Subscribe Feed (RSS)Exports versus domestic demand – the argument rages
May 8th, 2009 by Michael Pettis | Filed under Fiscal stimulus, Trade protection.
Today’s Financial Times and last week’s Economic Observer had articles that display the kinds of confusion that economic crises can create among policymakers. The Financial Times article was actually an opinion piece written by Wang Qishan – a Vice premier in the State Council and presumably one of the top three or four economic policy decision-makers in China.
It starts out, correctly I think, by warning that the global crisis is far from over. “The global financial crisis is still spreading,” Wang warns, “The world economy is going to get worse before it gets better, and the situation remains serious.” Much of the article discusses the same grab-bag of regulatory reform proposals whose purported aim is “to prevent a repetition of this financial crisis,” which include financial regulations to “strengthen, on the basis of sovereign rules, co-operation in regulating international private capital flows, financial institutions and markets, financial products and intermediaries.”
I have already written why I think financial reform aimed at preventing financial crises (as opposed to improving the capital allocation process during “normal” times) is largely a waste of time, and to that end I will remind my readers that Hyman Minsky, whose understanding of financial instability surpasses everyone else’s, argued that: “Stability, in a world with an uncertain future, and complex financial instruments, is destabilizing.” In “A Minsky Meltdown: Lessons for Central Bankers”, a speech delivered on May 1, Janet Yellen, president of the San Francisco Federal Reserve Bank, explains:
As Minsky’s financial instability hypothesis suggests, when optimism is high and ample funds are available for investment, investors tend to migrate from the safe hedge end of the Minsky spectrum to the risky speculative and Ponzi end. Indeed, in the current episode, investors tried to raise returns by increasing leverage and sacrificing liquidity through short-term – sometimes overnight – debt financing.
Avoiding financial crisis, in other words, is a total pipe dream because to the extent that we are successful and enforce conditions of stability we actually increase the probability of future instability.
But that is an aside. Wang goes on in his article to propose action:
It is imperative for countries to co-ordinate macroeconomic policies and for all to adopt stimulus, fiscal and monetary policies. It is vital unequivocally to reject protectionism of all kinds.
Anti-protection sentiments are, of course, all fine and good, but it doesn’t make sense to define protection too narrowly. In contrast to Wang’s sentiments, last week’s Economic Observer had a very different take on protection.
China should give preference to locally-produced goods in government procurement, the Ministry of Finance said at an April 22 meeting focused on the issue. Assistant minister Zhang Tong said at the meeting that most of the public welfare projects benefiting from the government’s four-trillion-yuan stimulus package announced late in 2008 were closely related to government procurement.
Chinese law stipulates that government procurement favor local goods. But the EO has learned that many officials were not satisfied with the amount of local goods that the government had purchased since stimulus funds kicked in last November. Against this backdrop, China’s State Council ordered on April 10 that government at all levels give preference to domestic goods, and new regulations tightening government procurement have been slated for legislation in 2009.
It is hard for anyone, especially the country that does most to export overcapacity, to preach free trade while putting into place such blatantly obvious restrictions on trade. Of course some might argue that this is no different than the “Buy American” provisions discussed last year by the US congress, but I think in fact it is very different, for at least three reasons.
First, the “Buy America” provisions were never enforced and, what’s more, they are in many cases against US law. Of course they may also be against the law in some cases in China, but there is a robust legal mechanism in the US that can be used to prevent the US government from enforcing rules that violate US laws or US trade agreements. Importers, American as well as foreign, can sue the US government with every expectation of winning in court, in a way that no one, especially no foreigner, would even attempt doing in China.
Second, US government procurement is a tiny fraction of total US purchases, even taking into consideration the US fiscal stimulus. In China, almost the entire stimulus package is going to expand investment in SOEs and/or government projects, so the share of government procurement in total GDP is much, much higher in China. That makes it a far more trade-constraining measure in China than it could ever be elsewhere.
Finally, and probably most importantly, China is the country that most desperately needs foreign demand to absorb its excess capacity. In a world of contracting demand, China is the country that is most likely to suffer from protection, for the same reason that it is the country that benefits most from absorbing other country’s badly-needed demand. In that case it is not enough to say that China is just doing what everyone else is doing (and never mind that it is much harder for foreigners to invest in China or sell to China than it is for China to do either abroad), since any dispute that resolves itself in greater trade protection hurts China worse than it hurts the other disputant.
Meanwhile the Economic Observer had also last week a very interesting (and a little troubling) editorial on just this subject. The title says a lot: “A shift is needed, but not overnight”. The article starts:
Chen Deming, head of China’s Ministry of Commerce, recently wrote in the Communist party magazine Qiushi that earnings from Chinese exports could trickle down to compensation, and ultimately end up stimulating domestic consumption. He came down against certain popular opinions in China, including that the country relied too heavily on exports, and stressed that although a withering global market has sapped demand for Chinese goods, it has also presented great opportunities. Chinese enterprises needed to push abroad under such circumstances and promote Chinese exports, he concluded.
Chen’s arguments come at a sensitive time for China’s exports. As the Canton export fair opened this past week, the export industry was not optimistic – official data just released showed another slide in China’s export value in March.
The article goes on to discuss China’s transition from export orientation to domestic market orientation. Although many foreign and Chinese commentators, including me, would argue that almost nothing was done to accommodate this transition – indeed that China in the past decade actually deepened its over-reliance on the export sector – the editorial gives the government good marks in managing the process:
In the past few years, the government has long sought to transform the economy from a export-oriented model to a consumption-oriented one, while the Ministry of Commerce strove to reduce the trade surplus. But the economy’s restructuring could not be completed within one day, and a consumption-oriented economy never meant wholly abandoning foreign trade. Eagerness for an overnight success could only lead to adverse consequences. In this sense Chen’s article reflected a realistic attitude.
We believe this was a positive sign that the Chinese government has a deep understanding of the necessity of economic transformation, and that the consumption-oriented model would remain the core of future policy. At the same time, it also meant China understood it needed to be patient throughout the process.
The editorial concludes basically by saying that although China must continue (!) improving the relative importance of domestic markets, it must “stabilize” exports since “foreign demand must still serve as the engine of the Chinese economy for a period of time.”
I think in one sense Minister Chen is right – foreign demand is still the engine of Chinese growth – which is one of the reasons I am so pessimistic about medium-term growth, but of course I am a tad more skeptical than he is that in the past few years there were active policies (as opposed to formal announcements) aimed at reducing China’s over-reliance on exports. For example two of the most obvious steps – increasing the value of the currency and allowing interest rates to rise to a ‘natural” level – were never really seriously tried, remembering that any increase in the RMB against the dollar, and other currencies, must be set against an even faster relative increase in productivity. This was almost certainly because polices aimed at assisting the transition would necessarily have slowed export growth, and with it economic growth in the short term.
The fact that the editorial and the original article from which it was draw were both published, and seem to be arguing a case, gives some indication, I think, of the ferocity of the debate taking place about the nature of the stimulus package. One side says: Before we can fix the economy we need relief, and that is most likely to happen by reinforcing the existing economic structure. The other side says: The longer we take to postpone the adjustment, the worse.
For the other side of the debate, Hu Shuli in last week’s Caijing insists that “Beneath the surface of China’s ‘warming’ economy are structural impediments to long-term growth that demand attention – now.” She dismisses the recent optimism about China’s “bounce” back with “The ‘warnming’ is more show than substance.” and she goes on to say:
Since we know that credit expansion is not the best economic healer, we should spend the coming days thinking about long-term approaches that will help China survive the crisis and pursue lasting development.
China is being forced to rebalance. It’s clear that, regardless of the angle from which we examine the situation, our economy is being squeezed by internal and external crises. Excessive consumption in the United States is a root cause of the global financial crisis. Instead of complaining about this fact, or even quietly congratulating ourselves, China must consider what to do if the United States learns its lesson and, for example, gradually raises its household savings rate. If external demand for Chinese goods is declining, how can internal demand rise?
At this juncture, structural adjustment should not be empty talk. It must involve a series of basic policies that deepen the nation’s economic reform. Structural adjustments can only follow the market’s lead and, for the most part, involve breaking up monopolies, opening the market wider, relaxing controls, and getting the pricing mechanisms right.
Instead of betting even more heavily on foreign demand to bail China out, in other words, China must urgently move towards policies that force the transition, even if those policies are painful in the short term.
And it is not just Caijing that is voicing criticism about the current stimulus policies. A number of very prominent Chinese economists have been scathing (at least in private, so I cannot reveal their names) about the failure to have taken the appropriate steps when conditions were optimal, and are now insisting that to continue increasing reliance on foreign demand is going to create huge problems for China. Increasingly I am hearing people here say that, although few expect a “collapse”, whatever that means, China is facing its own “lost decade” of sub-par economic growth and a very difficult transition. As regular readers know, I am very inclined to agree.
Next week (Wednesday, I think) I will have a piece in the Wall Street Journal arguing that the surge in lending actually makes China’s transition more difficult in the medium term because it will act to constrain future consumption in China. I think Hu Shuli might agree.
Tags: Chen Deming, Wang Qishan
Regarding the “buy America” provision, even the federal government did not put the wording in the law, many state governments/legislations as I know have passed similar “resolution” to prefer “buy American” when they planned to spend the stimulus money. As for Chinese stimulus, did you read the article in WSJ about how Chinese stimulus benefits American exporters?
I agree with the general thrust of this article, but one thing that needs to be pointed out is that as far as the preference given to Chinese domestic producers is concerned, it may be viewed as a protectionism move, however, in reality, it is indeed WTO consistent as China has not yet signed the government procurement treaty under the WTO. One key reason why the Buy-America provisions did not really become effective was precisely because it is against the obligations of the US under the WTO.
Fatbrick, no I haven’t read the article, perhaps you could provide the link. I would caution that the claim that some sectors have benefited is not a counter to claims about the overall macro impact.
DMA, one of the things that worries me is that many countries are defining protection as practiced by other countries fairly broadly, while defining protection as practiced by themselves very narrowly and only in terms of whether or not it violates WTO commitments. Although this may satisfy the lawyers, I am not sure it is the most effective way to combat rising protectionist sentiment. In the end policymakers are not going to read the WTO agreements. they are going to watch domestic unemployment and the trade account.
http://online.wsj.com/article/SB124104805235170859.html?mod=crnews
This is about stimulus money. The following is about the local protectionism in US.
http://www.usw.org/media_center/news_articles?id=0238
As far as I can see, there is no basic difference in various governments’ approaches. Thus, as this point, I am more interested in experts’ views on the sharp yield curve in US t-bonds. How long can it sustain?
Here is an example of benign protectionism–by not enforcing IP rights, China is favoring domestic manufacturers of knockoffs.
‘So far, however, China has done little to stop the proliferation of fake mobile phones, which are even advertised on late-night television infomercials with pitches like “one-fifth the price, but the same function and look,” or patriotic appeals like “Buy shanzhai to show your love of our country.” ‘
http://www.nytimes.com/2009/04/28/technology/28cell.html
Michael,
Are you familiar with Ralph Gomory’s take on trade?
“If trade is unbalanced, as it has been for many years, goods keep coming in, but we don’t balance them by making goods and services for export. Instead we sell our trading partners Treasury Bonds, which are essentially promises to pay later, or less often, ownership of some piece of the U.S. economy. Neither case leads to the creation of jobs in the United States. The first case adds to our already huge foreign debt, the second means that we are gradually turning over pieces of the country to our trading partners.
In free trade theory this unbalanced situation is supposed to be self-correcting. If a greater value of goods flow into the United States than flow out, currency exchange rates should automatically adjust to make imported goods more expensive and automatically rebalance trade. But suppose China, for example, engaged in building its economy by producing for export, subsidizes its industries so they become cheap exporters, and follows this up by preventing the rebalancing of its currencies.
The imbalance then continues. Companies in the United States are unable to compete at these artificial exchange rates and are destroyed, imports remain permanently larger than exports, and the jobs that would have made the goods to balance trade never materialize. This outcome is inconsistent with both the Ketchum goals. Balanced trade is therefore necessary if we are to retain productive jobs at home.”
http://mitpress.mit.edu/catalog/item/default.asp?ttype=2&tid=3682
http://www.horizonproject.us/images/FE/chain206siteType8/site175/horizon_final_0123.pdf
Professor Pettis: You are an articulate advocate of rebalancing the Chinese economy by reducing investment and increasing consumption. I have problems fully understanding this case and quote Wing Thye Woo’s critique. He calls this idea “an oxymoron — go slow growth and technology policy”. To quote him (see the Brookings Inst. website):
“It is now common to hear calls for China to rebalance its growth path by reducing investment and increasing consumption. This notion of consumption-led growth is an oxymoron because growth requires expansion of production and this cannot be achieved by lowering investment. The correct rebalancing is to increase consumption at the expense of the trade surplus and not at the expense of domestic capital accumulation. A government-induced increase in consumption that lowers investment will maintain full usage of the existing output capacity but it will diminish the expansion of output capacity, causing a lower GDP growth rate and, hence, a slower absorption of China’s surplus labor. Furthermore, China still has a long way to go before its technological level reaches that of the G-7; and technological upgrading requires investing in more modern capital equipment. So a policy that increases consumption and decreases investment is not only a slow-growth policy, it is also a slow technological upgrading policy.
Consumption could be increased without lowering investment by, one, the state providing an integrated health insurance system, a comprehensive pension system, and an extensive scholarship program; and, two, the financial system providing more sophisticated financial products like education and housing loans, and various types of insurance schemes, and stopping its discrimination against private investors. The establishment of a modern financial system requires the appearance and growth of competitive domestic private banks. As China is required by its WTO accession agreement to allow foreign banks to compete against its SOBs on an equal basis by 2007, it would be akin to self-loathing not to allow the formation of truly private banks of domestic origin.
Professor Woo is also critical of blaming China’s big purchases of US bonds as one of the major “causes” of the US housing bubble and subsequent financial crisis.
Paraphrasing him “this is akin to Pogo’s remark “I HAVE Met the ENEMY — and he is WITHIN”.
He and others argue that a big revaluation of the RMB would not necessarily change the US current account deficit, but only its distribution — drawing on Japan’s experience.
What is clearly needed is a global appoach to resolving global imbalances — China has a big role to play — but so does POGO.
Yours faithfully, James
chan-lee james:
“Consumption could be increased without lowering investment by, one, the state providing an integrated health insurance system, a comprehensive pension system, and an extensive scholarship program; and, two, the financial system providing more sophisticated financial products like education and housing loans, and various types of insurance schemes [...]”
The issue here is, as pointed out convincingly by Andy Xie / ??? in a Chinese interview in W4 Apr 09 accesible on caijing.com, that there is no trust in any sort of government-initiated and -managed health insurance or pension system. The risk of misuse and embezzlement of the therein accumulated funds is too large. The current pension system is not regarded as a pillar of safety which people really rely on for their post-retirement life, but rather as an add-on to the savings they have in their bank accounts.
The only financial “instrument” the majority of Chinese people really trust are plain bank accounts – the less complex, the better. For that matter, don’t forget that a couple of years ago the lawmakers pushed through the separation of banks and securities companies exactly because of an embezzlement scandal related to funds under custody of non-bank institutions, i.e. of the securities companies.
As an aside, I remember having read in this forum a few months ago (in an article on the bets of Chinese companies that the EUR yield curve would not invert) that one obstacle to establishing a modern, Western-style financial market is the reluctance of some Chinese counterparties in derivatives transactions to honour agreements. I don’t know the final outcome, though. But anyway, this implies that even amongst actors in the corporate world, the current legal environment is full of uncertainties – and uncertainties are always hindrances when big economic changes are to be implemented with the active participation of non-governmental entities.
To sum it up, any attempts in China to spur consumption by moving closer towards a Western-style social safety net requires first and foremost a much more stable legal framework. For this matter, I think it is not too much of a surprise that virtually only countries with a relatively stable legal system do have relatively stable social safety nets that their people (can) rely count on.
Imminent Global Stock Markets Collapse:
http://www.marketoracle.co.uk/Article10554.html
[...] the Export-lead Economy By justrecently Michael Pettis quotes Chen Deming (minister of commerce), who wants Chinese enterprised to push abroad (…) and [...]
Not sure if promoting domestic consumption is a panacea either. The very concept of increasing spending is in itself a cultural antithesis. Without the blessing of owning a global reserve currency to depreciate its way out of debts, I wonder how the common Chinese consumers will step up to spend their savings. Domestic consumption replacing exports as engine of growth is also an antithesis to the one-child policy. If China has the wherewithal to spend aggressively (and not worry about tomorrow), there would have no need for population control. Think about it: wouldnt it be better to abolish population control, which will surely spur consumption? Whatever the route, wanting Chinese to spend more than save is a behavioral change that cannot be switched back and forth like a light switch. Therefore the path of least resistance is to do more of the same. No change will come until it is forced.
chan-lee james ,
“two, the financial system providing more sophisticated financial products like education and housing loans, and various types of insurance schemes …”
Seriously, you really know little about China financial markets. Wing Thye Woo’s critique seems to be off the base on some facts here.
Dragonbay ,
I am not sure that the modern, Western-style financial market right now can claim any credit yet.
Dragonbay: I agree with the main thrust of Andy Xie’s and your arguments.
But it is a question of degree. One should recall that China had a totally dysfunctional legal and administrative system in 1978, with almost no trained judges and a handfull of lawyers. Things have changed dramatically over the past 30 years, although clearly much remains to be done.
There are also advantages for late comers in terms of building better legal systems (e.g. HK and Singapore). It took England over 100 years to develop Limited Liability Companies, but the French and Germans copied it in 8 years (SARLs and GMBs). Similarly, the US legal system was hardly a paragon of virtue a 150 years ago with the
Robber Barons (Carnegie, Mellon etc.). It takes time to build trust in institutions and even handed enforcement. But even here China is making progress. (See, Clarke D.C., Murell P. and Whiting S.H., “The role of law in China’s Economic Development”, George Washington University, Public Law Research Paper, 2006 No. 187.)
As regards China’s lousy provision of financial intermediation between savers and investors; we all know that. Hence, the big role of the government in allocating capital. Even so, there has been a big expansion of capital markets and the role of individual and institutional investors over the past 7-8 years.
But there is an even bigger failure to address that few mention: INTER-TEMPOREL or inter generational intermediation. This is why most of Asia (including Japan) uses the US (and UK) financial system as a surrogate to perform this type of intermediation (cf. big build up of FX reserves combined with FDI inflows). This is critical to the $ key currency status.
Finally, I agree that a stable legal system is necessary for stable social safety nets — but it is not sufficient. It also requires the “ability to pay” — which ultimately depends on technology and demographics.
Given the US and especially Europe’s extensive social safety nets and huge unfunded future pension liabilities…it is an open question whether the US capital markets and $ can continue to play its current role of intertemporel intermediation.
If so, why should China adopt policies to raise consumption and lower investment?
These uncertainties underscore the difficulties of finding working definitions of “global balance”. Yours faithfully, JamesC
Dr Frank,
About the global stock market collapse, I imagine it will begin with the emerging markets first. During the last round of deleveraging, one thing in common has happened across the whole developed economies: aggressive cutting of rates to near zero. Now we have the major CBs — FED, ECB, BoJ, BoC, BoE, SNB, and Riksbank — exercising extra-low levels of interest rates. That is one huge source of carry trades.
Near-zero rates were used to be Japan’s own. Not anymore now. It created the popular Japanese carry-trade. Certainly, during risk-seeking cycles, the carry trades will be not-so-Japanese-anymore and will have fewer places to go.
Those few places are emerging markets, which still generally exercises relatively high interest rates. Although I have no data to support this idea, it certainly looks like the emerging markets stock market moonshots are related to these.
I have a relative in Indonesia. So, I’ll discuss a little about Indonesian stock market & Indonesian Rupiah (IDR), as I have a relative there. The stock market shot up almost 60% in just 5-6 weeks. IDR shot up against USD almost 20% since mid-March. Stock market trading values (in IDR) more than doubled its peak volume during the last bull market. Earlier in the year, it was reported its exports were down 40+% YoY. Industrial output plunges as well. Don’t all of these seem very suspect, especially in the face of global deflation/deleveraging?
Indonesia still exercises 7.25% CB interest rates and still worries about inflation. It does seem like a good home for the new-generation carry-trades.
Any opinions on this? Perhaps Prof. Pettis can also add to the discussion? Thanks in advance for sharing some ideas.
Kind regards,
Roger
On the consumption question, China’s experience over the last decade is perhaps the last nail in the coffin for trickle-down notions of income growth. In fact, looking at factor imbalances, especially now (excess labor), it is unlikely that the wage share of GDP will increase. Also, when people talk about private consumption, they are really talking about affluent urban consumers, who cannot shoulder the burden to propel private demand in China, much less the world. The key to China’s consumption conundrum is in the countryside, and does not include loans to farmers so that that they can buy white goods. Just two-years ago thinkers in China were talking about relative prices (ag/non-ag) and a readjustment here would imply a large income transfer to the countryside where consumers would spend because they have to, not for over-priced clothing at redundant urban shopping malls. China wants to be a high-end manufacturer, but on the flip side it needs to encourage massive low-end consumption. High-end manufacturing is externally oriented, by the way, and a dead end for the next 6-8 years. This takes us back to the rural income question, relative prices, etc. The problem is not how to get urban middle class households to spend more, it is how to provide meaningful income gains to the 700-800 million rural people who have a high propensity to spend. Sure there needs to be a foundation for social services. But if you compare the pace of urbanization in China to Japan or Korea after 20-30 years of reform, China is way behind, and as long as this is the case, rural people will remain poor(er) and more dispersed than is necessary to harness their spending power.
@chan-lee james
I don’t quite understand your statement that France and Germany “copied” the English LLC concept “in 8 years”.
Usually, the present-day LLC is considered to be a German invention (the so-called GmbH being introduced in 1892), loosely based on English precedents.
The limited liability act of 1855 introduces limited liability into British law, and this is usually seen as the first time the concept of limited liability was put down in law.
In that sense, the UK invented limited liability in 1855, Germany took 37 years to create the GmbH based on the British invention, and France in turn modelled its law on the German GmbH another 33 years later (i.e. 70 years after Britain first put the concept into law).
http://www.llc-reporter.com/16.htm
@chan-lee james
I’m a bit confused about this point:
In what way does China’s financial system not provide “intertemporal/intergenerational intermediation”, whereas the West’s financial system does?
Prof Pettis, Bellum has posted a reply to latest post here:
http://bellum.stanfordreview.org/?p=1319
Humbly submitted.
Thomas:
How long it took the French and Germans to copy the UK model of Limited Liability Companies is taken from Rajans and Zingales’ critique of the Legal Origins reasoning proposed in “Law and Economics”; by La Porta, Silanes, Vishny and Schleifer. You can check out R&Z’s views on their GSB Chicago website.
The 8 year figure is illustrative and by memory from one of Luigi Zingales’ seminar; I think that it does not refer to the dates of legislation per se, but rather to how long it took to establish workable legal frameworks. The same phenomenon can be seen with recent changes and improvements in insolvency proceedings in Asia and of course the long lag between formal TVEs legislation (1996)and the start of their operations (1975-76) that built on Mao’s Work Brigades.
The point about intertemporel and intergenerational transfers is that you can’t carry them out in the absence of deep long-term bond (and private debt) markets. Asia doesn’t have them. Mundell made the point in Tokyo. JGB’s maximum maturities are 10 years, whereas US Treasuries are 30 years and of course the UK issues perpetuals. A few US companies issue 100 year bonds. In the absence of a vibrant long-term bond market, insurance companies cannot transform their on-going premium cash-flows into sufficiently long term assets to match their liabilities over the actuarial “life” of their clients.
This is one of the arguments in the debate over “why do Asians save so much”, and also has implications for the $ role as a key currency. At a practical level, a starting place is with creating good government bond markets. This is the rationale for the ADB’s efforts in this area supported by the Japanese and Chinese authorities — even though I fully admit to Dragonbay that I have no idea how Chinese financial markets work.
best regards JamesC
Roger J:Thanks for your input. Your reference to Indonesia is very interesting. I used to travel to Jakarta quite often in the past. Interesting place to visit. You mentioned the emerging markets. You maybe right here. I am still nervous about the Shanghai and Shenzhen as well the Hong Kong markets. Stock prices at these markets to a very large extent are not supported by fundamentals. They are being driven by hot money coming in. I don’t know if they have anything to do with carry trades. Maybe Prof.Pettis can tell us more.
This is interesting. I wonder this will help boost domestic consumption.
http://www.cnsnews.com/public/content/article.aspx?RsrcID=47976
I apologize for my slow and limited responses, but I am traveling in Brazil and have little time between meetings (and trying to combat jet lag) to respond. That said:
Chan-lee, it may be true that “growth requires an expansion of production” but it does not follow that an expansion of production must result in sustainable growth or else overinvestment crises could not possibly exist. To take a very obvious and non-trivial example, there was a time not so long ago that Chinese manufacturers were producing hundreds of thousands of black and white television sets, even though no one would buy them, largely because local officials refused to allow the manufacturers to close down facilities or banks to refuse to provide financing. As a result these piled up in warehouses until finally it became impossible to continue producing them. Their production had an immediate positive impact on GDP growth but the cost eventually had to be fully written down and represented a net loss to Chinese wealth
The point is not that China should stop investing. It is that China should stop misallocating capital in order to achieve short-term employment growth. Beyond my agreeing with his call for a “correct rebalancing” of China’s consumption (and I am pretty sure there isn’t an economist in the world who disagrees) I am not sure what he proposes. Finally I don’t want to criticize his views on China’s role in the creation of the liquidity bubble since I don’t know what it is, but at least superficially I think his explanation of what happened in Japan, as you characterize it, is very questionable.
Dragonbay, I agree with your point on the importance of a more stable (and robust) legal framework.
Kelaido, I know I am swimming against the tide, but I am skeptical of purely cultural arguments for high savings. I have been asked by Wilson Quarterly to do a piece on savings in China and I will explore these ideas more fully elsewhere.
Roger, thanks for you comments but unfortunately I don’t think I can contribute intelligently to your discussion of the Indonesian stock markets.
CNM, yes I think you are right. Income distribution is an important part for low consumption
@chan-lee james
I don’t quite see why you need long-term government bonds to do “intergenerational transfers”. I would even question that such bonds are helpful at all, as long as they guarantee nominal interest instead of real interest.
There is absolutely no reason why an interest-rate (nominal or real) needs to be guaranteed over several decades. Anybody who saves can and should take some amount of risk. Sure, insurance companies that guarantee nominal returns for several decades have a problem with their asset-liability matching. But nobody forces them to extend such guarantees in the first place.
In any case: For an entire economy, the concept of “intergenerational transfers” only makes sense in terms of real investments, not in terms of monetary investments (such as bonds or life insurance policies). If a society makes more long-term investments, it transfers wealth into the future. If people save a lot but nobody uses those savings to make investments, then there’s a lack of overall demand and the economy falls off a cliff.
Quote chan-lee james: “This is one of the arguments in the debate over “why do Asians save so much”, and also has implications for the $ role as a key currency.”
You are saying that Asian savings rates are high (among other things) because there are no bond-markets with 30-year or perpetual durations? And that Asians invest in the US because they specifically want to buy 30-year treasuries, and only the US provides enough of them?
Can’t say I’m convinced. Why would people choose to save more because they cannot lock in 30-year nominally fixed interest-rates?
Professor Pettis: thank you for your reply to Wing Thye Woo’s position.
It appears to boil down to “misallocation of capital”, hence the importance of TFP trends and rates of return on equity. Unfortunately the data are too murky to clarify the debate.
Your example about China’s production of obsolete black and white TVs is excellent — but isn’t it equally relevant to the US government’s bailout of GM, Chrysler, Fannie and Freddy and State governments’ constant pressure to save dud local companies and jobs? In short, is the US really becoming the United Soviet States of America?
Perhaps the bottom line is competition and society’s capacity to accept Schumpetarian death and to recycle damaged assets through sensible bankruptcy proceedings? (Hence why better capital markets are needed in China?)
Thomas: your remarks on high Asian savings rates are thought provoking. Mundell’s comments on the subject of 10 year JGBs vs. 30 year US Treasury’s were I believe made within the context of a “proxy” or signal for the quality and hence durability of Public TRUST in institutions. Nominal 30 year yields in this context are less pertinent to savings decisions, than the metaphysical question whether the “State” will still be around and able to pay its debts when we are both dead?
Given the wide range of views on long-run fiscal sustainability of the USA, EU, Japan, etc, I don’t claim to have the answers.. hopefully Prof. Pettis and others can provide enlightenment and insights.
best regards James
I really don’t think that there is very much of a “debate.” I don’t know of *any* Chinese political or economic leader that thinks that China shouldn’t move from export driven growth to internal growth or that China has much choice in the matter. I also have yet to meet anyone that doesn’t think that the Chinese economy needs structural changes. As far what people are argument about, much of it is about fine tuning the details, and I don’t see much of a division into two camps.
The main debates is a replay of the Keynes-Hayek debate.
MPettis: It is that China should stop misallocating capital in order to achieve short-term employment growth.
I simply do not understand how if the goal is to increase domestic demand and reduce precautionary savings, how increasing unemployment will make the problem better not worse. It seems to me that you want to get cash into the hands of consumers however possible, so that consumers start spending and developing domestic industries. If you create mass unemployment then you’ll never have the demand to create internal growth, and it’s also a false economy when it comes to government deficits because when your tax receipts plummet your debt is going to be worse off than before.
I just doesn’t make sense to increase unemployment. Even if people are being employed in things that are immediately non-productive, you maintain consumer spending which create productive industries. If you contract the economy, you’ll never have the mass consumer demand necessary to create productive industries and *that* is what causes lost decades.
This is the Keynes-Hayek debate all over again, and Keynes won that one. Keynes’s argument is that in an economic bust, you do anything to get people spending. He suggested paying people to bury money and dig it up again. So using Keynes’s theories, the most important thing is to spend money, what you spend the money on is less important.
Even there, it doesn’t look bad. Barry Naughton has written up a paper on the details of the stimulus package, and it seems to be to be spent on rather sensible things.
http://www.hoover.org/publications/clm/issues/44613157.html
Pettis: Kelaido, I know I am swimming against the tide, but I am skeptical of purely cultural arguments for high savings. I have been asked by Wilson Quarterly to do a piece on savings in China and I will explore these ideas more fully elsewhere.
I agree with you on this one. Cultural explanations for economic behavior are flawed and tautological. They don’t explain short term shifts in behavior such as the fact that Russians saved a lot in 1975, but not in 1995, or why Americans suddenly started saving in the last three months.
The drivers for savings tend to be institutional. People in Latin America don’t save because anyone that saved anything in 1950 would have been wiped out by 1980. If you want people to save, you need stable currencies and strong, trust-worthy institutions.
Pettis: First, the “Buy America” provisions were never enforced and, what’s more, they are in many cases against US law.
This is incorrect.
http://www.dlapiper.com/does-the-stimulus-packages-buy-american-provision-affect-you/
The ARRA was modified so that they wouldn’t modify existing US treaty obligations. Governmental actions are covered under a WTO Government Procurement Agreement which China is not a member of (Hong Kong is).
Roger J:Since we were talking about the stock markets I just came across something which is rather scary.
http://www.telegraph.co.uk/finance/breakingviewscom/5312628/Stock-market-optimists-need-to-read-a-history-of-the-Great-Depression.html
What is your comment?
Twofish: I really don’t think that there is very much of a “debate.” I don’t know of *any* Chinese political or economic leader that thinks that China shouldn’t move from export driven growth to internal growth or that China has much choice in the matter.
Me: Either you have (again) misread what everyone is saying or you have no idea of what is happening in China. There is definitely a debate, and a very tough one. And it seems pretty obvious to me that Pettis’s point is not that some people think China should make a transition and some people think China shouldn’t. Obviously no one would ever argue that China shouldn’t switch towards lesser dependence on exports – that has been the consensus for nearly ten years. The debate is whether the crisis should be an opportunity to force the change quickly or whether the transition should be postponed in order to limit the short-term impact of the crisis.
And when you say “It just doesn’t make sense to increase unemployment. Even if people are being employed in things that are immediately non-productive, you maintain consumer spending which create productive industries.” There I agree with you that the debate was won, but not in the way you think. Japan in the early 1990s showed just how misguided and risky policies aimed at misallocating capital in order to maintain employment can be.
Chan-lee, yes I think the bail-out of the car manufacturers in the US may be another fairly egregious case of capital misallocation. I suppose if we add up all the money, direct and indirect, that has been spent on subsidizing US car manufacturers we could have probably purchased the entire Japanese car industry, but I wouldn’t go too far in claiming a Soviet USA. The US has a long history of bailing out the car industry, and the most recent moves are very far from indicating a major slide into the command economy.
The recent greater interventions are a natural and easily predicted outcome of the current crisis, and they do not represent, I think, a sea change in the methods and ideology of the US government. I agree with you that this is about the appetite for the Schumpeterian process, which waxes and wanes with the cost, I suspect. Right now the cost is seen as high because so much is happening at once.
Twofish, I suspect you may be wedded to a version of Say’s Law, and what is more I think you are confusing, as many are apt to do, creating demand and creating net demand. Getting people to spend is certainly an important part of any solution, but only if it creates net demand. If the only way to keep people employed is by creating additional capacity greater than the ability of the newly-employed to absorb it, in a world of excess capacity there are likely to be one of two consequences. One, China is successful in forcing the exports of that overcapacity, in which case it pushes unemployment onto its trading partners and competitors – a policy which may work for a while but is likely to lead to trade frictions which will ultimately eliminate that option. Two, inventories rise until they can no longer rise, in which case for a variety of reasons the subsequent adverse employment impact is greater than the earlier positive impact.
In April for example there were indications that aluminum production in China rose by around 10%, even though the world is seeing a glut of aluminum production. This certainly helps employ aluminum workers, but it cannot magically resolve the unemployment problem except by pushing it abroad.
Michael,
What country has not subsidised it car industry? On top of that American car manufactures have watched as domestic markets were opened up to imports while foreign markets remained closed to them. Because of legacy cost, this tipping point snowballed into having a large cost on US auto manufacturers. That is not to excuse some of their sins, they certainly deserve criticism. Though, if they were allowed accesses to markets as freely as their own was offered up, they would be in a much better financial position today.
Dr. Frank,
Thanks for the article. I think the current crisis bears the same mark of some past great crises: 1874 Long Depression, 1929 Great Depression, & 1990 Japan bust. That mark is debt deflation. Debt deflation normally brings a profound change in the social mood, i.e. from extravagance to frugality/austerity. It took the WW2 & decades to fully resolve the 1929 Depression; Japan property values dropped for 18 consecutive years & its stock market in constant slumping. It always takes a long time to resolve debt deflation fully.
For more discussions on debt deflation, Steve Keen has put numerous excellent works:
http://www.debtdeflation.com/blogs/
What is more scary is that we have multiple bubbles bursting synchronously: consumer spending bubble, housing bubble, private debt bubble, even commodities bubble. It’s the greatest bubble in history. For commodities bubble, you may want to read Michael Masters’ article:
http://hsgac.senate.gov/public/_files/052008Masters.pdf
In the previous cases, there was only one or two bubbles bursting. In 1929 Depression, it was the stock market bubble. In Japan’s case it was asset prices & stock bubble. So, indeed the present situation is scary.
I’m not sure whether the impacts on the stock market will be as deep as the 1929 Depression (89% down from top to bottom), as the bubble in the stock market is not as big. The housing bubble wasn’t as big as Japan’s, either. But in terms of totals, our state is superior to anything before.
I’m kind of inclined to the Austrian views (although not married to it) that government interventions (bailouts, stimulus, etc.) will ultimately inhibit & prolong recovery. Just like Japan with its massive QE regimes. Also that savings levels must increase high enough to provide foundations for economic growth (the govts are discouraging this by those efforts!).
So, I think stocks will underperform for a long time. Dr. Lacy Hunt & Van Hoisington put off a nice discussion on this in their quarterly report:
http://www.hoisingtonmgt.com/pdf/HIM2009Q1NP.pdf
How bad will the stock market become? It’s as good as anybody’s guess. Some Elliot Wavers are putting targets of S&P500 below 140, DOW below 1000. In that scenario, we are actually still in primary wave 2 correction. Whether it is right or not, I don’t know. But does it make sense? Probably. The amount debt relative to GDP to be unwind is enormous, even more than that of 1929 Depression. So, naturally it will take a very long time (wave 1 is 17 months, using that count) to get to the stock market bottom.
Jack P: The debate is whether the crisis should be an opportunity to force the change quickly or whether the transition should be postponed in order to limit the short-term impact of the crisis.
I don’t think that is the debate, and if that is the debate, it is a very silly one since the degree to which China can rely on exports is something that totally out of China’s control. Everyone I’ve seen wants change. The question is “change to what?” A lot of discussions end up with you have one group that portrays themselves as “progressive reformers” and the other group as “evil regression people that want to turn the clock back to the past.” It usually doesn’t describe what people are actually arguing about. Everyone wants to move things forward, the trouble is that people disagree as to the direction.
Jack P: Japan in the early 1990s showed just how misguided and risky policies aimed at misallocating capital in order to maintain employment can be.
And I think people draw the wrong lessons from Japan. Japan (and for that matter the Soviet Union) “stagnated” at standards of living far, far beyond those of anything China is likely to see in the next three decades. Japanese stagnation existed largely because of lack of productivity growth because in an industrialized economy, the only way of generating growth is through productivity increases. If you have a non-industrialized economy, there are other, easier ways of generating economic growth, and the cost of “capital misallocation” are far smaller.
Japan’s experience may be relevant to China in 2030, but applying it to China in 2010 leads to totally incorrect policies, since Japanese stagnation is a much higher standard of living than Chinese growth. If someone comes up with an economic policy that leads to ten years of stagnation at Japanese standards of living, that a wonderful policy that we need to adopt, because it puts China at a higher standard of living than anything that anyone has proposed.
In any case, if it is choice between Japan-1990 and US-1930, I go with Japan-1990.
Pettis: I suspect you may be wedded to a version of Say’s Law.
I’m a Keynesian. Say believed that production naturally creates its own demand, and I certainly don’t believe that. Suppose you have aluminum workers that are producing too much aluminum. They should really stop producing aluminum. That’s fine. The trouble is that if you have them stop producing aluminum and then leave the factory with income, they stop consuming anything, at which point you have this
unemployment -> reduced demand -> unemployment -> reduced demand -> unemployment
spiral that led to the Great Depression, and it’s not a matter of hitting bottom and bouncing back, you don’t bounce back.
So here are the policy options in order of preference.
1) Your best situation is if you get them to stop producing aluminum and pay them to start producing something useful.
2) Your second best situation is to get them to stop producing aluminum and pay them to do nothing.
3) Your third best situation is to pay them and keep producing aluminum.
4) The worst thing you can do is to shut the factory down and put them out of work, because at that point you end up with a domino effect, that you are not going to get out of.
Pettis: Getting people to spend is certainly an important part of any solution, but only if it creates net demand.
How is putting people out of work going to create net demand? If you put the aluminum workers out of work, yes you stop producing aluminum, but you have this domino effect as the workers no longer purchase goods and services which puts more people out of work.
You can see this in the trade data. Chinese net exports has *increased* over the last few months, but growth is going down. Why? Because when you put a migrant worker out of work, you end up putting five other people out of work. Now that migrant worker is just no going back to the export factory. So have them build a school or hospital.
Pettis: If the only way to keep people employed is by creating additional capacity greater than the ability of the newly-employed to absorb it, in a world of excess capacity there are likely to be one of two consequences.
If that is the problem then employ people generating things that don’t produce new capacity. If we have too many steel mills then employ people to demolish them and replace them with parks and hospitals. Employ people to build lots of tanks and aircraft, and the put them in the middle of the desert and blow them up. That’s what got us out of the Great Depression.
Pettis: In April for example there were indications that aluminum production in China rose by around 10%, even though the world is seeing a glut of aluminum production. This certainly helps employ aluminum workers, but it cannot magically resolve the unemployment problem except by pushing it abroad.
If you can’t think of anything better to do, then take all of of that aluminum, put it in the middle of the south China sea and then sink that ship. That is what happened in World War II except that no one has to die.
That’s assuming that you can’t think of anything better to do, and I can think of a dozen things.
If you have lots of cheap aluminum, then give people coupons to buy refrigerators that use that cheap aluminum.
What I find very odd is that the problem of idle hands and overcapacity is not a new one. It existed throughout the 19th century, and some of the best economic minds of the late 19th and early 20th century thought deeply about what to do. Some of the answers they came up with were wrong (say hi to Karl Marx), but it seems very strange that after dealing with the problem of overproduction and unemployment for a century and a half we are having this debate as if this is a new and original problem, and I’d appreciate it if someone would explain what the big problem is with the solution that Keynes suggested 70 years ago.
Quote: The US has a long history of bailing out the car industry, and the most recent moves are very far from indicating a major slide into the command economy.
And the first moves toward a market economy that China took in 1977 were just minor corrections. Now that the US government has crossed the Rubicon, events are going to take on a life of their own.
What is different is that the default assumptions have changed. Two years ago, you could argue that private companies were better run than state-owned ones and people would generally agree. You now have to argue the point.
Quote: China wants to be a high-end manufacturer, but on the flip side it needs to encourage massive low-end consumption.
Which is why the immediate future of China requires massive creation of low-end service jobs. You build a refrigerator, and you create jobs for truck drivers, refrigerator salesman, refrigerator repairmen, interior decorators, restaurants for refrigerator workers, ice cream parlors, day care providers, etc. etc.
The interesting thing about the structure of Chinese employment is that the number of people employed in manufacturing hasn’t increased in the last twenty years, whereas the main change are fewer people in agriculture and a lot more people in services.
One big problem with the Chinese financial system is that it is biased toward large lenders, whereas the big engine of growth in the Chinese economy are small mom-and-pop enterprises. Part of my disagree with a lot of economists is that people have this misguided notion that if you cut credit to large enterprise, you end up with more credit to the SME’s that you want to support. Except that I’ve never seen a case when this has actually happened.
If you cut credit, then what happens is that if you contract credit, banks will preferentially lend to well known, high capital deep pocketed customers with quasi-official backing which pushes the economy away from the direction that it should go. What you want is to expand credit so that money goes through the infrastructure projects to the SME’s that really need the capital. How do you get the Bank of China to lend money to a dim-sum stand and beauty salon? You don’t. You have BOC lend money to the shipyard that is being built next to the dim-sum stand and beauty salon.
I’d argue that if you count the service jobs that you create around the shipyard, you end up with far, far more wealth creation than the loses that you create from the shipyard. Now once everyone is employed in dim-sum stands and beauty salons, money that you pour into shipyards becomes a dead loss. Which is why China is different from South Korea or Mexico, and why growth in Southeast Asia stalled in 1990, and why the economic policies I proposal will cause Chinese growth to eventually stall if they aren’t changed.
This model also explains why the Soviet model stopped working, they were just pumping money into shipyards, and not letting people start dim-sum stands and beauty salons next to the shipyard. Latin America failed when the owners of the food stands, weren’t able to reinvest their money to create new dim-sum stands.
I agree with most of the criticism of the Chinese and banking financial system, but I cannot understand how most of the policies that are being suggested by some of these critics don’t make the problems far worse.
One problem with these discussions is that any time an argument becomes A versus B, you end up missing something important. Are you in favor of a Japanese bailout or not, is a loaded question, because the assumption is that if you are against what Japan did in the early 1990’s, then you must be in favor of this other policy, which isn’t the case.
In the case of Japan, one problem is that you ended up with “living dead companies”. That the Japanese government did just enough to keep the companies barely alive, but no more. One could argue that the Japanese government should have let the companies collapse, or one could also argue that the Japanese government should have taken the opposite approach of flooding the companies with enough cash so that they had clean balance sheets, which is what China basically did with its SOE’s.
Also one assumption is that pain and pleasure are balanced and you have to have some pain to get something good. The universe doesn’t always work this way, and (as Mao demonstrated) sometimes you can endure a great deal of pain and get nothing. Given the experience with the Great Leap Forward, you are really going to have to argue the point, if you are arguing that a lot of pain right now is worth it, and I really do not see how widespread unemployment is going to help fix the structural problems in the Chinese economy, and someone needs to explain this to me.
A Bloomberg article that most agrees with many of the points made in this blog:
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_pesek&sid=a6_rXxtBSsnk
It hasn’t exactly been on the radar, but A-shares are back into bubble territory again. They’re trading for a PE just under 30 times and up 75% from the botton. In my experience A-shares are one of the best indicators of loose versus tight credit conditions, and right now they’re clearly loose. However, we already know April’s lending was significantly lower than the previous few months, and the PBOC has said that May will be around the same level. This seems like it should be bearish for A-shares.
Twofish, i don’t think the great leap forward achieved “nothing”. Obviously whilst the pain associated was severe and not worth the rewards, Steel production (one of the main focuses) did increase.
But that is just a pointless aside. I don’t mean to wade into a debate between you and M Pettis, but i think the aluminium example is quite useful here.
Chinalco, to use one Chinese company as an example, have been hard hit by the crisis. Aluminium and alloy products are used in construction, aircraft, etc etc.
When the crisis struck Chinalco were forced to cut production, but as an state-dominated company, were unable to lay off any of their “excess” workers. Demand plummeted, but the company had no choice but to continue (albeit scaled back) production. OF course, many workers have been left idle (whilst on salary). To offset the cost of keeping this “dead wood”, Chinalco have been forced to slash salaries across the entire company – and we can assume that the lowest paid workers were not earning a lot of excess income in the first place. I agree that being unemployed would be worse, but poorly paid workers who are now being paid even more poorly are limited in their potential to lessen the deflationary spiral you are concerned about.
Providing these workers with a decent unemployment benefit from the government – as opposed to keeping them on extremely low pay (effectively unemployment benefit from the company), producing products for which there is no demand – would arguably be better. For one it does not burden the company with future debt – debt which although possibly subsidised, will strain the company – particularly if the borrowing is being used to employ pointless workers.
In addition, continuing to produce whilst demand is so low may be sustainable for Chinalco (with its access to cheap credit – although the long run may be tough if the lending is not subsidised by local governments), but the surplus product is contributing to a delay in price recovery across the whole international market. (although the bauxite miners must be fairly happy of course!)
I don’t mean to guess Prof. Pettis’s thoughts, but i think his point is that (failing to blow up the aluminium in the desert as you say) there is a danger that China will suffer from increasing friction with its main partners / competitors as China’s policies are seen to be hindering recovery elsewhere. On the other hand, these partners are not always very quick to act, so in the short term this may be feasible.
Laying off these excess workers, and increasing State unemployment benefits too them / perhaps even retraining, some would argue, is preferable to keeping them on doing profitless work, forcing their employer to amass a large future debt burden (let’s not forget Chinalco does have shareholders other than the govt.), and all the while risking anti-China sentiment from abroad.
Having said all this, i can see your logic if the unemployment occurs without a boost in benefits from the government.
Twofish – you need to distinguish between output and income. I think we should be able to imagine a scenario where the economy grows (measured by output), unemployment increases, and the wage share of national income FALLS! It is very common to conflate expenditure and income accounting, but it is nonetheless wrong to do so, just as it would be to take accounting profits as if they were cash flow. In China the wage share of national income is small compared to other economies, that is why the stimulus package in China will produce a smaller bang than if something of equal proportion to GDP was tried elsewhere.
Also, we all forget that the Chinese economy is not in a recession, which makes Keynes less relevant. China has a Keynesian hangover, so more Keynes is probably not a good idea. Is it rationale to expect that suddenly the Chinese economy will distribute income more efficiently in the next 6 months than it has during the past 10 years under the same structure? Certainly not, so propping up industries (output) where the supporting flows of effective demand (income) are falling (in the west, and in China too as unemployment rises), does not seem to make much sense. Sure, in the short-term there is a least worst option, and given China’s circumstances there not a more attractive alternative. But stepping back and looking at the big picture, we have not yet felt the true effects of deleveraging, which implies that globally the world will not be able to consume at the same multiple of current income, and sooner or later the real economies in producer nations are going to contract, not just grow more slowly.
Roger J: Thank you for the info. I will take time this weekend to discuss them. It is indeed very scary with S&P below 140 and Dow below 1000. I incline to agree with those Elliot Wavers as I have been expecting S&P to be around 400 in a worst case scenario.
Obama has finally said, “we can’t expect to continue living by borrowing from China and other countries..” He is right. What will happen if one day China lost interest to buy anymore American debt. Interest rates will rocket sky high. This will not be in the interest of America and it will affect every American and the world at large.Then hyper inflation will come in like in Germany before the war.
My gut feeling is that something very nasty is going to happen in the world soon and only this will help reshuffle the cards and start all over again.
Its a fairly unremarkable observation now that over the last two decades there has been a very marked fall in Chinese domestic consumption as a proportion of GDP. And in particular a decline of wages as a proportion of GDP.
That is not the same thing as saying that the total of wages have fallen, they have been growing very fast, just that output and productivity have risen even faster.
So is this a problem for the Chinese economy?
Certainly not for as wages have fallen the profits have risen by the same amount but in the opposite direction. In other words the rise of profits is a function of the fall in wages.
Raise wages, increase domestic consumption at the expense of profits and China would head into crisis not the other way around. For capitalism is a system based on profits, which provide both the incentive and the means for capitalists to invest.
Says law – production creates its own demand – is based on a logical reality. Value has to come from somewhere and it comes from production. Says error was not that. Rather it was to assume that because value has been created it must be spent. Hence even if production creates its own demand, there can still be a crisis of demand as consumers, those with the money, may choose not to spend it.
Seems like a group of starving men are arguing over the relative nutritional merits of rice versus vegetables.
In other words, if both export demand and domestic demand pick up just a little bit, it would still be no bad thing.
On the export side; if demand for goods is the main concern here, I’ll point out that there is no shortage of demand out there. People still want goods. Try looking in Africa, India, South America, Eastern Europe, you will find a great number of people wanting Chinese made goods. The real problem is not lack of demand but lack of any capacity for these people to pay. Don’t think about the problem in terms of stimulating demand, think about the problem in terms of searching for payment mechanisms by which a wider base of customers can buy your product.
To Houhui: One thing that happens in these discussions is that people compare real systems to ideal systems. In the case of Chinalco, I personally think that in general government unemployment systems are better than those provided through companies, for various reasons.
The trouble, however, comes if you compare a real system with a abstract, ideal system that doesn’t exist. For example, there may be reasons specific to the aluminum industry why giving workers reduced payments may be better than firing them, and there are certainly general social reasons for doing so. Also when making these sorts of comparisons, people often assume “all other things being equal” when they never are. You run into the problem that it’s very unlikely that any real system will have the same funding and benefits as the what Chinalco has, and the fact that a new unemployment system will have “bugs” that have been worked out in the old system.
To give one obvious example of the sorts of problems you need to think about. Chinalco is likely very good at keeping track of its workers, whereas in any state employment scheme, you have problems with corruption.
So the fair comparison would be to compare what the SOE’s are doing with what exists now or what could be realistically created in the near future or what *could* have been created had different decisions been made, and it doesn’t look that bad.
To Houhui: Laying off these excess workers, and increasing State unemployment benefits too them / perhaps even retraining, some would argue, is preferable to keeping them on doing profitless work, forcing their employer to amass a large future debt burden (let’s not forget Chinalco does have shareholders other than the govt.)
The problem is that it takes several years to create an unemployment scheme, that in the case of aluminum it’s far from clear that they are structurally unemployed. Also if we were in the situation that Chinalco were hopelessly in debt and just couldn’t support workers, then we’d have a different situation. We don’t.
Personally, since I think that the banking system is too strongly biased toward SOE’s, I think that the requirement that SOE’s continue to employ workers in the bad times is a “fair tax” for getting government support and funding in the good times.
The other thing to point out is that this is a separate discussion from the export business closures. Light manufacturing factories are all being closed, and SOE’s aren’t either willing or able to hire migrant workers in large numbers.
Zhige: China has a Keynesian hangover, so more Keynes is probably not a good idea.
No. It’s a great idea. China’s problems may have been caused by pumping the economy in a credit boom, but right now we are in a credit bust. Pumping money into the system in 2006 may have been a very bad idea, but it is now 2009.
Zhige: Is it rationale to expect that suddenly the Chinese economy will distribute income more efficiently in the next 6 months than it has during the past 10 years under the same structure?
No.
1) the Chinese economy is reasonably good at distributing capital. There are a lot of biases that need to be corrected, but the system is functional.
2) the efficiency of capital allocation isn’t something that people should obssess about, since capital efficiency is not what drives the Chinese economy. Right now and for the next two decades, the Chinese economy is all about capital mobilization and not capital efficiency. If capital inefficiency decreases GDP growth by 2-3% each year, so what if growth is at 10%. On the other hand for Japan and the United States, the 2-3% you get from increasing total factors productivity is the only thing you have.
What drives the Chinese economy is that 90% of the people in agriculture is surplus labor. If you get a Chinese peasant to do *anything* other than farm you’ve created wealth. The reason that I think SME’s and low-end services are going to be the most important things in the Chinese economy goes forward is that it’s the only thing that I can of that can absorb that much labor.
Zhige: I think we should be able to imagine a scenario where the economy grows (measured by output), unemployment increases, and the wage share of national income FALLS!
It also works the other way. You can have a stagnant economy but one in which people are rather comfortable. This is what happened in Japan. Ultimately, one of the big reasons that Japan went through the “lost decade” was that the Japanese decided that zero GDP growth was acceptable for little unemployment.
China’s political situation is different. Neither high unemployment or slow GDP growth are politically acceptable, which makes it very challenging for economists. If you can’t come with an set of economic ideas that allow for high GDP growth and low unemployment given the current situation, then you need to think some more and keep thinking until you can find one.
Zhige: Sure, in the short-term there is a least worst option, and given China’s circumstances there not a more attractive alternative.
In the long run, there is always a least worst options. Something that economists have to accept is that except in rare situations (like when you have militarily occupied a country) you have to deal with existing political constraints and come up with least worst solutions.
This has the very strange effect of economists being upset that there isn’t a total economic and political collapse so that can fix the economy and advocating pushing things toward total economic and political collapse so that they have a blank slate.
There *will* be waste, inefficiency, and corruption, you *will* have an NPL problem, you *will* have a bias toward large SOE’s which will starve SME’s of capital. If you try to *solve* things problems you’ll quickly discover that the problems are unsolvable, and which point you run away and conclude that China is *doomed*.
But trying to solve the problems is a bad approach. The better one is that given all of the political and economic constraints, what can you do to *reduce* the bad stuff. There *will* be NPL’s as a result of the stimulus package. What can be done to reduce them so that they are annoying rather than fatal? The stimulus package will be overweighted toward infrastructure building and to big SOE’s, what can be done to *reduce* this problem.
The ideas that I have are:
1) focus the stimulus on employment rather than capital efficiency. If you have a choice between building a steel plant and an apartment complex, pick the apartment complex.
2) focus on institutional development. This means deepening private equity and bond markets. One way you can do this is rather than by just written a check, do matching funds.
Europe having worst recession since the war as Germany suffers:
http://www.telegraph.co.uk/finance/economics/5331129/Europe-in-deepest-recession-since-War-as-Germany-suffers.html
Two Fish: I agree with many of your thought provoking ideas.
A lot of the criticisms of China’s developmental policies, such as capital misallocation and NPLs appears to come from comparing apples and oranges (i.e. applying neo-classical 1st best criteria to a dual economy).
China’s dual economy has a huge rural sector with say some 250+ million unskilled excess labour supply. The shadow price of the latter is zero — hence the logic of Asia’s Developmental State and “smart protection”. This approach has big inefficiencies (NPLs, capital misallocation) — but 10% growth absolves many past sins. Why? — because “inefficient” output per head in the “modern sector” is three times that of the rural sector and you can “grow out” of your inefficiencies.
The mystery is how China has been able to navigate these treacherous waters over the past 30 years despite incomplete institutions, poor governance and a weak banking system and capital markets. At the same time, TFP and profitability appears to be pretty good — and in a few sectors — it is developing world class technology and companies.
Intiguingly, the Develomental State has mostly failed for the reasons noted above (Africa, Latin America, Middle East) or hit a glass ceiling (e.g. Japan, Korea, Phillipines, etc.).
Hence, I think the big issue is whether China will meet the same fate — now that the options of export cum investment led growth are less appealing?
PS I don’t want to muddy the waters, but the official investment figures as % of GDP are way overstated by including land sales and inconsistent price deflators. Data for consumption are also understated by incomplete sampling and coverage of newly created business, the self-employed and migrant workers. If we had decent data, China might look a lot more like a “normal” developing country. regards James.
Twofish, you still do not understand the income side of the equation, and is it key to creating adequate consumer demand, and is seperate entirely from the distribution of capital. It has to do with returns on specific factors, and China has always been unbalanced in this respect, and even more so as a result of the distribution of capital. The result is the shrinking wage share of GDP, and the consequent fall in the private consumption share on the expenditure side. ALso, we are still talking about Keynsian stimulus at a time of relatively high growth, which is not what Keynes had in mind. The problem is that the job stimulus is taking place in a manner that will not produce sustaining income effects, and will not absorb enough of the excess labor to solve the problem. This is like making a fire with lighter fluid as the fuel. Burn up the capital and then what?
Twofish, my professed Kenynsian friend, what we need more of in China is private demand, so build the big projects I say, they are fine, but make sure that one of them includes a helicopter factory so that the government can air drop cash into consumers. This would be a far more effective way of achieving the kind of stimulus everyone wants to see instead of a means of stimulus that compounds structural imbalances and unhealthy path dependencies. Sure, China needs a lot more infrastructure, thousands and thousands of hospitals, and investment will be a big part of the growth picture for a long time. The point that you miss is that over time the model has become increasingly inefficient at creating jobs and income. Also, if you study large SOE financial statements you will see that a very big share of their profits come from huge slugs of depreciation and are backed by weak operating cash flows. Net out upstream energy and raw materials and it looks pretty ugly. This is what the stimulus you so love to hail is propping up. The net effect is the weak link between high growth, job creation and income distribution, and the ability to rebalance the economy over time, and during times when stimulus is not needed. Based on what you have written above, it would seem that you would agree that if just giving away cash was more effective at producing employment than building either the steel plant or the apartment building, than cash would be better. The reason is that the Chinese model is a supply side model running out of steam precisely because there is inadequate underlying demand being created. Bridges, steel plants etc. don’t change that at this point. I say just give away an extra trillion yuan, and they would get more for it.
Quote chan-lee james: “the official investment figures as % of GDP are way overstated by including land sales”
I’ve heard this statement a few times (that Chinese GDP investment figures allegedly include land sales).
Is this definitely true? Do you have any idea as to how much of official GDP is accounted for by “land sales”?
It sounds weird, because why would land sales be included in official GDP statistics?
Quote CNM Zhige: “Also, if you study large SOE financial statements you will see that a very big share of their profits come from huge slugs of depreciation and are backed by weak operating cash flows.”
I don’t understand that sentence: Profits cannot “come from depreciation”. Depreciation reduces profits.
If you have a lot of depreciation in your p+l, cash-flow is much higher than profits, not the other way round.
Twofish:
Yes, i see your point about the danger of using abstract ideals as compared to any realistic possibilities for comparison. I chose Chinalco as an interesting example – it is a State dominated Firm, it has listed abroad as well as in Shanghai, and it is heavily involved internationally – both imports and exports. I think we should be careful idealising the current system before we see how well it holds up – time will tell. Suggesting alternatives is very rarely useless.
I dont fully agree about the health of Chinalco however, their retained earnings in 2008 compared to 2007 show a drastic and horrendous decrease. I dont have the figures at home with me, but i think the 2008 figure is about 1/18th of the 2007 figure. (will have to check back – but eitherway it is dismal).
If we are to assume that this inability to fire workers is causing trouble at other SOEs, and i know it is at some i work with, including the SOCBs, then they are stacking up future pain (either government / shareholder or employee) for questionable short term “benefits.”
I dont think we would need to have an “ideal” system in order to improve on the current one. I guess this argument will all be answered in time.. I think many people who have watched China’s businesses becoming more and more efficient and “modern” over the last 10 years are a bit disappointed to see them being turned back into a surrogate welfare state tool, and equally disappointed to see them borrowing with no clear way to use the funds profitably.
Government subsidising of some of these loans as you say, could be seen as a partnership kind of agreement, you get very cheap money, as long as you use most of it to maintain social stability on behalf of the government. Fair enough.
Lost decade – perhaps a little too dramatic – lost five years perhaps (seeing as how they are so used to five year plans) ?
It will be difficult but transition is the only way out isn’t it – the silver lining is, when everyone else is suffering and there is someone else to blame – suddenly things don’t look so bad, particularly for the bureaucrats.
Thomas: I don’t have any definitive answers to your questions concerning the reliability of Chinese investment or savings data.
Curiously,Angus Maddison (1998, 2001) and others claimed that China’s growth rate is overstated owing to provincial authorities’ tendency to report high figures to further their careers. But, the level of GDP is probably understated by 30-40 per cent, owing to a huge underground economy and high marginal tax rates (33 per cent corporate tax and top personal rates of 45 per cent). Revisions to national accounts in 2005 raised the level of GDP by 16+ per cent, virtually all in the private services sector. But, given 150+ million migrant workers, an explosion of small business and poor sampling procedures, these revisions capture only a part of the underground economy. Furthermore, China’s investment data do not fully correct for land sales, when land prices are rising sharply. In addition, China’s national accounts are internally inconsistent. If fixed investment was 45 per cent of GDP and grew by 25 per cent in 2006, then GDP growth would be 11 per cent even without booming net exports and rising consumption that officially added 6 percentage points to GDP. If expenditures data are accurate this would imply a GDP growth rate of 17 per cent. Incomes based GDP data have similar problems. China’s current account surplus was 7 per cent of GDP in 2005, based on “hard” customs data of importing and exporting countries. But, if the gross domestic investment ratio is 45 per cent, this plus the current surplus imply a 52 per cent domestic savings rate. By comparison, World Bank and sample surveys place the national savings rate at 44 per cent. In sum, the level of private consumption and GDP appear to be significantly understated (and probably GDP growth rates, albeit to a lesser extent). Hence, savings and investment ratios are also overstated. If savings and investment rates are indeed in the 34 – 37 per cent range, these would be similar to those in Korea and Japan during their periods of high growth. best regards James
Twofish:
I would be interested to hear your thoughts on the points that Prof Pettis (and others ) made here saying that China’s policies risk “exporting unemployment”.
I don’t put too much stock in the US / EU ’s ability to pressure China over policies which harm the outside world, but in Aluminium at least, we are not necessarily talking just about the US and the EU.
Personally I see the Chinese govt. making the only choice (politically) that they could have made. This choice involves several doubtful areas (future NPLs, trade frictions, continued allocation of capital to over-capacity) and some would say a gamble or two, nonetheless, the weak and anxious political system pretty much takes away the other options.
[...] expert Michael Pettis analyzes a Financial Times article written by Wang Qishan – a Vice premier in the State Council and [...]