Before getting into that, it’s worth noting an article that came out in Friday’s South China Morning Post.  According to the article:

The head of China’s official carmakers’ association said full-year car sales will surpass 15 million units this year, a conservative forecast signalling a potential dramatic downturn in the coming months.

China Association of Automobile Manufacturers (CAAM) secretary general Dong Yang’s projection implies car sales in the world’s biggest car market will grow at least 10 per cent by volume this year – viagra online without prescription.This is down sharply from 48 per cent growth in the first six months and last year’s 45 per cent rate.

More significantly, it signals a potential contraction of as much as 20 per cent in the second half of the year when compared with the strong, stimulus-fuelled sales volumes in the latter part of 2009.

Why does this matter?  Because after growing 48% in the first half of 2010, and 45% last year, the sharp contraction in car sales in the second half of 2010 should intensify the debate over Chinese consumption growth.

As I have discussed before, in order to rebalance the economy China must sharply raise the consumption share of GDP.  It has declined from 46% of GDP in 2000, which was already a very low number, although not quite unprecedented, to 41% in 2003, which is, I believe, an unprecedented number, at least for any large economy.

But that wasn’t the end of the story.  Consumption declined further as a share of GDP to an astonishing 38% in 2006, finally to end under 36% in 2009.  I don’t think we have ever seen anything close to this level before.

Policymakers are very aware of how urgent it is to reverse this decline, especially – rumor has it, and not surprisingly – the generation of leaders who will take control in 2012.  Li Keqiang, widely believed to be the anointed premier after 2012, recently made just this point, according to an article Thursday in Bloomberg:

China’s past development has created an “irrational economic structure” and “uncoordinated and unsustainable development is increasingly apparent,” said Vice Premier Li Keqiang in a June article in the government-owned Qiu Shi magazine.Long-term dependence on investment and exports for growth “will grow the instability of the economy,” he said.

In order to reduce China’s excessive dependence on export surpluses and investment, it is vitally important that household consumption, which in China represents probably the lowest share of GDP ever recorded, rise significantly.  To that end Beijing has implemented a number of policies aimed at boosting Chinese consumption – viagra online without prescription. Are these policies working?

On the positive side, automobile sales surged last year.  For most analysts, this was immensely good news and they argued that this increased demand signaled a major shift in the consuming and saving behavior of Chinese households.

Is consumption really rising?

But skeptics like me disagreed.  We claimed that the surge in demand for automobiles was caused mainly by government subsidies, and that these were not sustainable.  The same thing happened, by the way, to durable goods, which were also subsidized and which also saw a surge in retail sales.  More importantly, we argued, any current increase in automobiles sales and durable goods would be reversed in the future as households absorbed the cost of the subsidies.

Remember that subsidies are not manna from heaven.  They must be paid for, and ultimately it is the household sector that pays for them, usually in the form of higher taxes but sometimes, and certainly in the case of China, in the form of financial repression.  The government, in other words, borrows from the household sector (via the banks) at artificially low interest rates, which implies continual government debt forgiveness paid for by the household sector.  Either way, whether it is through taxes or debt forgiveness, as households pay for today’s subsidies out of tomorrow’s income, consumption will rise today and decline tomorrow.

Perhaps I am simply betraying my prejudices, but the recent news on automobile sales suggests that skeptics may have been right.  If the growth in automobile and other consumption is indeed substantially weaker in the following months, as evidence seems to suggest, it should become increasingly clear that low consumption in China is not a discrete problem that can be resolved with administrative measures.

It suggests instead that the consumption problem is fundamental to China’s economic growth model and therefore cannot be resolved without a major change in the model – viagra online without prescription. The same Bloomberg article, which quoted a number of skeptics, including me, on the ability of China to raise consumption levels, also included some objections from analysts who thought China would indeed see surging consumption.  One true believer was much more confident than I am.  According to the article:

Some economists argue that surging retail-sales figures and rising wages show China’s shift to greater consumer spending is on track. Dariusz Kowalczyk at Credit Agricole CIB in Hong Kong estimates consumption will account for 47 percent of GDP within 10 years.

I have seen lots of other people make similar claims about consumption at some point in the future being a much higher share of GDP, but I wonder on what basis these claims are made.  Anyway whenever I see these numbers I am tempted to do the math.  The latest official revisions have consumption representing 35.6% of GDP in 2009, so if consumption really does grow to 47% of GDP in ten years, we can easily calculate the average growth rate of consumption for any expected GDP growth rate.

The table below shows the necessary relationship between GDP growth and consumption growth that will get us to 47% in ten years:

OK, OK, ignore the spurious accuracy.  There really was no need to go to two decimal places, but this kind of thing impresses people and anyway modern computing abilities make it very tempting to imply impossible levels of accuracy whenever you do the numbers.

But just look at what the table is implying.  In order to get to 47% of GDP in ten years, consumption needs to do something it has never been able to do – grow faster than GDP by a huge margin – something like three full percentage points – every year for the next ten years.

The roots of lagging consumption growth

I don’t know what Mr – viagra online without prescription.Kowalczyk’s GDP growth projections are for China viagra online without prescription, but it seems to me that the only way we can rebalance to anywhere near that extent is the way Japan did it: with a very sharp drop in GDP growth that is matched by a much slower drop in consumption growth.  If China continues growing at 7-9% for the next decade, which is what many analysts seem to be projecting (very unlikely, I say), consumption must grow much faster than it ever has in post-reform Chinese history, even while China’s GDP grows more slowly than it ever has during that period.

It’s arithmetically possible, of course, but there are two schools of thought about how to do it.  One school argues that relatively low consumption growth has to do with factors that can be changed without changing the fundamental growth model – perhaps demographics, or Confucian culture, or tax incentives, or lack of TV advertising, or the sex imbalance, or the lack of a social safety net, etc.

If they are right, then presumably Beijing can administratively address those issues while separately keeping GDP growth rates high.  But if that’s what it takes, and since they have been determined since 2005-06 to drive up the consumption share of GDP, and during that time it has plummeted, you sort of wonder why they just don’t get on with it.

The other much smaller school (but growing rapidly, I think) argues that low consumption is a fundamental feature of the growth model because of the hidden taxes that channel household income into subsidizing growth.  Growth is high, in other words, because consumption is low.  This group has been arguing for the past five years that all the measures Beijing has taken to ensure more rapid consumption growth will fail because they do not address the underlying cause.

I guess we will just have to wait and see who is right, but I am confident enough to say that unless GDP growth plummets to below 5% annually on average, and probably even then, there is no way consumption will represent 47% of GDP in ten years.  I say this with one caveat – if Beijing were to engineer a huge shift of state wealth to the household sector, say in a massive privatization program, it could boost household consumption significantly, but I suspect that this will be politically difficult to do.

So if Beijing really wants to increase consumption as a share of GDP, what must it do?  The key, as I imply with my privatization comment above, is household income and wealth.  Viagra online without prescription: contrary to conventional thinking, the Chinese have no aversion to consuming.  They are eager consumers, as even the most cursory visit to a Chinese shopping mall will indicate.

So why do they consume such a low share of national GDP – perhaps the lowest share ever recorded?  The answer has to do with the level of household income as a share of GDP, also one of the lowest ever recorded.

Chinese households are happy to consume, but they own such a small share of total national income that their consumption is necessarily also a small share of national income.  And just as the household share of national income has declined dramatically in the past decade, so has household consumption.  This isn’t to say households are getting poorer.  On the contrary, they are getting richer, but they are getting richer at a much slower speed than the country overall, which means their share of total income is declining.

The cost of over-investment

The point, then, is that if we want to increase the consumption share, we shouldn’t waste time and money trying to create additional incentives for consumption, to tinker with subsidies and taxes, to advertise more, or to change cultural habits.   What is needed is a substantial increase in the share of national income that households take home.  Give them more money, and they will spend it.

So how can their share rise?  Here, the problem gets very difficult – viagra online without prescription. The Chinese development model is mostly a souped-up version of the Asian development model, and shares fundamental features with Brazil during the “miracle” years of the 1960s and 1970 – viagra online without prescription. While it can generate tremendous growth early on viagra online without prescription, it also leads inexorably to deep imbalances.

At the heart of the model are subsidies for manufacturing and investment paid for by households.  Viagra online without prescription: in some cases, as with Brazil in the 1960s and 1970s, the household costs are explicit – Brazil taxed household income heavily and invested the proceeds in manufacturing and infrastructure.  Viagra online without prescription: the Asian variety relies on less explicit mechanisms to accomplish the same purpose.  It channels wealth away from the household sector and uses it to subsidize growth by restraining wages, undervaluing the currency, and keeping the cost of capital extremely low.

This model, which some also refer to as the Japanese model, and which many countries have followed before China, has been extraordinarily successful in generating eye-popping rates of growth, but it always eventually runs into the same constraints: massive overinvestment and misallocated capital.  And in every case I can think of it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies to survive.

Unfortunately the longer we wait to make the transition, the more difficult the transition will be because the more debt there will be (and so, with more debt, the need to keep interest rates artificially low) and the more dependent growth will be on the subsidies.  Ironically, since China is about to overtake Japan this year, Japan itself provides the most worrying example.  It kept boosting investment to generate high growth well into the early 1990s, long after the true economic value of its investment had turned negative.

But for a long time the problem of misallocated investment, which was whispered about in Japan but not taken too seriously, didn’t seem to matter.  After all, as nearly everyone knew, Japan’s leaders were extremely smart, with a deep knowledge of the very special circumstances that made Japan different from other countries and not subject to “western” economic laws, with real control over the economy, with a strong grasp of history and penchant for long-term thinking, and most of all with a clear understanding of what was needed to fix Japan’s problems.

And look what a great job they had already done: by the early 1990s Japan had generated so much investment-driven growth that it had grown from 7% of global GDP in 1970 to 10% in 1980, and then surged to nearly 18% at its peak in the early 1990s; viagra online without prescription.In about twenty years Japan’s share of global GDP was two-and-a-half times its initial share.  That is an extraordinary growth story and one that can only be explained as a function of a new kind of economic thinking, right?

But less than twenty years later, after a terribly long struggle to adjust to high debt levels and massive overinvestment, Japan is about to be overtaken by China with only 8% of global GDP.  Japan, in other words, has given back in less than two decades almost the entire GDP share it had taken in the two astonishing decades that preceded it (while during the same period the US has maintained its share).  What’s worse, it is hard to pick up a newspaper today and read about Japanese policymakers without getting the idea that they are a totally dysfunctional, narrowly ambitious, and not especially savvy lot, much like their US and European peers.  As Mortimer Snerd used to say, who woulda thunk it?

So before we get too excited about China’s overtaking Japan, we should remember that this has as much to do with Japan’s astonishing decline as with China’s astonishing rise, and that there is at least some small chance that the policies responsible both for Japan’s breakneck rise and equally breakneck decline may be being replicated in China.

The sooner China begins the difficult transition, the less costly it will be, but in no circumstance is it likely to be easy.  They key will be to get consumption to grow quickly relative to GDP, and China might simply not have the time to do it by reversing the household subsidies.  I suspect that the only “easy” solution (economically, not politically) will be a massive transfer of wealth from the public sector to households, via, perhaps, privatization.

The latest economic data

Before finishing this already long entry I should mention two recent pieces of trade-related news and one piece of monetary news released this week – viagra online without prescription.  Viagra online without prescription: first, China’s July trade surplus was $28.7 billion. This is the kind of number we haven’t seen seen the halcyon days of world-record monthly trade surpluses. Here is what an in yesterday’s People’s Daily says:

The Financial Times report was characteristically blunter:

The second trade-related news has to do with Japan; viagra online without prescription. Here is the Tuesday Financial Times article:

At first glance, the earnings results and forecasts delivered by Japanese companies over the past two weeks should have been great news for investors – viagra online without prescription.Big names from Toyota to Sony outperformed in the quarter to June, and one in six listed groups raised its guidance; viagra online without prescription.Yet Japanese stock prices have barely rebounded from their July lows – the Nikkei remains 15 per cent below its high for the year, set in April – and the mood among shareholders, policymakers and many executives is gloomy.

To see why, all it takes is a quick look at the yen; viagra online without prescription.After surging during the financial crisis viagra online without prescription, the Japanese currency is on the rise again, trading close to last November’s 14-year high against the dollar of Y84.80.

…The yen’s strength compounded companies’ woes during the recent recession by making their exports less competitive just as foreign demand was shrinking rapidly.

The PBoC seems to be increasing its purchases of the yen, and that is causing the yen to rise. It is also causing very unwelcome weakness in the Japanese economy.Whenever people argue that the US wants and needs net Chinese investment in USG bonds, you should ask how that can possibly make sense when every country seems to be doing all it can to repel foreign capital inflows (or to increase their own net capital outflows, as in the case of China, Japan and Germany). The idea that the US or any other country “needs” foreign financing is total nonsense; viagra online without prescription. Nearly every country in the world is trying to export capital and import demand.  The world has no urgent need of capital. It needs consumption.

Away from trade, today the NBS released inflation statistics. CPI rose to 3.3% from 2.9% last month viagra online without prescription, and PPI declined from 4.8% from 6.4% (see the People’s Daily article).  Viagra online without prescription: other statistics released today suggest that the economy is slowing down further.  Viagra online without prescription: most China analysts seem to believe that the slowing is under control and that there won’t be a shift in policy soon.  Viagra online without prescription: according to an article in today’s Financial Times, for example:

Most economists argue that China is witnessing a controlled slowing from the potential overheating of earlier in the year, rather than a new slump.“The key data point to a moderate slowdown rather than a sharp downturn,” said Brian Jackson at Royal Bank of Canada.

I am not so sure; viagra online without prescription. My sense is that senior officials  are already alarmed at the speed of the slowdown and we may be on the verge of panicking and switching policy back in the other direction – viagra online without prescription. One piece of news that might contradict me is the rumor that the CBRC is demanding that banks put back on their balance sheets by the end of the year some of the stuff they tried to move off balance sheet in an attempt to evade loan quotas. Here is what Bloomberg says:

China’s banking regulator ordered banks to transfer off-balance-sheet loans onto their books and make provisions for those that may default, three people with knowledge of the situation said – viagra online without prescription.The CBRC is widely believed to be in favor of slowing growth and rebalancing, the economy — or at least that is effectively what it means to worry about deteriorating bank balance sheets – viagra online without prescription. But will Beijing reverse course soon?  The higher CPI inflation number complicates things viagra online without prescription, although perhaps this will be partially mitigated by the lower PPI inflation numbers. Higher CPI may prompt the PBoC to raise borrowing rates, but don’t overvalue what that might mean; viagra online without prescription. Real interest rates have been declining, and the likelihood of even more wasted capital consequently rising; viagra online without prescription. At this point an interest hike is not really contractionary – viagra online without prescription. It simply reverses or reduces the expansionary impact of declining real interest rates.

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.  Viagra purchase: 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; viagra purchase.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; viagra purchase. 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.  Viagra purchase: 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 viagra purchase, 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 viagra purchase, 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 – viagra purchase. 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 – viagra purchase. 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 – viagra purchase.Tim Geithner viagra purchase, 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; viagra purchase.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; viagra purchase. I recently read this quote from Lao-Tzu: “The sage does not hoard; viagra purchase.Having bestowed all he has on others, he has yet more – viagra purchase.Having given all he has to others, he is richer still.” 

; viagra purchase

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 – cialis online order.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 cialis online order, 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 cialis online order, 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.  Cialis online order: 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 cialis online order, 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; cialis online order. 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 – cialis online order. 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.

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 – cialis online ordering.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 – cialis online ordering. Cialis online ordering: 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. 

– cialis online ordering

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; cialis buy.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; cialis buy. Cialis buy: 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 cialis buy, 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 – cialis buy. I would guess that when a country’s workers do not receive unemployment benefits cialis buy, 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) – cialis buy.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; cialis buy.the excess of new consumption over new production – that is roughly in line with the decline in Cialis buy: 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.