressure to not fire workers.
If Chinese consumption must increase and capacity decrease, presumably US demand must decrease and capacity increase? But US policy seems entirely focused on stimulating demand/consumption, a misapplication of the Keynesian recipe for a country w/ over-CAPACITY to one suffering from over-CONSUMPTION.
So what is the adjustment the US should make? Do I understand correctly that (ideally at least) the US should support a gradual decrease in demand/increase in consumption over 4-5 years while China undertakes the opposite? What are the consequences of the less-than-ideal US response we’re likely to get (besides a trade war)?
So China is not making increase demand/ decrease capacity adjustment the demand decrease in the US necessitates. But it seems the US is only making its adjustment involuntarily, since there (1) is no one left to lend money to who can pay it back and (2) at least for another month or so, there is no government to replace commercial lending to support consumption. Yet the Bush govt is doing that to some extent and it seems clear that once the Obama gov’t is in place it will do so in a big way: nearly $1 trio to support consumption in what seems like (as Michael has noted here) a misapplication of the Keynesian recipe for overCAPACITY to overCONSUMPTION.
Is the planned US stimulus strategy wrongheaded and, if so, what is the correct US policy response? Increase capacity? And what are the consequences of the planned US response? Does China simply keep over-producing and the US keep over-consuming with just a new source of financing (i.e., the US govt)? How does that end?