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 the 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.