After such a long entry last week I thought I would spare my readers and do something much briefer.  A few days ago I read a good article (“Stuck on Neutral”) about Japan in the August 18 issue of the Economist.  You can find the article on the Economist website if you are a premium subscriber, but if not, it has been partly reprinted elsewhere.

It may seem strange to be reading an August article in March, but in fact I often find myself a year or more behind in my reading.  This may seem a little perverse, but it does let me see what the smartest people were thinking at the time while knowing what subsequently happened.  Among other things this makes it clear how often informed consensus gets bogged down in the minutiae of everyday events while trying to understand the bigger picture.

In the case of this particular article, however, what triggered my interest is that it was about Japan’s post-1989 rebalancing, and among other things discusses why, in spite of every attempt, Japan has not been able supposedly to rebalance the economy and achieve any real growth during the two lost decades after 1990.  Private consumption never took off to drive economic growth.

Many of these reasons for low consumption we have heard before, and no doubt will hear again, but I am not sure how meaningful they are.  According to the article, the Japanese don’t take enough holidays, they are aging, exporters squirrel away profits to replace households as a source of savings, small companies are too inefficient, government supports big business, the Japanese don’t like to borrow, house prices are too high, and so on.  Maybe these really are the causes of the failure for the surge in consumption, but many sound like variations on accounting identities, and as such they are as likely to be consequences as causes of low growth.

But what interested me is that in spite of the fact that Japan’s economy didn’t grow, and contrary to the article’s claim, some serious rebalancing actually did take place, at least as I understand it.  Japanese gross national savings declined from around 35% of GDP in 1990 to around 23% last year.  The household savings rate dropped too, from around 10% in the 1990s to around 2%.  Neither declined in a straight line, but decline they undoubtedly did.

Household consumption, according to the article, nonetheless failed to grow meaningfully – in the past two decades it only grew by 1-2% annually – and this is much lower, presumably, than consumption growth in the 1980s.

But it was nonetheless higher than GDP growth, and that is exactly the point: consumption growth may have been low, but it exceeded GDP growth.  Rebalancing in the context of Japan (and China) does not mean that consumption growth must surge.  It just means that consumption must grow faster than the economy so as to become a bigger share of GDP and a bigger driver of total growth.  Put another way, it means that the savings rate must decline.  If this is what actually happened, then in fact Japan did partly rebalance.

But, mysteriously, in spite of the fact that Japan may have experienced real rebalancing and a real growth in the relative share of household consumption, the Japanese economy stagnated during the past two decades.  If you had predicted in 1990 that Japanese household and national savings would have declined so sharply as a share of GDP, and that consumption would have risen, you probably also would have predicted that Japan, after a couple of tough years, would resume rapid growth (or at least growth more in line with other rich economies) as surging private consumption pulled Japanese growth forward and away from its over-reliance on net exports.

But you would have been wrong on two counts.  First, Japan did not grow very quickly at all. It stagnated as consumption growth actually declined.  Second, its reliance on net exports did not decline.  The current account surplus remained high as a share of GDP.

Why didn’t Japan grow more quickly?  One reason may be obvious from the very fact that the current account surplus did not decline.  Although Japan certainly rebalanced by some measures, its current account surplus dropped from its peak of 4.2% of GDP in 1986 to 1.5% at its trough in 1996, only to turn around and surge, eventually to reach 4.8% in 2007, dropping to 3.1% in 2008 on the back of the collapse in international trade (and albeit on a much smaller economy as a share of global GDP than in 1990).

Since the current account surplus is another name for the excess of savings over investment, obviously this means that national investment declined as sharply as did national savings.  The article helpfully provides us with the numbers for both in an accompanying graph, and this confirms that investment indeed dropped, from a peak of around 32-3% in 1990 to around 22% last year.

With investment such an important part of Japanese growth prior to the bursting of the bubble, the fact that it declined so dramatically seems to have had a huge impact on Japan’s subsequent lack of growth.  So although in some important ways Japan “rebalanced”, for two decades it was nonetheless unable to grow even with a still-very-high and rising trade surplus, largely because investment declined sharply.

I am not an expert on Japan by any means, even though in the past two years I have been giving myself a crash course on recent Japanese economic history, but my Asian-development-model story suggests at least one explanation of what happened.  After many years of excess investment driving growth, Japan’s rebalancing process, which occurred after corporate, bank and government debt levels prevented the investment party from continuing, locked the country into many years of slow growth because it had to grind through years of debt-fueled overinvestment.

In fact Japanese investment jumped in the last two years of the 1980s, after the 1987 stock market crash in the US should have spelled the end of rapid Japanese export-led growth, from an already-high 28% to nearly 33% three years later.  In other words Tokyo seems to have responded to the collapse in the US by increasing its already-high level of investment to counteract the impact on the trade surplus.  This is what happened in China too, after the 2007-08 banking crisis in the US.  This jump in investment seems to have kept Japanese growth going solidly for another two years after the current account surplus began its steep nine-year decline.

But growth in investment wasn’t maintained.  After 1990, when investment growth could no longer keep up, perhaps because Japanese corporate, banking and government debt levels were becoming a serious constraint, the Japanese economy began a long, slow, painful decline.

The government tried to continue subsidizing growth over the subsequent decades by keeping both wage growth and interest rates low, not to mention maintaining the undervalued currency, as we know.  This unfortunately may have slowed the growth of both household income and household consumption, while maintaining the high trade surplus.  This also may explain why the drop in household savings was partly matched by the rise in corporate savings – households continued seeing transfers of income to the corporate sector.

But ultimately in spite of maintaining some of the old trade-related policies that kept manufacturing growth so strong for so long, there was nothing Tokyo could do to combat the effects of the decline in investment.  Had they allowed a more rapid rebalancing via higher wages, interest rates and the currency in the first two or three years, perhaps they would have had a tougher time early in the 1990s, and a lot more liquidations, but ultimately they might have pulled out of the slump a lot sooner because they would have transferred income to households more rapidly (although of course had they done this too aggressively, unemployment would have soared and consumption collapsed).

So where am I going with all this?  I am not completely sure, and no doubt I am oversimplifying the Japanese story.  Certainly I am not smart enough to figure out all the inner workings of Japan’s economy.  Just trying to keep the accounting identities in line and, making sure that everything that is supposed to balance actually does balance, is tough enough.

But this macro approach might have some benefit in that it shows how the overall system can constrain the micro-developments that we all hope for.  At the macro level, in other words, it doesn’t matter what individual policies we take to boost consumption if these polices don’t in the aggregate represent a real transfer of income to the household sector, as they did not in Japan.  Rebalancing must occur, but as an accounting-identify matter it can occur both through good ways (a surge in consumption) and bad ways (a drop in growth).

In Japan it occurred the latter way.  Without a serious attempt to redistribute income more rapidly back to households, Japan rebalanced, but not via a surge in consumption.  Since it could not maintain investment levels, on which the economy was too dependent, and in fact increasingly dependent after 1987, it rebalanced via a sharp slowdown in growth.  Either way achieves rebalancing – which only means that consumption has to grow as a share of GDP – but of course the former is much better than the latter.

Japan’s experience suggests one of the risks China faces.  It is easy to talk about rebalancing as a solution to the underlying problem China faces, but as the Economist article points out, rebalancing can be “tricky,” and it does not lead automatically to growth – that depends to a significant extent on how quickly consumption grows, and can take many years before that happens.

Will China rebalance?  Of course it will.  It is not a question of if but rather of how.  The same was true of Japan.  No economy the size of China’s can be so heavily dependent on exports to absorb its excess production, especially once unemployment in the rich countries reaches significant levels.  And no large economy can keep investment rates so high – and the allocation process so constrained by governance issues – for very long without running into the problem of capital misallocation.  But there are many ways rebalancing can occur.

Chinese household consumption will undoubtedly rise as a share of Chinese GDP over the next decade or two, but the process nonetheless can be disappointing for growth.  It depends on lots of other moving parts, most importantly perhaps the change in investment and the speed with which income is transferred to households.  And the change in investment might depend on debt capacity constraints and the extent of earlier overinvestment.

How fast does consumption need to grow in China in order for a meaningful rebalancing to take place?  Probably a lot more than you think.  This is arithmetically the case because China is starting from such a low base.

At roughly $1.2 trillion in 2008, total Chinese private consumption is only a little more than that of France (around $1.0 trillion) and still less than that of Germany (about $1.3 trillion, not to mention the UK’s $1.4 trillion and Japan’s $3.2 trillion).  This fact alone should cause us to be extremely skeptical of feverish claims about the role Chinese consumers can play in making up for any contraction in US consumption – which at roughly $9.4 trillion last year is nearly eight times the size of China’s – without even taking into account that Europe and Japan are likely to exacerbate, rather than help absorb, the contraction in US net demand.

Chinese private consumption has dropped dramatically as a share of GDP in the past two decades.  McKinsey put out a much-discussed report on consumption in August, which like many McKinsey reports is thoughtful and thorough, and generally does a good job of summarizing the informed consensus – for example the claim that a major reason for high savings is the lack of a social safety net, for which I think there is much less than meets the eye.

Unfortunately, the report tends explain the sources of low consumption too often by referring to consequences of the underlying dynamics, rather than the underlying dynamics themselves, making its proposed solutions either impractical or irrelevant.  For example, the report complains that “China’s investment- and industry-intensive model crowds out consumption.”

In fact the main reason for overinvestment, and the fact that much of it is misallocated, thus widening the future gap between production and consumption, is probably too-low interest rates and a distorted credit allocation system, so it is not a question of reorienting growth away from a capital-intensive model.  It requires first of all a fundamental reform of interest rate management and banking governance.

One can also easily argue that the fact that “China’s consumers make limited use of credit”, as the report claims, reflects the underlying industrial strategy more than just a technical failure to develop consumer credit.  A burgeoning consumer credit market – big enough to matter – will undermine the growth model by changing the direction of implicit subsidies.  This is a pretty big reform.

But that is an aside.  Like most McKinsey reports it has lots of great data.  For example it shows that the Chinese were not always so reluctant to consume.  According to the McKinsey (and the National Bureau of Statistics) data, in 1990 consumption represented just a little over 50% of GDP.  Around the time of the inflationary crisis of 1993-94 it dropped to around 45% of GDP and stayed at that level until shortly after the 1997-98 Asian crisis, when it began a fairly steep decline, hitting 40% in 2003-04 and around 35% currently.  Crises seem to drive the household consumption rate down, even though bull markets don’t seem to drive it back up.  Is that because crises cause households to worry about risk (although if that were true they wouldn’t go permanently down, would they)?  Or is it because the government responds to crises by increasing the amount of misallocated investment, the consequence of which is to reduce future consumption?  Government consumption, by the way, has stayed pretty steady, at around 15% of GDP, during that period.

Compared to non-Asian countries Chinese consumption rates are astonishingly low.  Consumption for most European countries lies in the 55-65% range.  Consumption for other developing countries can easily fall in the 65-70% range – where much of Latin America falls.  US consumption has been around 70-72% in recent years.

Even by Asian standards Chinese consumption is off the charts.  South Korean and Malaysian consumption is around 50% of GDP (although during and after the Asian crisis Malaysian consumption did drop to around 45% of GDP, before recovering).  Other major Asian economies, like India, Japan, Taiwan and Thailand, show consumption in the 55-60% of GDP range.  Compared to those numbers China’s 35% is astonishing, even if, as some claim it may be somewhat understated (which by the way may be true of other developing countries).

The flip side of the decline in consumption has been the rise in household savings.  After bouncing around erratically between 10% and 20% of disposable income in the 1980s, around 20 years ago Chinese household savings equaled 12-15% of disposable income.  Around 1992 they began rising steadily until 1998, and then stabilized at around 24-25% until very recently, when they rose slightly to about 26% of disposable income.  The report correctly notes that the real increase in national savings in recent years was caused by the sharp increase in corporate savings, although as I have often mentioned before, I think corporate savings are themselves caused by the transfer from household savings via low interest rates.

During that same period China ran small surpluses or deficits on the trade account until 1996, when it booked its last trade deficit, beginning a steady upward march of its trade surplus until 2003, when the trade surplus was around 5% of GDP, after which time it surged to over 10% of GDP in 2007-2008.  Investment, too, rose steadily during this period as a share of GDP.  In 1990 it was around 23% of GDP.  It rose sharply in 1992-94 to around 31% of GDP, stabilized at that level, and then began climbing inexorably around 1997-98 to reach around 40% in 2008.

Rising investment and rising trade surpluses are inextricably linked in China’s case.  Strategies that explicitly or implicitly boosted Asian savings rates and constrained consumption, I have argued many times before, were viable strategies as long as the resulting trade surpluses, which were an almost automatic account of these policies, could be absorbed by trade deficit countries.  Of course the US has played this role for the past thirty years, but there is good reason to believe that it might not be able or willing to do so much longer.

These growth strategies basically forced households to subsidize investment and production, thus generating rapid economic and employment growth at the expense of household income growth, and as I have argued many times before it is the growth in household income that has primarily constrained household consumption growth.

This is borne out by the numbers.  From 1990 to 2002, according to the McKinsey numbers, household income ranged from 64% of GDP to 72% of GDP.  It peaked in 1992 and then began a slow, erratic descent to 66% in 2002, after which time it plunged to 55%.  I suspect that if there were a way to measure changes in wealth – for example the value of the deteriorating social safety nets and the environment, the present value of savings as interest rates are changed for policy reasons, etc.—and household income were adjusted by these changes, the decline would have been greater.

The report goes on to discuss McKinsey’s projections and expectations for consumption growth over the next few years.  I read it with interest but frankly I find these kinds of exercises not terribly useful because of the tremendous difficult in ascertaining the various feedback loops – of which there are many in China – which inevitably force reality far away from expectations.  But I did try to do some quick arithmetic, in order to determine what kinds of numbers we are going to need to get anything resembling a rebalancing.

Rebalancing is the key word here.  Many analysts think that what we need is for consumption in China to grow quickly, and this will resolve China’s (and the world’s) problem with contracting net demand in the US.

Actually, no.  What we need is an expansion in Chinese net demand – rebalancing in other words – so that China can adjust to contracting net demand from the US in a way that doesn’t harm trade partners and competitors and rebounds on itself with escalating trade tensions.  The way to rebalance is not for consumption to grow, but rather for consumption to grow as a share of GDP.  Even if consumption declines, and GDP decline more quickly – a horrible outcome to be sure – rebalancing will occur.  The best way of course is for GDP to grow quickly and for consumption to grow even more quickly.

But this is I think what most people miss.  Just growth in Chinese consumption alone does not help if it grows in line with GDP, and less so if it grows slower than GDP.  In that case the imbalances will get worse, and while the impact on the trade account can be temporarily disguised if investment continues to surge, ultimately it just postpones the needed adjustment (and increases the cost if the investment surge is misallocated).

What kind of consumption growth will we need for the country to rebalance?  The numbers are a little worrying.  If China grows by 8% a year, consumption would have to grow by a little over 11% to raise the consumption share of GDP from 35% to 36% in one year.  It would have to grow by a little over 9 1/2% annually to do it in two years.  Consumption, in other words, must grow substantially faster than GDP for the rebalancing even to begin to take place.  This is arithmetically true because China begins the process with such a low consumption ratio.

Look at it over the longer term.  Just to return consumption to 40% of GDP over the next five years (and even that level is widely considered to be way too low, and probably unprecedented in the world excluding recent Chinese history), 8% average annual growth rates in GDP would require a tad under 11% annual growth in consumption.  Similarly, 7% average annual GDP growth rates would require that consumption grow annually over the next five years by nearly 10%.  To bring Chinese consumption in 20 years up to 50% of GDP, which is the low end for other high saving Asian countries, and far lower than any other large economy in Asia (and remember that large economies are less able to rely on exports to fuel growth than small countries), 7% annual GDP growth would require average annual consumption growth of just under 9% for twenty years.

In other words while GDP growth slows significantly from its 12-13% rate of the past several years, consumption will nonetheless have to surge at rates far in excess of the 8-9% growth rates of recent years in order for even a small, partial rebalancing to take place.  I don’t think I have ever seen a case in which consumption has grown at nearly that rate for any length of time.  I believe if China pulled it off it would be unprecedented.

Of course this will not be easy, and I think too many commentators underestimate the magnitude of the problem.  China’s rebalancing process will even in the most optimistic of cases take many years before it can even reach the lowest consumption levels reached by other Asian countries that pursued investment-driven policies accompanied by too-low interest rates and undervalued currencies.  This will be a long haul, and if I am right – if we need to see a transfer of income back for the state sector to the household sector really to get it going – we should expect much lower GDP growth rates over the next decade than anyone is currently projecting.

As Beijing slowly unlocks from its 60^th anniversary celebrations – the streets are still relatively empty but more and more people are going out, although my local Starbucks still hasn’t reopened, forcing me to go elsewhere for my hardcore caffeine fix – a lot is still going on in the rest of the world. Both the US and the IMF have come out with releases that help us to pick through the problems that China and the world are facing.

Before discussing these releases, let me make a quick digression to an event that a lot of people have been asking me about. Two weeks ago China Construction Bank announced that it would rollover 24.7 billion yuan in bonds that it had “purchased” from its AMC, Cinda, for another 10 years. Bank of China and ICBC, which sit on 473 billion yuan worth of AMC bonds, will probably do the same when their AMC bonds come due.

What does this all mean? Remember that as part of the recapitalization of the banks after the NPL fiasco of 10-15 years ago, the AMCs (asset management companies) were created to purchase and liquidate the bad debt. There is a big argument as to whether or not they took out all the garbage loans, but at any rate they bought a lot of bad debt and, since they had no assets of their own, paid for them with issues of medium term bonds, which they exchanged in two tranches. One tranche was for 100% of the face value of one portion of the bad loans they took on, and the other was for 50% of face of the rest of the bad loans they acquired.

The problem of course is that these bad loans were worth a lot less than either 100% of face or even 50% of face. In fact they have been liquidated at a rate of about 20% of face. This leaves the AMCs bankrupt and unable to repay the bonds, so when they came due the bonds were simply rolled over. There is a sort of comfort letter from the Ministry of Finance (its exact value is in dispute), so the banks have been able to get away with treating the bonds as money good. The point of all this is to remind us that all the .losses for the earlier spate of bad loans, even assuming that all the bad loans were identified and cleaned up (which I doubt) have not been resolved.

Someone (the banks? The Ministry of Finance?) will eventually have to pay up. If the process is allowed to drag on for many years, I suspect that the banks will pay out of retained earnings, but since retained earnings at the banks consist primarily of the very wide spread between the lending rates and the interest rates that banks are allowed to pay depositors, ultimately this means that households will be forced to recapitalize the banks. If there is a short term problem, however, perhaps leading to a crisis of confidence in the banks, I suspect that the MoF (unless debt at the sovereign level in the mean time becomes a problem) will explicitly guarantee the bonds or take them directly on the government balance sheet.

US unemployment picture is ugly

To return to the rest of the world, unemployment in the US is not getting better. Yesterday the Labor Department released figures that showed the US unemployment rate climbing to a fresh 26-year high of 9.8% in September. According to an article in the Financial Times:

Official figures on Friday showed that non-farm payrolls dropped by 263,000, making it the 21st consecutive month that the US economy has shed jobs. The data were worse than even the most grim expectations, as economists predicted a 175,000 drop in payrolls, and followed a decline of a revised 201,000 jobs in August when the unemployment rate was 9.7 per cent.

Although I think most economists are expecting that US economic growth in the third quarter was a fairly healthy 3%, as far as China is concerned it is not the future growth in the US economy that matters so much as future growth in US consumption. A jobless recovery in the US, if that is what we get, probably means that dragging household consumption will not be the engine of US growth, and even less will it be the engine of Asian growth, which it was for so many years. Any Asian and Chinese recovery predicated on a revival of out-of-control US consumption is likely to be disappointed.

On Thursday the IMF released its World Economic Outlook, which was mildly positive on the global economy, arguing that “the recovery has started, financial markets are healing, and in most countries growth will be positive for the rest of the year as well as in 2010,” although in line with the US employment report it worried that “the pace of recovery is expected to be slow and, for quite some time, insufficient to decrease unemployment” (later in the report they say “the current rebound will be sluggish, credit constrained, and, for quite some time, jobless”). The report also argued that because most of the “recovery” has been based on public spending and, I guess especially in Asia, gearing up capacity without much regard for demand, an economic recovery was likely to be slow and risky.

The IMF seems increasingly to be agreeing with the “global imbalances” analysis of the economy, probably to the dismay of China and other surplus countries. Early in the report it says:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand and imports.

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. To accommodate the shifts on the demand side, there will need to be changes on the supply side.

Surplus countries must consume more

The interesting thing for me was this focus on surplus countries. Although there does seem to be an economic rebound, the report says, the recovery will be weak unless countries with large trade surpluses step up domestic demand. To keep growth up, surplus countries like China must boost domestic spending, and appreciate their currencies. This pretty tough claim will probably not make Beijing, Berlin or Tokyo very happy, although it does chime with US views on global trade imbalances. In their own words:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand—notably emerging economies in Asia and elsewhere and Germany and Japan.

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. In these economies, private consumption and investment are unlikely to pick up the slack that will be left by diminishing fiscal stimulus, given that household incomes and corporate profits will be subdued and balance sheet repair will be under way for some time, implying higher saving rates.

The authors of the report do not seem terribly optimistic about the prospects for a sustainable spurt in surplus-country domestic demand in the near term (“This process of rebalancing global demand will be drawn out.”) but I am not sure, perhaps because the IMF is after all a very politicized institution, that they specify the trade consequences. They acknowledge that there will be a problem with expected increases in savings in one part of the world conflicting with high savings elsewhere, and they don’t seem very optimistic about prospects for a surge in investment, but it seems to me that they shy away from working out how this will happen and how the pain will be distributed (through the trade account, I would argue).

What about overinvestment?

In a section in Chapter 4 of the report entitled “Do Precrisis Conditions Help to Predict Medium-term Output Losses?” there was an interesting discussion about the relationship between output losses associated with a crisis and pre-crisis investment levels. On especially commented on section had this:

The prominent role of investment and capital losses suggests that the level and evolution of precrisis investment would be good predictors of eventual output losses. Indeed, regression results provide strong evidence that economies with high precrisis investment-to-GDP ratios, measured as the average investment-to-GDP ratio during the three years before the crisis, tend to have large output losses.

In contrast, the investment gap, defined as the deviation from its historical average of the investment-to-GDP ratio during the three years before a crisis, is not statisti­cally significant. We return to potential interpretations of these results later in this section, but it is worth mentioning that the precrisis investment share is particularly robust as a leading indica­tor, even after controlling for the level of the current account balance. This suggests that countries that have high investment rates tend to experience larger output declines follow­ing banking crises, irrespective of whether the investment is financed by foreign or domestic savings.

For those of us who worry about China’s having recently increased its already-excessively-high investment rate, this passage was an uncomfortable read. In addition for people like me, who believe strongly that the very process of misallocated investment will act as a damper on future consumption growth (and I think this is becoming much more widely accepted, or at least discussed, in policy circles), the combination of warnings over overinvestment and pleas for more consumption from trade surplus countries is deeply worrying. By the way, for a short and quick view of why I think consumption won’t grow, you can check a recent debate held by the New York Times on the subject of Chinese consumption growth.

So what about all this excess investment? The State Council recently made a lot of noise about its determination to curb excess capacity. Here is the Financial Times version of the story:

China has issued a stark warning about the risk from rising overcapacity in the economy, saying it could hamper recovery and lead to a surge in non-performing bank loans. The State Council, the country’s cabinet, issued a new plan to combat overcapacity in seven industries, barring new aluminium smelters for three years and criticising “blind expansion” in parts of the steel and cement industries.

The cabinet statement, which came late on Tuesday evening in Beijing, follows a crescendo of warnings from senior officials. It also outlined measures to restrict manufacturing of equipment for “green” industries of wind and solar power. China’s economy has rebounded sharply in recent months due to an investment boom – much into infrastructure – fuelled by increased public spending and a surge in lending by the state-owned banks.

But over the past three months many government officials have begun to publicly warn that the credit binge could create overcapacity in heavy industry, which could produce a new round of bad bank loans.

The article in the South China Morning Post adds some color, and a partial explanation of why all these angry statements about preventing excess capacity over the past few years have had so little effect:

In unusually blunt wording, the cabinet also pointed its finger at local authorities. “Some regions have acted illegally. We are once again seeing cases of illegitimate approvals, of construction starting before it has been approved, and of construction starting even as the approval process is underway,” it said.

The cabinet’s strident warning about overcapacity underscored why officials have been circumspect about the economy, repeatedly saying that it has shown signs of recovering from the global financial crisis but is still not on solid ground.

It is hard to give up investing

The truth is everyone in the world is against the creation of “excess” capacity, but as long as Beijing has in place policies that explicitly subsidize investment and production, it will take an awful low more than fulminating against wasteful investment to eliminate it. I would argue that wasteful investment is the automatic consequence of policies that lower the cost of capital to “unreasonable” levels, implicitly socialize risk, and otherwise subsidize producers in the name of boosting employment.

Since Beijing has very explicitly chosen to attack rising unemployment in the short term – probably wisely, although also probably more ferociously than was optimal – there is little they can do to prevent a massive rise in wasteful investment. You cannot take an economy with the highest investment rate in history, and already massive waste, and very quickly force investment rates up even higher, without also increasing waste. The problem with all this wasted investment, of course, is that someone must pay for it, and that “someone” will undoubtedly be Chinese households, who will then almost certainly go on to disappoint us by failing to splurge on consumption.

And are they really serious about tackling excess capacity? Here is what Bloomberg said in an article earlier this week about the shipping industry:

China and South Korea’s support for shipbuilders may add to a glut of capacity, slowing a recovery in freight rates and vessel prices. The world’s two largest shipbuilding nations have taken steps this year to aid shipyards and safeguard jobs as customers delay or scrap orders amid tumbling world trade. That support will likely ensure more vessels enter service, even as lines mothball and scrap existing ships because of a lack of cargo.

“The Chinese and Koreans, in particular, will make sure that these ships come,” Philip Clausius, chief executive officer of lessor First Ship Lease Trust, told a conference in Singapore yesterday. The “daunting number” of ships that “will hit the market over the next three, four, five years will make the recovery a rather slow and painful one.”

China’s bid to become the largest shipbuilding nation by 2015 may also worsen the glut as it competes for market share, said Matthias Umlauf, senior economist at HSH Nordbank AG. The world’s shipyards have dry-bulk ship orders with a combined capacity of 64 percent of the existing fleet, according to data compiled by Bloomberg.

China has “the chance to become the world’s largest shipbuilding nation and they will not let this chance go,” said Umlauf. “They will support their national champions and that will definitely add to the overcapacity situation.”

As I have said many times before, I don’t see how pressures to increase savings in the US and other trade-deficit countries will not conflict with pressures in China, Germany, and other trade-surplus countries to maintain policies that force up savings rates, especially if sustainable global investment rates decline. The only outcome, I think, is increasing trade tensions. In that light, today Bloomberg reported a very worrying escalation of the conflict:

The two largest groups representing U.S. companies in China said the Asian nation has enacted a series of policies discriminating against foreign investors and imports. The U.S. Chamber of Commerce and the U.S.-China Business Council said in testimony today that Chinese contracting rules, technical standards and licensing requirements were protectionist. Chinese officials have made the same charge against the U.S. following President Barack Obama’s imposition of tariffs on Chinese tire imports.

Both organizations have previously defended China, calling it a large and growing market for U.S. exports and lobbying to fend off legislation aimed at punishing China for currency policies and government subsidies. The criticisms of the two U.S. groups reflect mounting tensions that economists said could spark a spiral of retaliatory measures between the countries.

“There are growing indications that China’s movement toward a market economy has stalled,” Jeremie Waterman, senior director for China at the U.S. Chamber of Commerce, testified to a hearing at the U.S. Trade Representative’s office today. “The voices of protectionism in both countries are on the rise.”

The Shanghai stock market was up 4.5% in very nervous trading today but down 16.3% since its recent peak at 3478 on August 4, and still trading at more than 30 times earnings.  All this turmoil is triggering all sorts of worried comments about the sustainability of the fiscal stimulus package and whether it has already reached the end of its effectiveness (it hasn’t – the government still has credit and fiscal firepower, and will use it if growth slows down significantly in the next few quarters).  It also makes it harder, but probably more useful than ever, to focus on the bigger picture, and this entry is definitely big picture.  It also turned out to be a very long piece, as these big-picture pieces tend to. 

The topic is whether or not the global imbalances that have led to the current crisis were in any way “caused” by the Asian savings glut, and besides arguing why I think this may be the case, I want also to argue that getting this argument right is far more important than many seem to realize.  Mohamed Ariff, executive director of the Malaysian Institute of Economic Research, indirectly suggests why in a good OpEd article in today’s New Strait Times: 

China is seen as the beacon of hope in these days of gloom and doom. This has led some observers to think China will lead East Asian economic recovery and thereby spearhead a global economic turn-around. But this faith in China as saviour may be misplaced.China’s imports from the rest of East Asia consist mostly of raw materials, intermediate products and components and parts, the bulk of it turned into manufactures for exports. China’s imports of consumer products from the region account for no more than a small proportion.

China’s imports from its neighbours have plummeted in the wake of the slump in China’s own exports, although the Chinese economy is growing at seven to eight per cent, because China depends largely on domestic production for its own consumption, which does not spill over to the rest of the region through trade.

I started writing this because while googling around looking for something else, I stumbled early this week upon a blog by LSE’s Danny Quah with the intriguing title “Where in the world is Asian Thrift and the Global Savings Glut?”  I later found that like mine, his blog is carried by Nouriel Roubini’s RGE Monitor.  I also subsequently discovered by a weird coincidence that on Saturday I am sharing a panel with him in a conference at the Guanghua School at Peking University, where we will be discussing the “Reconstruction of Global Finance”.   

The whole “savings glut” debate is a controversial one because almost from the start it has degenerated into a fairly silly argument about who to blame for the global imbalances and the subsequent crisis – or more specifically and more excitingly, whether the predator was wholly the foolish American consumer or the beetling Chinese saver.  Three months ago Brad Setser discussed all this in one of his blog entries that (inevitably) drew more comments than most, and as usual he provides a concise and enlightening discussion on the subject which you might want to read.  He is a proponent of the hypothesis, but nonetheless pretty fair-minded. 

Professor Quah weighs in on the other side of the savings glut debate although, unlike most others in the debate, he seems not terribly concerned about assigning full blame to any of the major parties.  It is neither excess US consumption nor excess US savings that solely “caused” the imbalance, in other words, because necessarily both sides are required for it to exist. 

Except for the possibility of trade with outer space, the US deficit has to be matched dollar-for-dollar by trade surpluses in the rest of the world. Correspondingly, therefore, the rest of the world has been saving—consuming less than it has been producing—and accumulating dollar claims against the US as a result. 

In this description, however large the global imbalance, a savings glut—wherever or however it might arise on Earth—has no independent existence. It makes as much sense to say the world’s excess savings caused enthusiastic US consumers to flood into Walmart to buy $12 DVD players, as to say US consumer profligacy made hungry Chinese peasants abstain even more and instead plow their incomes into holdings of US Treasury bills.  

When two variables have always-identical magnitudes, obviously neither can usefully be said to cause the other.  

Who are the predators?

This is correct, but as an aside, the discussion about enthusiastic American consumers forcing the Chinese to save, or hungry Chinese savers forcing Americans to consume, typically uses colorful but totally inappropriate images to describe the dynamics of the this process.  For example, I often hear opponents of the Asian savings glut hypothesis say, voices dripping with disbelief, that the savings glut hypothesis insists that the poor American consumer rushed out to buy another DVD player because terrible China forced him to borrow the money and buy the DVD player.  How could that possibly happen? 

Well, that’s not how it would have happened.  In any large country, there are millions of households able and interested in increasing savings or in increasing borrowing.  Specific policies or financial conditions will determine at any given time changes in the behavior of some of these individual households, so that at the macro level, and only at the macro level, the country will have seen an increase in savings or an increase in consumption.   

It is not every household that rushes out to consume when consumption rises, and this never happen because predatory savers force an otherwise unwilling consumer to buy.  So if it had indeed been rising Asian savings that drove the US consumption binge, policies aimed at constraining Asian consumption and boosting Asian production (which cause savings to rise) will have initially led to a rising Asian trade surplus and US trade deficit, as the tradable goods sector in Asia expands and the tradable goods sector in the US contracts. 

This surplus would be recycled into the US via purchases of highly liquid securities.  If the Fed failed to respond to this increase in liquidity by raising interest rates and contracting money (and contracting the tradable good sector), the financial system would have to accommodate the rising liquidity as it has always done throughout history – by growing financial balance sheets and taking on more risk.  In that case the conditions for consumer borrowing will have been made increasingly easy, and those households who needed or were predisposed to borrow under easier lending conditions, and pressure on the parts of banks to extend credit, will do so.   

As long as there are some households willing, however appropriately or foolishly, to increase consumption, the easier availability of consumer credit will cause them to increase consumption – this has happened many times and in many countries, and has nothing to do with a predisposition to excess consumption.  Furthermore as recycled liquidity boosts household wealth by boosting the value of homes and investment portfolios, the rising wealth of each individual household will have an impact similar to rising income – and with it consumption will rise.   

So the point is the not very controversial suggestion that a surge in domestic liquidity in the US can easily cause US consumption to rise.  If that liquidity surge was “caused” by the recycling of a large and growing trade deficit, then it is easy to see how at the macro level US consumption would rise in response to a surge in Asian savings. 

Similarly, the proponents of the Asian savings glut hypothesis wonder in disbelief how an American consumer deciding to buy a DVD player could have possibly “forced” poor Chinese peasants to cut their already minimal consumption and increase their savings.  But there was no force.  A sudden explosion in binge consumption in the US would divert production from China, and as China increased the share of its output dedicated to exports, total production would not immediately be matched by total domestic consumption (Americans bought some of it) and the Chinese savings rate would necessarily increase – whether at the household level or at the corporate or government level. 

The interest rate argument 

The point is that sarcastic comments about predatory American consumers forcing dim-witted Chinese households to save more and consume less, or predatory Chinese savers forcing helpless American households to borrow and consume, may be good debating tactics but they are misleading and explain nothing.  At the macro level either event – higher Asian savings leading to higher American consumption, or higher American consumption leading to higher Asian savings, or even a combination of the two – is perfectly possible. 

So why should we accept the Asian savings glut hypothesis?  One argument that I first saw proposed by Brad Setser was that if the imbalances had been driven by US consumption, and therefore US borrowing needs, the consequence should have been an increase in US interest rates.  Had they been driven by excess savings, US borrowing rates would have probably declined.  

In fact during most of the relevant period US interest rates did decline, even leading to the US Fed several times complaining about its inability to control domestic long-term rates.  So that pretty much settles it, right?  But Professor Quah dismisses this argument: 

Many other factors could, of course, have driven down short rates: US monetary policy responded to national economic downturns in 1991 and 2001. Through the 1990s inflation rates worldwide converged and fell, together with short-term interest rates set by central banks everywhere. The burst of the dot-com bubble in March 2000 saw the NASDAQ index decline 77% in the following 18 months, prompting action by the US Federal Reserve. Japan’s monetary policy during its decade-long recession drove nominal interest rates there to zero. 

Although he is right, this is not a completely satisfying dismissal.  The same savings glut that pushed down US interest rates could easily have pushed down global interest rates, especially in a world that was seeing rapidly rising capital flows that in many cases were aimed at “arbitraging” (absolutely the wrong word, of course, but one widely used in the markets at the time) interest rate differentials.  After all it is often the case that, especially during periods of large international movements of capital, increases or reductions in US interest rates (or in British rates during the globalization period at the end of the 19th Century) are matched by changes in foreign interest rates. 

Still, the fact is that his response does show that the interest rate argument is not final.  There might be other perfectly good reasons that explain the decline in US interest rates. 

The bilateral trade argument 

Quah’s main argument against the savings glut hypothesis, at least as far as his blog entry, seems to be that it could not have been a rise in Asian savings that drove the global imbalances because had it done so, much of the imbalance would have rested between Asia (or China, more specifically) and the US.  The strongest piece of evidence he presents is a chart that shows the US bilateral trade balances between the US on one side and China, developing Asia, the EU, and oil exporters on the other.  I have reproduced the graph below, but if you can’t see it well, just click on Quah’s blog (blocked in China, so China-based readers will need to use a proxy), and click on the graph itself for an enlargement (I wish I was clever enough to do things like that).

As the chart shows, the US trade deficit rose nearly as quickly, or even more so, with those other regions as it did with China and/or developing Asia.  It wasn’t just a US-China phenomenon or a US-Asia phenomenon, it was a US-everybody phenomenon. 

Quah’s argument seemed to be a powerful one at first, and I had to think about it for a while or else I would have to find myself deserting from the “savings glut” camp.  In the end, however, I think his argument it turns out not to be very satisfying and I still think it runs against a timing story that better explains the imbalances.  I’ll say more on that later, but it seems to me that in a “globalized” world, if the Asian savings glut hypothesis is true, not only would rising bilateral trade deficit between the US and other countries outside of developing Asia be possible, but they would even be almost necessary. 

Why?  Because we have to be careful about misreading bilateral trade numbers.  It is the aggregates that usually matter.  I don’t have the data in front of me, but I believe that Europe did not run significant and rapidly growing aggregate trade surpluses during this period.  If that’s the case, then a growing bilateral surplus with the US is perfectly consistent with the savings glut hypothesis as long as you assume that trade is international and that any specific product can be produced and assembled in many countries – which is of course a pretty unremarkable assumption. 

So, for example, if rising Asian net savings “caused” rising American net consumption (in the way described above – no sarcasm, please), it would mean that money recycled from Asia into the US caused the US trade deficit to rise as it was intermediated by the financial system into consumer financing, even as it caused Asian trade surpluses to rise. 

It’s the aggregate balance that matters 

But, and this is the important point, the trade did not need to occur only at the bilateral level.  If rising Chinese savings was intermediated into rising US consumption and this bilateral relationship was resolved, to take a concrete example, by Chinese exporters producing shoes and American consumers buying shoes, the trade would not have had to occur directly between the two.  When Americans shop for shoes, they don’t care which country saw net savings rise, and when Chinese sell shoes they don’t care whose economy saw an increase in net consumption.  China could have produced shoes, sold them to a designer in Italy, where they would be packaged and branded, and then sold to American consumers. 

In this simple case, Chinese excess savings would have “caused” Americans to borrow money and buy the shoes, and so China would run a trade surplus, the US would run a trade deficit, and Italy would be balanced.  But Italy would nonetheless show a bilateral surplus with the US and a bilateral deficit with China.   

Excess US consumption, in other words, would still have been “caused” by excess Chinese savings in this case, but global trading and processing networks would have the bilateral trade imbalances, and their countervailing obverses, spread out though the world.  Many countries would run surpluses with the US and deficits with Asia, but at the aggregate level they would balance out at close to zero, and the US would be left with the sum of its bilateral deficits and Asia with the sum of its bilateral surpluses. 

The point is that there is nothing in the Asian savings glut hypothesis that requires that all trade imbalances occur at a bilateral level and only between the participating countries – that the deficit/surplus imbalances occur between the US and Asia.  It only requires that the US, as the equilibrator to rising Asian savings, have a large and growing trade deficit and Asia have a large and growing trade surplus.  If other regions also have large and growing aggregate trade surpluses that fed into the US deficit at the same time, that would perhaps be the problem Quah says it is, and either would need to be explained or would create problems for the hypothesis.  But they didn’t. 

With one big exception, of course.  Oil exporters did see not only rising bilateral trade surpluses with the US, but they also saw rising aggregate surpluses.  Does this somehow weaken the savings glut hypothesis?  Again no, because those surpluses reflect one thing only, rising oil prices, and in an environment of rapid US and Asian growth, we would expect oil (and other commodity) prices to rise.  In fact the savings glut hypothesis would predict that as long as the recycling was occurring efficiently, both countries would grow quickly and high commodity prices would be not only possible, but in fact highly likely. 

So as I see it, this is how the arguments and counterarguments stand: 

1.        The argument that declining US interest rates proves the correctness of the savings glut hypothesis is wrong.  Declining US interest rates are suggestive but not final.  Other things could have explained declining US interest rates during this period, and of course there is easily a possibility of feedback loops in which any initial decline in US interest rates could, by increasing household wealth (via rising asset values) increase consumption and the US trade deficit, leading to Asian recycling, and so on to more lower interest rates. 

2.        The argument that rising US bilateral deficits with many regions around the world disprove that the savings glut hypothesis is also wrong, and much less suggestive.  On the contrary, if the hypothesis is correct and if trading is truly globalized, we would expect US bilateral deficits to be high with nearly everybody.  At the aggregate level, however, we would not expect anyone except the high-saving Asian saving countries to run large trade surpluses. 

3.        There was also an argument that I associate with Morgan Stanley’s Stephen Roach – a very smart man who by the way disagrees strongly with the hypothesis – since he was the one who first made this argument to me, over a lunch at Peking University two years ago.  According to Roach there has been no significant increase in global savings during the savings-glut-hypothesis period, which pretty much demolishes the idea of a saving glut.   

I disagree because the hypothesis doesn’t imply in any way that global savings have increased.  In a closed economic system, unless investment has increased commensurately, an increase in savings in one part of the system must necessarily come with a reduction in savings elsewhere, and this was exactly the point of ascribing the current trade imbalances to a forced rise in Asian savings.  Rising Asian savings “forced” declining US savings by causing the US financial system to accommodate growing domestic liquidity by taking on risk (again, no sarcasm please – you might disagree but in itself this is not implausible). 

Timing the flows 

So where does that leave us?  Before answering, I think there is another thing to think about here, as I wrote earlier in this entry, and that is the timing issue. 

In a June 4, 2008 entry, much of which is reproduced here, I mentioned a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the “Global Capital Flows Paradox”).  In it the author considers the “paradox” of high and rising capital flows from developing to developed countries during the past decade.  This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers. 

Bibow rejects the Asian savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds – he claims that the saving glut hypothesis is based on the “fatally flawed” (his words) loanable funds theory.  However his narrative (to be horribly post-modern for a moment) of events seems very close to my own. 

What interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).  First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.  

Basically, according to the data quoted in Bibow’s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.  The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.  The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward to peak at around 7% of GDP in 2007.  

As an aside I should add that there was an acceleration of the growth rate of the deficit around 2004, if I remember, and I have a pretty strong suspicion that this had something to do with the financing of the Iraq war.  As I have pointed out before, US asset markets and consumption often boom during unpopular wars, like the Vietnam War, which tend to be financed not with taxes but with money creation and debt, and often these two things lead to great markets – for a while. 

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges – a small one from 1984-88 and a very large one after 1997.  If it was driven by Asian savings, this pattern becomes a little easier to understand – or at least, what amounts to the same thing, we can posit a more plausible story to explain it.   

The narrative  

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.  The post-1997 surge is much larger and more interesting.  1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day.  

Since the main cause of the crisis seemed to be the sudden reversal in the early 1990s of current account surpluses into substantial deficits, along with highly unstable balance sheets in which large external obligations were mismatched with domestic assets and “hedged” with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997. 

These countries, consequently, but into place “mercantilist” policies in order to achieve both goals – persistent trade surpluses and large amounts of foreign currency reserves.  This (I think plausible) story is reinforced by another graph Bibow reproduces.  The global capital flow “paradox” to which he refers in his title is the fact that developing countries are exporting capital to rich countries.  According to his data, developing countries have almost always been net recipients of private capital flows – which is what one would have expected from most economic theory and history.   

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.  (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.) 

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.  This is when the “paradox” of net capital flows from developing to developed countries begins.  Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows). 

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit, although exacerbated by the second surge around 2004.  Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.   

The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.  Of course that doesn’t mean that nothing relevant happened in the US.  US monetary policy was clearly too accommodative, and especially in reaction to the Iraq war, so that it exacerbated the conditions created by the Asian savings glut.  If anyone is still looking for which country to blame, my understanding of the creation of the imbalances suggests that you can blame almost anyone you like and there is a good chance that you’ll be at least partly right. 

Why does this matter? 

The issue of what drove what is not simply of academic interest.  The consequences for the world of a system in which imbalances were driven by a sudden and self-perpetuating explosion in US consumption, which then forced higher savings onto Asian countries, are very different from a system in which imbalances were driven by a sudden and self-perpetuating increase in Asian savings, which then forced higher consumption onto non-Asian countries.   

Deciding whether or not the savings glut hypothesis is correct is important not just because it allows us finally to decide which country really is the evil predator, the US or China.  It matters for a very different reason. 

If it was an explosion in US consumption which drove the global imbalances, then we are likely to see a fairly benign resolution to the crisis for everyone, except maybe the US.  After all in that case the imbalances were driven by US consumption excesses, and since those excesses are, like it or not, going to be resolved by the need for US households to repair their badly-damaged balance sheets, the imbalances too will be resolved, and in a way that is mostly benign for everyone except recovering US households.  This process may be postponed by current US fiscal policy, and especially by recent policies that subsidize consumption, but it will only be postponed, not derailed. 

And just as Americans can no longer binge consume, their binge consumption will no longer force Asians to save such a high and rising portion of their income.  Asian growth, and especially Chinese growth, will be much more balanced. 

But if the global imbalances were driven by a surge in Asian savings, Asian and Chinese growth will still rebalance, but the rebalancing will be much more difficult.  Why?  Because too-high Asian savings, caused in large part by post 1997 policies that encouraged differential growth between consumption and production (as I discuss here, for example), have until now been matched by too-low US savings rates.  As long as the two imbalances balanced, the world economy could continue functioning without too much distortion. 

But now if we can expect net savings in the US (and perhaps in many other parts off the world) to rise, we need to see a rapid change in those policies that encouraged too-high Asian, and especially Chinese savings.  In that light there was an interesting and worrying OpEd article in today’s Financial Times by the Peterson Institute’s Fred Bergsten and Arvind Subramanian: 

The Obama administration is increasingly signalling that the US will not continue to be the world’s consumer and importer of last resort. The clearest statements came last month from Larry Summers , White House economics director, in a speech at the Peterson Institute for International Economics and in an interview with the Financial Times. The US, he said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth. 

If the US really is serious about this shift towards higher savings, and if the primary source of the imbalance was the Asian savings glut, and not an original US consumption “glut”, this means that in the future US policies will be in direct conflict with still-current Asian policies, and unless the US is unable to accomplish these goals, Asian countries will need to force through an adjustment in their development policies as quickly as possibly.  Asian and especially Chinese officials have acknowledged the need to increase consumption more quickly. 

But for now this adjustment in policies that encouraged too-high Asian, and especially Chinese, savings does not seem to be happening.  “The optimal choice is to expand household consumption,” PBoC governor Zhou Xiaochuan said in a speech last month.  ”That is, however, easier said than done. While the current income structure cannot be dramatically changed in the short term, the second-best choice is to maintain and expand investments.”  He is almost certainly right, at least except for his last statement. 

In fact as I have argued many times (for example here, and here), I suspect that most of the Chinese fiscal stimulus is exacerbating the imbalances – both by boosting current and future production and by creating conditions that will constrain future consumption growth.   

In that case there has been no significant rebalancing yet towards more rapid consumption growth taking a greater share of Chinese production – just a frenzied attempt to keep current growth rates high by boosting investment, which will almost certainly lead to capital misallocation and rising non-performing loans, and clearly unsustainable attempts by the Chinese government artificially (and unsustainably) to boost short-term consumption by subsidizing it heavily with government debt (something the US seems to have been doing too) which has the effective consequence of reclassifying fiscal expenditures as household consumption. 

The end result?  Planned increases in investment in China eventually become forced increases in investment – rising inventory – that ultimately must lead either to writing inventory off or closing down production facilities in the future.  This is, by the way, just another way of stating the excess capacity problem.  

Perhaps what we need is a real return to Confucian roots.  I recently read this quote from Lao-Tzu: “The sage does not hoard. Having bestowed all he has on others, he has yet more. Having given all he has to others, he is richer still.” 

Tags: Bibow

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.

By coincidence I had two OpEd pieces that came out last week, one in the WSJ and the other in the Financial Times.  The latter came about because about a month ago Martin Wolf asked me to write a piece based on my June 20 entry.  The former came about on the previous Friday when I was thinking about last week’s SED meeting and why I wasn’t expecting much to come from it.  Although they are very different pieces, both of them build on this idea that the inversion of the consumption/GDP growth relationship in the US has important implications for China’s future GDP growth. 

For the WSJ piece I start by pointing out that when the Japanese and German currencies soared in value against the dollar after the Plaza Accords were signed in September 1985, many analysts thought that at long last their trade surpluses with the US would decline.  They were partly right in the sense that the German trade surplus with the US did indeed decline.  But in spite of the fact that the value of the yen doubled, Japan’s trade surplus nonetheless surged. 

I don’t think this should have come as a surprise.  There is a tendency to think that the value of the currency and the level of import and export tariffs are the main policy tools affecting the trade balance, and so absent a change in tariffs, any increase in the value of a country’s currency will automatically lead to a decline in its trade surplus.   

Trade surplus

In fact the trade surplus reflects the gap between what a country produces and what it consumes, and so anything that affects that gap is implicitly a trade policy.  I discussed this in some depth in my June 3rd entry. 

In the case of Japan in the post-Plaza Accords environment, the Ministry of Finance and the Bank of Japan responded to the currency agreement by directing a flood of low-interest credit into the manufacturing sector while informally guaranteeing borrowers, so assuring lenders that profitability was irrelevant in determining the flow of credit.  Sound familiar?  As a consequence Japanese manufacturers increased their production even as the flow of funding into the manufacturing sector and traditional constraints on household consumption forced an increase in the gap between Japanese production and Japanese consumption.  The result: a rising trade surplus.   

By the way I have been reading Akio Mikuni and R. Taggart Murphy’s Japan’s Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance, an interesting book that covers a lot of this ground.  I recommend it to China watchers, although I am no expert on Japan and I did have a big problem with the often-repeated assertion (and one that often pops up in discussions about China) that because Japanese trade was not denominated in yen the Bank of Japan was forced to accumulate dollars.  In fact it doesn’t matter what currency your trade is denominated in – if you run a net current and capital account surplus, your central bank must accumulate foreign currency.  Had trade been denominated in yen foreign buyers would still have had to convert dollars to yen with the Bank of Japan in order to make their purchases. 

But that is a digression, and aside from a few irrelevant disagreements I think the book is quite illuminating.  In China, like in Japan during the 1980s, there are a number of factors besides the value of the currency that affect the country’s trade account, and even if the value of the Chinese yuan rises, it will not automatically lead to a decline in China’s trade surplus commensurate with the contraction in global trade, especially if it is matched by a significant credit expansion to the manufacturing sector. 

Several policies are aimed at boosting production besides the undervalued currency.  As I have discussed before, these include very low lending rates enforced by the People’s Bank of China, energy and commodity subsidies, and probably most importantly, a flood of credit aimed at investment both in infrastructure and in the manufacturing sector.  At the same time very low deposit rates, constraints on consumer financing, and low wages, among other factors, prevent consumption from growing at nearly the pace necessary to absorb everything that China produces.   

As an aside MacQuarie’s Paul Cavey has a very interesting OpEd piece in last week’s Wall Street Journal, based on a longer research piece which I am not able to link.  Among other things he argues that although China has run negative interest rates for much of recent history, until last year there was no credit bubble because credit was rationed – and credit rationing implicitly raises the cost of capital for the system, even if interest rates are nominally low.  Recent conditions, however, are different, and all rationing has disappeared with the explosion in credit of the past eight months.  Cavey concludes: 

It’s not impossible for Beijing to take away the punch bowl of credit. There is plenty of room to defy the skeptics and in the next few months and push through structural reforms. For instance, some of the privileges state-owned enterprises continue to enjoy in terms of the ability to provide domestic services like banking and telecoms could be dismantled, allowing the country’s more productive private sector to thrive in local markets rather than just overseas. But without such changes China will be relying on growth financed by cheap domestic debt. This means China will be decoupling itself from the U.S. consumer, but at the cost of a credit bubble. 

China’s consumption will rise 

So to return to the main story, with the credit expansion and other measures aimed at boosting production, will China’s trade surplus soar?  Probably not.  Every trade surplus requires a trade deficit elsewhere, and as the leading trade deficit country, policies in the US that affect the gap between consumption and production will also determine the size of the US trade deficit.  If the Obama administration is successful in forcing a rise in US savings levels, and even if it is not (since in the short term US households have no choice but to increase their savings rates), US consumption must grow more slowly than US production and the US trade deficit will narrow, except in the very unlikely case that US investment soars – investment would have to grow faster than savings to keep the trade deficit from contracting. 

For China this almost certainly forces the country into either of these two outcomes  

1.  The government continues the current fiscal expansion forever, in which a huge expansion in government-led investment pushes growth forward.   

2.  The consumption rate in China must rise as a share of GDP. 

There are at least three problems with the first option.  First, a significant portion of the fiscal stimulus (and almost certainly a higher share than reported) is directed into manufacturing in the tradable goods sector, which needs anyway to be absorbed by rising consumption, either in China or globally.  Second, given the inefficiency of the current fiscal and credit expansion, and the concomitant rapidly rising direct and contingent government debt, there is a real question as to whether this program can be sustained for more than one or two years.   

And third, and this seems to be the most confusing point for some, the economic purpose of investment is to increase future production, and even if the fiscal stimulus turns out to be hugely efficient (it isn’t), without a surge in future domestic consumption to absorb the additional Chinese capacity we will still be stuck with the need for a massive return to US profligacy, and Chinese funding of that profligacy, to absorb the increased production.  

The first option, in other words, is at best possible for a very short time, and ultimately we are forced into the second option: Chinese consumption must rise as a share of GDP, or to put it another way, Chinese GDP must grow more slowly than consumption.   

So why should the US care what China does to rebalance its trade if changes in US consumption will force a rebalancing anyway?  Isn’t discussion and coordination pretty much unnecessary if a rising savings rate in the US must ultimately force an adjustment on China?   

No.  US and Chinese policies matter because there are many ways that international trade can rebalance.  In the US we will see consumption grow more slowly that production, just as in China we will see consumption growth outpace production growth.   

Both will happen, but in both countries there is a good scenario and a bad scenario.  The good scenario for the US would see some growth in consumption buttressing healthier GDP growth.  But the bad scenario would involve a contraction in GDP driven by even faster contraction in consumption.  For China a good scenario would involve surging consumption driving slightly slower GDP growth, and a bad scenario would consist of slow consumption growth dragging down GDP growth.   

If China continues to pump out capacity and tries to export this excess abroad, and if US household savings rise much more quickly than US fiscal dis-saving (borrowing), we will almost certainly see the bad case scenario occur, at least in China, and especially if it leads to trade friction around the world.  The nightmare scenario is that in the US a still-high trade deficit prevents a slowdown in consumption from nonetheless causing a sharp slowdown in economic growth, which leads to rising unemployment, which causes consumption to slow down even further.  Meanwhile in China rising inventories eventually lead to cutbacks in production, which also lead to rising unemployment. 

As fewer Chinese get jobs, the unemployed consume less, and the employed also try to increase their savings because of rising uncertainty.  Since net Chinese savings must decline if net US savings rise (note I am assuming the rest of the world, including sustained investment levels, is constant, but I suspect the impact of the rest of the world will actually be adverse), the only way for this to happen if the Chinese savings rates rises is either for a burst of inefficient and unsustainable debt-fueled investment by the government, or for GDP growth actually to slow sharply. 

I know all this sounds drastic, but the imbalances have to be worked out one way or the other.  Rising savings in one part of the world, even assuming no changein global investment, requires declining savings somewhere else, and although it may be unrealistic to expect no change in global investment, the plausible prediction is that global investment will actually decline, which increases the pressure.  This is just another way of saying that changes in trade deficits in one part of the world require equal changes in trade surpluses elsewhere.  This is also just the obverse of saying that declining consumption in one part of the world requires rising consumption elsewhere (or sharply rising investment, which since it represents future production only postpones the need for consumption growth) or else global GDP must contract. 

Uncoordinated policies 

What will determine whether or not the two countries follow the good scenario or the bad scenario?  Clearly fiscal and monetary policies in both countries will matter because they will set the speed of the adjustment and they may or may not speed up the adjustment process. 

In the US, fiscal expansion is aimed primarily at slowing the pace of demand contraction.  This may be necessary since I expect US consumption will grow slower than US GDP for many years, but it comes at the expense of a rising fiscal debt.  I am not as worried as many others seem to be about US fiscal indebtedness and I am certainly not worried about the ability of the US to fund its debt, especially since the stock of debt in the US is declining (private debt is dropping faster than public is rising).  As I have argued many times, I also think all the fear-mongering about whether or not China and other foreigners will continue to fund the US fiscal deficit is totally muddled thinking and among the least important things to worry about.  Foreigners will and must fund the US current account deficit, and the bigger the deficit the more they will fund – so really we actually want foreigner to reduce their funding.  

But there are reasonable limits to how much debt we want to see in the US, and we certainly don’t want to see a continuation of the global imbalances in which the debt-fueled consumption binge of US households is simply replaced by the a debt-fueled consumption binge by the US government, especially since as long as the trade deficit is high a large part of the job-creating aspect of US fiscal deficits will leak abroad, requiring even larger US fiscal deficits.  In addition, the US fiscal program should be accompanied by specific measures aimed at increasing US household savings – I am not able here to go into much detail on how to do this (and I am no expert on the subject), but for example perhaps we can eliminate taxes on interest income, raise consumption or gasoline taxes, and so on. 

Of course forcing an increase in US savings means improving the long-term US outlook while hurting short-term prospects for employment.  Rising US savings means declining consumption growth, and remember that US GDP growth will be less than growth in US demand for the next few years as US debt levels decline.   

I think China will face an even more drastic version of this trade-off, and this is because, as I have been arguing for two years, contractions in global demand force the most difficult adjustments not on the “sinful” low-savings trade-deficit countries but rather on the “virtuous” high-savings trade-surplus countries.  China needs to cut capacity drastically and put into place the factors that will lead to a rise in net consumption, but most of these policies will actually hurt employment in the short term.  I have already discussed what these policies are likely to be in my June 3rd entry, and almost all of them will almost by definition force a contraction in the tradable goods sector. 

China’s problems will be made much worse if it is forced to cut capacity very quickly, which will happen if trade disputes get worse.  Already disputes with Asian neighbors are pretty nasty, and they are likely to get worse with the US and Europe.  There has been a lot of discussion recently about China turning to other developing countries as sources of net demand to replace the US, but this is unlikely.  Aside from the fact that no one is large enough, none has the ability to run persistent trade deficits.  China can fund these deficits for a while, but it will learn, as many have before it, that funding persistent current account deficits for developing countries eventually leads to defaults on the debt. 

So after all the premable on what do I think the SED discussions should focus?  Since this entry is long enough already I will postpone that part of my discussion for a couple of days. 

One of the reasons why trade-related discussions can seem so off-the-mark, I think, is because the conditions governing international trade are much more complex than we often realize. The determinants of the international balance of trade basically include anything that affects domestic consumption and domestic production, which pretty much means nearly everything in economics. Among other things this means that there is a very wide range of government policies that can affect trade – sometimes explicitly and sometimes implicitly.

Unfortunately much of the analysis and debate doesn’t seem to get this. For example, many economists have pointed out that the bailout of GM is effectively a protectionist measure. I think it clearly has a trade impact, and this impact is “protectionist”, although not intended that way. What is missing from the discussion, I think, is a clear explanation of why it is effectively a protectionist measure. I would argue that the GM bailout has a trade impact because it affects in specific ways the balance between production and consumption in the US (and, of course, elsewhere), and since the US trade deficit is also the gap between US consumption and US production, to the extent that the bailout affects this gap it must affect the US trade balance.

In that case we can posit at least two obvious ways in which the bailout affects the gap. First, by effectively subsidizing the cost of producing GM cars, it increases automobile production in the US. Second, by allowing GM to retain the workers it would have otherwise fired, it increases consumption in the US by the amount which the retained GM workers spend on consumption, i.e. some large fraction (depending on their savings rate) of their wages. At first I was going to suggest that the relevant number was actually not their wages but the difference between their wages and their welfare payments, since most of the workers would presumably continue to earn some money after they were fired, but then it occurred to me that their welfare payments would have reduced other government spending, so perhaps it is not relevant (this is a subject of much disagreement between Keynesians and monetarists).

Since the GM bailout almost certainly increases production by more than it increases consumption, its direct impact is to reduce the US trade deficit (although to be complete we would also need to consider how the GM bailout affects GM’s competitors, many of whom produce cars in the US). However there are of course secondary impacts, the most important of which is the funding of the bailout. If funding the money used to bail out GM ended up crowding out investment in other production facilities, then the question becomes whether or not those other production facilities would have involved a more productive use of the money and, therefore, had a better impact, either in the short term or in the long-term on total US production. This is also part of the debate between Keynesians and monetarists.

So because we typically think of the currency and tariff policies as the main tools to affect trade – which usually means to boost net exports – much of the discussion surrounding trade policies tends to be limited to these two issues (although when the subject of “dumping” comes up the discussion becomes a lot more sophisticated). This leads to strange arguments. For example when I talk about an increase in trade frictions leading to an increase in trade protection, I am often countered by the argument that the WTO makes tariffs very difficult so that protection becomes almost impossible. This is manifestly not true, but more on that later. These, at any rate, are the two best-known trade-related policies:

¨ Currency policies, whose first-order impact is to determine the relative pricing of imports and exports, but there are also a series of second-order impacts that can be very important.

¨ Tariffs, especially import tariffs, whose first-order impact also determines the relative pricing of traded goods, usually imports.

To repeat, any policy that affects the relationship between production and consumption must affect the trade balance because the excess of production over consumption is the trade surplus (or deficit, of course, if consumption exceeds production). So currency policies affect the trade balance primarily by their impacts on diverting production and consumption. A country, for example, that devalues its currency, raises the cost of imported goods and so reduces the real value of wages. This of course usually causes total consumption to decline. At the same time it allows local producers who compete with imports, who might not have been as cost effective as foreigners at the previous exchange rate, to begin producing more goods for sale to the domestic market. The combination of reducing domestic consumption somewhat and increasing domestic production means that the trade deficit will decline or the trade surplus increase.

One thing that economists always point out, and contrary to the mercantilist view, is that this increases domestic employment, but it doesn’t necessarily improve local welfare. Remember that by devaluing its currency, a country is worsening the terms of trade for its own products – it must now produce more stuff locally for export to pay for the same amount of imports. It also results in a net reduction in total consumption. Currency policies often involve a tradeoff between employment and total welfare in the short term. Over the long term it is not always clear that this is true, however.

Trade tariffs work in very much the same way. Devaluing the currency by 10%, for example, has the same impact as putting a 10% subsidy, or negative tariff, on exports (the government pays exporters an amount equal to 10% of the value of their exports) and a 9.1% tariff on imports.

But, as I hope these examples show, it is not just tariff and currency policies that affect the trade balance. Anything that affects the gap between consumption and production also affects the balance of trade. These include:

¨ Corporate and personal income taxes. Personal income taxes reduce consumption by reducing disposable income. Corporate income taxes reduce production by raising costs for producers.

¨ Sales and other taxes. Depending on their impact they can also affect trade. The most obvious case is a sales tax which, by raising the cost of goods, reduces real wages and so reduces consumption.

The impact of taxes on trade are complicated by the fact that taxes represent a transfer of resources, so to understand fully their impact we also need to know what the government does with new tax revenues or how it finances reduced tax revenues. These can enhance or reduce either consumption or production.  So, for example, if the government put into a place a sales tax (which reduces consumption) and used the proceeds to reduce corporate taxes (which increases production), it could cause a large positive move in the trade balance (and by positive I mean an increase in net exports).

There are a lot of other factors that impact trade, and I have randomly included the following, which I think are especially important, at least in China. Others can and will have others to add or may dispute some of my arguments.

¨ The level of worker’s wages. They impact trade in two ways – by affecting consumption via affecting the purchasing power of households, and by affecting production via the cost to businesses of labor, and they tend to work in the same way as far as the trade balance is concerned. Lowering wages reduces consumption and increase production, so as to have a positive impact on the trade balance. Needless to say many economists have pointed out that low wages in China are one of the reasons for the high trade surplus.

¨ Unemployment benefits. Unemployment benefits tend to cause consumption to decline more slowly than production when factories close, for obvious reasons, although of course we need to take into account how these benefits are funded. I would guess that when a country’s workers do not receive unemployment benefits, it tends to be “positive” for the trade balance.

¨ Subsidized costs to producers – electricity, oil, commodities, etc. Subsidizing the cost of production is a very effective way to increase exports since it directly increases production by increasing the returns to producers. It also has an impact, albeit usually much smaller, on increasing consumption via its impact on employment. Since these subsidies are financed by taxes, subsidies may also constrain consumption somewhat, depending on the nature of the taxes used to fund subsidies.

¨ Subsidized costs to consumers. This boosts consumption, of course, although with the same caveat as above – its net effect depends on how the subsidies are financed.

¨ Corporate lending rates. This should be included in “subsidized costs to producers” but I put it in a separate category because it is a very important type of subsidy, especially in China. Low interest rates for manufacturers of course make it much easier to borrow money to fund otherwise unprofitable production facilities, thereby increasing production (and increasing consumption somewhat by its impact on employment). If the lending is directed at non-manufacturing activities, such as to the service sector, it will not spur manufacturing production but will still increase consumption. As an aside, in my May 20 entry I discuss an HKMA study that argues that in China 100% of SOE profitability can be explained by interest subsidies which, I argue, actually understate the true value of those subsidies, suggesting that many SOEs would actually be value destroyers if it were not for subsidized financing. This is a very important reason for the Chinese trade surplus, in my opinion.

¨ Deposit rates. In last week’s entry this claim generated a certain amount of controversy in the comments section, but it is widely believed that in some countries, like China, reducing deposit rates causes savings to increase and consumption to decline. I discuss some possible reasons in my November 27 entry, the most important of which is probably that in high savings countries in which most savings are in the form of bank deposits, the interest earned on banking deposits is a significant fraction of total disposable income, and lowering deposit rates has an effect similar to lowering wages. Of course if this is true, low deposit rates are likely to reduce consumption, just as low lending rates to producers are likely to increase production. They may also increase production by reducing the opportunity cost for corporations of investing retained earnings.

¨ Other credit intervention – lending guarantees, directed lending, forbearance on addressing NPLs, etc. This is fairly complex since there are many ways to intervene in credit, but any policy which increases the provision of credit to manufacturers must increase production directly. It increases consumption somewhat too, as in the two previous cases, by creating employment and thus raising the total amount of wages paid. If the lending policy increases credit provision to consumers or the non-manufacturing sector, it increases consumption directly. Credit for infrastructure investment is a little more complex since it probably increases consumption today and production tomorrow.

¨ Special mention: cleaning up NPLs. This really belongs in the category above but in the case of China it deserves its own entry. There are two ways to recapitalize banks suffering from a surge in NPLs. One way is to recapitalize them directly. When the government does this is simply transfers money to the banks, as China did before the IPOs of the major banks. Depending on how these transfers are funded, they can have a variety of effects on production and consumption. The second way is to guarantee banking profitability by keeping a wide spread between lending and deposit rates. Policymakers may also keep lending rates very low in order to slow the accumulation of NPLs and make it easier for marginal borrowers to survive. As I discuss above, this can result in very low deposit rates, which constrains consumption, and very low lending rates, which increases production.

I focus a lot on various financial sector issues because it seems to me that it is through the banking system that policymakers can have their largest impact on the trade balance. By keeping rates excessively low (and remember that almost all interest rates in China are either fully controlled and set by the PBoC or very heavily affected by the controlled interest rates), policymakers can boost production and constrain consumption quite easily.

When production grows faster than consumption this necessarily forces an increase in the savings rates – which ties this entry into my previous entry. And of course by controlling the direction of credit, either directly or indirectly by implicit or explicit government guarantees, the government has a major say in the total amount of production. It is probably not a coincidence that in the countries that followed export-oriented growth policies, the so called Asian development model, interest rates and credit tended to be highly controlled either directly or indirectly by the government and regulators. These countries have all had “surprisingly” low interest rates and banking systems that channeled funding mostly into the manufacturing sector (when those countries had large informal banking sectors, as does China, the rates there tended to be much, much higher, suggesting that the controlled interest rates were far from an “equilibrium” level). I would argue that a controlled banking sector is a very important tool for trade policy.

Another one of the issues that this opens up is the distinction I have made many times between total consumption and net consumption. Notice that many policies increase both production and consumption. They usually do the latter by increasing employment. In many cases Chinese policies have been successful in boosting consumption in just this way. Since the world manifestly needs more consumption, as US household consumption declines precipitously, anything that boosts Chinese consumption should be a good thing, right?

Maybe not. What the world needs from China is not an increase in total consumption but rather an increase in net consumption – i.e. the excess of new consumption over new production – that is roughly in line with the decline in US net consumption. If consumption grows, but production grows just as fast, or even faster (and we can tell by looking at the trade balance corrected for various pricing effects and one-off purchases or sales), then the world imbalance is getting worse and the overcapacity problem will not have been addressed.

This means that many policies that may seem on the surface to be purely domestic policies are actually trade policies too, and legitimately subject to scrutiny and even criticism from abroad. This is clear from the GM bailout. I don’t believe that Congressmen agreed to the bailout because they wanted to engage in protectionist behavior. They did so because they wanted to protect American jobs, but they did so in a way that almost inevitably has a trade impact. The same thing is happening in China, but there is a real reluctance to consider that policies aimed, for example, at limiting unemployment among aluminum plant workers in Hunan (or is it Henan?) are not just internal matters but also international trade policies.

Demographic causes

• Declining dependency ratios, especially via decline in the number of young people. From the mid-1970s to roughly the middle of the next decade we know that China’s dependency ratio has contracted sharply. A much larger share of the population is of working age today than thirty years ago. Besides being a great source of rapid growth, I think this fact creates a bias towards savings since I think of working population as a proxy for production and total population as a proxy for consumption. This means that with China’s working population growing so much faster than total population (a process which will be reversed over the next three or four decades) Chinese production has grown much faster than Chinese consumption. The difference, of course, is the savings rate.

Structural causes

• Lack of social safety net. With a risky health care system, no social safety net, and limited ability to borrow, Chinese households have to self-insure. This means they save on average much more than they need on average to cover these costs.
• Rapid growth in wealth. When per capita wealth grows very quickly, it may take a while for people to change their consumption behavior as quickly, so growth in consumption lags growth in wealth. Of course the difference between the two is the rising savings rate.
• The generation of “little emperors.” I have heard not-always-satisfactory arguments that households save a huge amount because of the one-child policy — they are essentially spoiled, the argument goes, and parents will sharply limit their own consumption in order to provide everything for their only child. I am ambivalent about this explanation, but I do think the maturing of the one-child generations may have an impact on future savings. They are much more likely, it seems to me, to spend money on themselves, although this argument may be a little too glib.
• Lack of consumer credit. Without easy availability of consumer credit, households who want to borrow to purchase big-ticket items have little choice but to save today for a future purchases.

• Low exchange rates. The reasoning and causality are unclear, but there is evidence that countries with artificially low exchange rates tend to have high savings rates, perhaps because low exchange rates reduce real wages.
• Low interest rates. We also have a lot of evidence that low interest rates create higher savings rates in countries like China. This claim generates a lot of confusion, and I am often asked how this can possibly be true when the opposite is true in the West. My guess is that it occurs because of both portfolio effects and income effects. For the former, because Chinese don’t save in the form of stocks, bonds and real state, but rather in the form of bank deposits, declining interest rates do not increase the value of their savings portfolio, but actually reduces it. This is why reducing interest rates causes savings in the West to decline (Westerners feel richer) whereas it causes savings to increase in China (Chinese feel poorer). For the latter effects, with interest income such a large part of total income, low interest rates are similar to low wage rates in their impact on consumption.
• Policies aimed at running trade surpluses. This is generally a catch-all and must be true by definition. A trade surplus occurs when production exceeds consumption, so any policy aimed at growing production faster than consumption is also implicitly aimed at raising the savings share of income.
• Policies aimed at running fiscal surpluses. Of course this contributes by creating government savings.
• Policies aimed at forcing profitability in SOEs via interest rates and other policies. Another catch-all for policies that drive up corporate savings.

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Things have been so busy this past week with various writing commitments and with the celebration of the third anniversary of my music club (four amazing shows with some of Beijing’s greatest artists and a lot of support and coverage from local music scene participants an the press) that I have been neglecting my blog. For today’s entry I don’t have any major points to make but I did want to take a look at some of the anecdotal information we are getting about the bank-part of the fiscal stimulus package.

The context is last week’s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP. However if the current loan explosion is mismanaged, this may itself sharply constrain Chinese consumption growth, thus locking China into a long transition period of turgid growth.

In that light two weeks ago The Economic Observer, one of the better local newspapers, had an interesting article titled “Millions of Small Businesses Still Starved of Credit”. The growth of smaller businesses, many of which are in the service industry, is one important way for Chinese net consumption to grow, but it seems that their ability to obtain financing is being sharply limited by formal or informal policies that are driving capital into the investment sector. The article suggested that even with the explosive loan growth in the banking system, smaller companies are finding it extremely difficult to get loans.

New loans in China for the first quarter of this year would amount to nearly 4.6 trillion yuan, but behind the staggering figure, millions of small and medium-sized businesses nationwide were still struggling to raise funds.

Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.

The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:

The Chinese government has recently pushed measures to solve financing problems for small and medium-sized businesses – for example, China’s Banking Regulatory Commission has required banks to open loan departments exclusively for small companies. But Chen said it was hard to tell how effective these measures would be: “What we can see clearly now from the statistics is that loans for small and medium-sized businesses are still dropping.”

It would be normally be surprising that loans are expanding so rapidly (we have already increased net new lending in the first quarter of 2009 by more than all of last year’s loan increase) while whole sectors of the economy are struggling to find financing, but my friend Dan Rosen sent me a Bloomberg article from Friday with a line which he found very funny and a tad startling. According to the article:

The largest borrower in the quarter was government-owned China Aviation Industry Corp., or AVIC, the nation’s biggest aerospace company. The Beijing-based company received 236 billion yuan from 11 Chinese banks, including ICBC, China Construction and Bank of China. It won another 100 billion yuan of credit from Export-Import Bank of China on April 16, without specifying how the money will be used.

AVIC General Manager Lin Zuoming said in an April 16 interview with Beijing-based newspaper Economic Observer that his biggest worry is how to allocate the borrowings to increase returns.

It’s the last line, of course, which Dan marked out. The largest single borrower, it turns out, has taken out around $35 billion in loans but doesn’t seem terribly certain about why he borrowed the money. I don’t want to read too much into a single throwaway line, but it is certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money. Of course it helps that managers aren’t terribly concerned about creating value for their shareholders, but this is almost certainly a recipe for future growth in NPLs.

Obviously I (along with most of the readers of my blog) am not the only ones to realize this. Friday’s South China Morning Post had this to say:

Citic Bank Corp, the country’s seventh-largest lender, is optimistic about this year’s earnings outlook and is reining in loan growth to safeguard against a rise in bad loans. Chief executive Chen Xiaoxian said the bank would adopt stricter loan checks and had sent inspectors to those branches that had recorded a surge in discounted bill financing in the first quarter. “Banks need to take more forceful actions to increase risk controls,” he told reporters.

The article goes on to say:

Total lending by mainland banks in the first quarter reached a record 4.58 trillion yuan, close to the government’s minimum target for the whole year of 5 trillion yuan. Asked about his top concern, Mr Chen said: “Of course, it is asset quality given such fast loan growth.”

Mr Chen called the surge unsustainable. He did not disclose how much Citic Bank had lent in the first three months, but he said the pace would slow. “No matter how complicated your businesses are, you must clearly know the default rate,” he said of lessons learned from the global financial crisis.

Of course Mr. Chen is right. The current rate of loan growth is unsustainable and the biggest concern must be the risk of a sharp rise in NPLs. One would expect that all of this would quickly cause the PBoC to put the brakes on lending. The always intelligent Jim Walker of Asianomics thinks this will happen, but is nonetheless so worried about continued loan expansion he asks in an April 14 report:

Exactly why is this process dangerous?

First of all, China has an extremely high M2 to GDP ratio to begin with. As Figure 2 shows, M2 in 2008 already represented 158% of GDP. Compare this with money conditions in the US where M2 accounts for just 54% of GDP (the US ratio is read off the left-hand scale). If the US’ monetary easing efforts are such that investors are convinced that the dollar is no longer available reserve currency then the conclusion must be the same as regards the renminbi – only much more so. The only reason that the renminbi is not nose-diving in world currency markets is because domestic economic actors are not allowed to sell it.

For Walker, the explosive growth in lending is exacerbating what was already a very big problem, China’s huge bank-funded overinvestment. He goes on:

The second word of warning is that this breakneck monetary expansion will have to cease soon. The PBoC says that it will support economic growth through easy monetary conditions. It has certainly been true to its word so far but the problem will quickly become one of having a ‘tiger by the tail’. In Hayek’s analysis of economic growth he concluded that the only way an economic system hooked on credit could maintain its growth rate was for it to add ever increasing amounts of credit to that already existing. Adding the same amount of credit would result in recession-like conditions.

This, in his view, was the road to hyperinflation. The alternative, putting the brakes on monetary expansion, would lead to economic depression. On the assumption that Beijing will not wish to risk a hyperinflationary outcome we suspect that it will slam the brakes on the banks (which are clearly out of control already) within the next few months, regardless of the comments being made by the PBoC today. The next move in monetary policymaking in China will be to tighten, a move that will be badly received by markets that are already starved off profits.

Perhaps, but most analysts are betting against Walker. Xinxin Li of the Observatory Group points out that Wednesday’s decision by the State Council (effectively the equivalent of the executive cabinet) to reduce the capital ratio requirement for financing capital spending for infrastructure “is a further effort by the central government to implement its massive fiscal stimulus plan, in order to boost investment demand and support economic growth.” In his opinion the current policy environment “makes any hawkish statement from the PBoC politically incorrect. Just a couple of days ago, Vice Premier Li Keqiang said that the global financial crisis is having a deeper impact on the Chinese economy, showing that the top leaders are unlikely to drop their guard on the economic difficulties until Chinese economy firmly is on a recovery track..” In his April 28 report he concludes:

While the PBoC is concerned about the current pace of money expansion, it is unlikely to impose tightening measures to slow lending growth in the near term, due to an unclear economic outlook and the political priority on economic growth. China’s loose monetary conditions will likely persist in Q2.

The problem here is that Jim Walker’s analysis may be right but Xinxin Li’s prediction may also turn out to be right (and I suspect that Li doesn’t necessarily disagree with Walker’s analysis). Just because there is an urgent need for a policy doesn’t mean that it will happen. I remember that in early 2007 I argued aggressively that the PBoC would have to engineer a maxi-revaluation of the RMB because a slow revaluation would create huge hot money problems for the country. Of course the maxi-revaluation didn’t happen, and many of my friends seem to find my very wrong prediction a never-boring topic of conversation, but I defend myself by saying the analysis was correct, the prediction of huge hot money inflows was also correct, and soon enough the warnings about how destabilizing these inflows will be will also turn out to be correct. The global crisis intervened, and we will now see that China’s failure to have adjusted the currency much earlier, as a way of accelerating the transition from export growth to domestic-consumption growth when conditions were so good, will have a very painful cost.

So even if Jim Walker is right in that Beijing has no choice but to slow loan growth, he can still be wrong about assuming that they will. That of course would be the worst possible outcome.

Before ending, I wanted to cite a line from my friend Justin Winkle, who was responding to the comment discussed above that Dan Rosen found funny and startling. I am sure this has absolutely nothing to do with the topic under consideration, but here it is anyway.

My quote of the year is a line from Lewis Carroll appropriated by my stockbroker to describe the global economy: “If you don’t know where you are going, any road will get you there.”

As long as I am doing literary allusions I was just rereading PG Wodehouse’s classic Joy in the Morning, in which Lord Worplesdon explains to Bertie Wooster, in one of their very rare moments of camaraderie, why an American businessman they know seems so easily startled:

“Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.”

“Coffee?”

”That and the New Deal. Over in America, it appears, life for the businessman is one long series of large cups of coffee punctuated with shocks from the New Deal.

I guess you can find economic history in the oddest places.

Tags: Lewis Carroll, PG Wodehouse, SMEs

One of the few areas in which the Chinese fiscal stimulus package is unquestionably having a positive effect is on growth forecasts – although mainly because forecasts seem to be coincident indicators more than leading indicators. In the past couple of week Morgan Stanley raised its 2009 forecast for Chinese GDP growth from 5.5% to 7.0%, while Goldman Sachs upgraded growth forecasts from 6.0% to 8.3%. UBS has raised its forecast from 6.5% to between 7% and 7.5%. RBS has jumped from 5% to 7% and Barclays is up from 6.7% to 7.2%. On the other hand Standard Chartered, worried about the sustainability of the “rebound,” has kept its 2009 GDP growth forecast at 6.8%, and the IMF is still at 6.5%

At any rate I’ve never provided my own forecast of Chinese growth partly because I am not smart enough to come up with an economic forecast and partly because it always seemed to me that in the short-term Chinese growth was going to depend very heavily not on economic conditions but rather on the hard-to-predict outcome of the fierce policy debate taking place in China. As I see it, one side of the debate – which seems to include people around the PBoC and the National Bureau of Statistics, along with many of the more prominent of the think-tank policy critics – is arguing that as difficult as it is, the crisis is a good occasion to force China to change its development model and financial system in a direction that will provide China with a healthier basis for stable, long-term growth. They are eager to see policies aimed at switching resources from production to consumption, even at the expense of a short-term increase in unemployment, and they tend to see the recent surge in credit and investment not as solutions to the crisis but rather as policies that will make things worse for China in the medium term.

On the other hand a different group of policymakers and power brokers – who include, I think, the Ministry of Commerce, the important exporter constituencies, and above all the powerful provincial and municipal leaders – are much more concerned with enacting measures that immediately address the expected rise of unemployment in the short term. These measures include pouring money into investment – mainly into infrastructure and the SOEs – and of course the huge increase in bank lending. They often point out that these policies saved China after the 1997-98 crisis, and so can save China again.

As an aside, and without wanting to take the 1930s analogy too far, this debate in China is a little like the split in the 1930s between the internationalists in the US who favored hard money (incorrectly, I think) and a rapid liquidation of overcapacity (painful but probably correct), and who vehemently opposed measures, including tariffs and competitive devaluations, to boost employment via boosting the export of overcapacity, versus the large and powerful constituencies, dominated by local congressmen, miners, farmers and many industrialists, who stressed immediate moves to weaken the currency, boost production, and resolve US unemployment even at the expense of the global system. In part because the 1929 stock market collapse thoroughly discredited bankers and economists, and in part because politicians are always more likely to be influenced by large domestic constituencies than by internationalists, the latter group pretty resoundingly won the debate, at least in the early part of the crisis, and clearly not to the US’s obvious benefit.

Although the debate is much less transparent in China today than it was in the US in the early 1930s, I think the latter group – the domestic constituency and provincial leaders – is once again winning the debate, at least for now. It is probably no surprise to regular readers of my blog that I largely disagree with this camp, and the main reason I didn’t want to forecast very low 2009 GDP growth numbers with much confidence is because I doubt the former group will win the debate. As I see it, the massive expansion in credit and investment we are experiencing is simply more of the same set of policies that, especially over the past five years, have pushed China ever deeper into the Asian development model, and to the extent that they are successful they will keep pushing China, which I think of as exemplifying the Asian development model on steroids, in the same direction. Beijing, in other words, is increasing the dosage of steroids. (I think I am mixing metaphors all over the place.)

The reason I think this is a mistaken strategy is because I would argue that the Asian development strategy is dead, and over the next three to five years it will become increasingly evident that 2008 was the year it died. I may be wrong, of course because it is doubtful but not inconceivable that the great consumption party in the US can resume for a few more years. It would not be the first time that what seemed like an unstoppable correction in the trade imbalances was interrupted. To a certain extent we already saw a dress rehearsal for this event in the 1987 crash, around which time the US trade deficit, which had risen to around 3.5% of GDP the year before (a level which seemed unimaginably high at the time), began its inexorable reversion, to the point where the US achieved a small surplus in the early 1990s.

The period during and after the 1987 crash more or less marked the end of that stage of the Japanese miracle, although by then Japan was so caught up in the monetary expansion that had begun with the automatic monetizing of its massive trade surplus with the US in the early 1980s, that an internal bubble kept the local party going for another 2-3 years before it, too, finally ended, and ended disastrously – although many people, especially here in China believe, mistakenly in my opinion, that the bubble was set off by the Plaza Accord.

But the Asian development model didn’t really die then (although the temporary shift in US consumption may have created the serious dislocations that helped lead to the 1997 crisis). At the time the US was itself caught up in great productivity and liquidity growth cycles that kept the model alive by causing a surge in US growth and, later, an even more rapid surge in US consumption.

The rise of US savings

What does the structure of US growth have to do with the Asian development model? As I see it the Asian development model involves polices that aim directly or indirectly at boosting savings and channeling huge amounts of subsidized resources (usually subsidized by savers, and so constraining consumption) into investment and manufacturing capacity. Some people call this mercantilism, and in many ways it does correspond to certain classic mercantilist policies, but I am wary of defining it this way because “mercantilism” is such a loaded word.

At any rate because the combination of consumer constraint and producer subsidy meant that growth in production was likely seriously to outstrip growth in consumption, the Asian development model necessarily involved generating large and consistent trade surpluses – either Asian countries exported the difference between consumption and production or they would have been forced to run up ever increasing inventory. Of course for small countries, running trade surpluses didn’t matter too much – and it made sense to have a strong external outlook because domestic markets weren’t big enough to create the necessary efficiencies and economies of scale to justify the huge investment, and their individual trade surpluses were easily buried within overall global trade.

In other words for small countries the need to export is not likely to be a constraint since they can always generate trade surpluses without creating significant global trade distortions. But when large countries, or a large grouping of countries, have policies aimed at generating trade surpluses they run into a very strict constraint – that some country or group of countries must be capable and willing to run large corresponding trade deficits. Without this willingness to run trade deficits, the Asian development model must inevitably run into brutal 19th-Century-style cycles of rapid production growth leading to overinvestment crises.

This is the main vulnerability of the Asian development model – its dependence on an importer of last resort. We don’t often think of this as a weakness because for so long the US was seen as the automatic importer of last resort, so much so that we didn’t even consider it a constraint. But we may have gotten lazy in our thinking. Many people who should know better simply write off US consuming habits as something endemic to American culture, and we just assume it as a universal constant, but in fact US consumption levels, like those of every other country, respond to changes in conditions, and these are about to change.

There are at least two reasons for the change. The first has to do with specific policy initiatives, and the second with changes in underlying economic conditions, especially household balance sheets. To address the first, I will refer to President Obama’s economic speech last week when he said: “We must lay a new foundation for growth and prosperity — a foundation that will move us from an era of borrow and spend to one where we save and invest, where we consume less at home and send more exports abroad.”

A New York Times editorial draws from Obama’s speech at least one important implication for the future growth of China and Asia:

In a series of comments in recent weeks, Mr. Obama has begun to sketch a vision of where he would like to drive the economy once this crisis is past. His goals include diminishing the consumerism that has long been the main source of growth in the United States, and encouraging more savings and investment. He would redistribute wealth toward the middle class and make the rest of the world less dependent on the American market for its prosperity. And he would seek a consensus recognizing that an activist government is an acceptable and necessary partner for a stable, market-based economy.

…Embedded in that approach is a far-reaching implication: that the rest of the world should no longer count on the United States to snap up imported goods or run up large trade deficits. It is by no means clear that Mr. Obama has the policy tools needed to bring about that kind of change; we are, after all, fundamentally a consumer society. His advisers point to his support for innovative ways of increasing personal savings.

We should never underestimate the immense flexibility of the US and its ability to restructure itself at a pace far faster than most other countries can manage (anyone who grew up in the dismal 1970s will remember the dramatic – and seemingly improbable – US economic transformation of the 1980s), and if the Obama administration is serious about creating conditions for an increase in US savings, it probably wouldn’t be a good idea to bet heavily against success..

Negative US consumption growth?

More importantly, during the past decade while the US was growing rapidly, the US trade deficit surged from just over 1% of GDP to over 7% of GDP. When consumption growth exceeds GDP growth, which must happen when the trade deficit is growing, it necessarily implies a build-up of debt, and sure enough, debt levels in the US surged while savings collapsed to zero and the trade deficit grew rapidly.

Those days are almost certainly over. Even without Obama’s desire to create conditions for an increase in US saving rates, US households have to increase their savings and rebuild their balance sheet, which means that we have several years ahead of us of deleveraging and increased savings. It also means we have several years ahead of US consumption growing more slowly than US GDP. I don’t think anyone is expecting much net growth in US GDP for the next three or four years, and so it is not at all implausible that we will see negative growth in US consumption and, as a consequence, a collapse in the US trade deficit, which may even turn into a trade surplus. The pace of this transition will largely depend on US fiscal policies aimed at slowing, but not eliminating, the contraction in demand.

If the US is no longer the importer of last resort, and if no one else can replace the US in that role in the medium term (I stress medium term because in the long term the demographic changes in Europe and Japan – and China for that matter – may well result in rising trade deficits in those countries), then any development model that necessarily results in production growth exceeding consumption growth – high savings development models, in other words – will run into the trade deficit constraint. They must run surpluses to grow, but if no one else runs sufficiently large deficits, they simply cannot run those surpluses.

This is what I mean about the “death” of the Asian development model. The not-so-hidden but also not-always-explicit assumption behind Chinese growth – with China, as I wrote earlier, representing the Asian development model on steroids – is that large and growing US trade deficits were vital to its success. But if the US is now entering a period of contracting deficits, the model is dead.

This is why I am worried about recent fiscal and credit policies. It is not just that these policies are slowing down the rate at which China will adapt to the new world of lower US trade deficits. More importantly perhaps is that the only obvious replacement for US demand – domestic Chinese demand – will itself be sharply constrained by current policies, especially credit policies.

Why? Among other things because if the explosion in new lending (loans are up 15% in the first quarter of this year) leads, as it almost certainly will, to a subsequent explosion in non-performing loans, in the next few years just as China is expanding its production and struggling with US reluctance to absorb its rising excess capacity, the resolution of the NPLs will itself constrain Chinese consumption. Resolving future NPLs, in other words, will reduce future domestic consumption growth in China, just as the current resolution in the US of bad loans and shattered household balance sheets must come with reduced US consumption growth.

This is because if China’s banks see an explosion in non-performing loans it will have to pay for that increase in the coming years in one or both of two ways. The central government can recapitalize the banks by giving them money, which they have raised by borrowing or increasing taxes, or the regulators can keep deposit rates very low as a way of subsidizing bank profitability so that they earn their way out of the NPL losses. They did both after the last banking crisis, and will probably do both again. There is a third thing they can do, appropriate the money from SOEs, but I suspect that there won’t be nearly enough to resolve the NPLs – the World Bank estimates that the last banking crisis cost China 55% of GDP.

Both strategies will represent, ultimately, a large transfer of income from households to banks, and in either case it will also represent a continued drag on consumption growth in the medium term. If the government borrows to bail out the banks, it will divert resources from the real economy and so slow income growth. If it raises taxes, it will reduce disposable income and so reduce household consumption growth. If it keeps interest rates low it will again reduce disposable income (interest income is an important source of income) and so slow consumption growth (in China lower interest rates tend to increase the savings rate).

Since it is unlikely that the US will be in a position in the near future to return to the halcyon days of large trade deficits, and since no other economy can replace the US in the role, turgid consumption growth in China will translate directly into turgid GDP growth for many years. Rising non-performing loans are not a small threat to China’s long-term growth. If the Asian development model is dead, China will need domestic consumption growth more than ever, and this is cannot be the best time for China to try to revive the production-enhancing model in a way that may limit future domestic consumption growth.

By the way in their next meeting the Guanghua Students Monetary Policy Committee will debate whether or not the PBoC should cap loan growth. I will report the arguments and conclusions of these remarkably sophisticated students.