Earlier this week Ambrose Evans-Pritchard had an article in the UK paper The Telegraph which starts off with “For the first time in my life, I am starting to feel twinges of anti-German sentiment.” The article goes on to lambaste the German government, and especially German finance minister Peer Steinbrück, for what Paul Krugman earlier called “boneheadedness” in refusing to participate in the European fiscal expansion and, worse, for calling British and French programs “crass Keynesianism.” According to Krugman:

The world economy is in a terrifying nosedive, visible everywhere. The high degree of European economic integration gives Germany a special strategic role right now, and Mr Steinbrück is doing a remarkable amount of damage. There’s a huge multiplier effect at work; it is multiplying the impact of German boneheadedness.

Evans-Pritchard explains why a number of European countries, led by France and England, are so angry:

Put bluntly, Germany is pursuing a beggar-thy-neighbour policy. It is not fulfilling its responsibilities as the world’s top exporter and pivotal power of Europe’s monetary union. It is leaching off global demand, even as it patronizes Anglo-Saxons, Latins, and Slavs. No doubt binge debtors in the Anglosphere are much to blame for this crisis. But Germany rode the boom too. It made those Porsches and BMWs driven by the new rich. Its banks are among the most leveraged in the world.

Nor should we not forget that the European Central Bank set interest rates at recklessly low levels early this decade to help Germany out of a slump. Can this be separated from the property bubbles in Club Med, Holland, Ireland, Scandinavia, and Eastern Europe now causing such grief? Within the EMU, Germany has gained a competitive edge against France, Italy, and Spain for year after year by screwing down wages. In pre-euro days the North-South rift did not matter. The D-Mark revalued. Balance was restored. In monetary union it is toxic.

The point he is making is that the imbalances were not created simply by “binge debtors in the Anglosphere” but also by those countries that subsidized directly or indirectly overproduction, which ultimately have had much to do with the very conditions that led to consumption binge. This includes not just Germany but any of the countries that created persistent and high trade surpluses. Evans Pritchard makes the comparison very explicit:

Germany now has a current account surplus of 7pc of GDP. It is hollowing the industrial core of Latin Europe. Yes, Club Med needs to pull its socks up, but the flip side of the coin is that Germany is in breach of EMU’s implicit contract. The rules of the game are that surplus countries should boost demand. The Gold Standard collapsed in the early 1930s because they – then the US and France – refused to do so. The burden of adjustment fell on deficit states, who had to tighten yet harder.

The downward spiral dragged everybody into depression. Germany and China are today’s violators. Their trade surpluses over the last 12 months have been $283bn and $279bn, respectively. They are exporting excess capacity.

What does all this have to do with China? The reasons I bring this up is because it is, I think, a foretaste of the type of nasty battles that are likely to erupt between the trade-surplus and trade-deficit countries as global demand continues to contract. The overconsuming trade-deficit countries cannot reduce their overconsumption except with a collapse in production (and sharply rising unemployment) if the overproducing countries do not also adjust. Furthermore, fiscal expansion aimed at generating employment in countries with large trade deficits will not be nearly as effective as they might be if they are not matched with programs in trade surplus countries (essentially demand boosting fiscal programs) that prevent domestic demand from bleeding out the trade account.

The French and the British (and much of the rest of Europe) are concerned that if their governments borrow to boost domestic demand and employment at home, they are also borrowing to boost demand and employment in Germany, which means that they bear the fiscal cost for the foreseeable future while Germany gets a substantial chunk of the benefit. This may be a great deal for Germany, but it is one hard for the rest of Europe to embrace.

In Europe it is clear to me that the economic debate is migrating rapidly towards consideration of the impact of trade, and it would be surprising if the debate does not quickly globalize. If Europeans, nominally members of one country (sort of), can get into such an acrimonious debate among themselves, what hope is there for a polite and statesmanlike discussion that involves countries less tied together? I believe that in the US there is a much stronger commitment to free trade and, in spite of Mr. Bush, multilateral cooperation on economic issues, then elsewhere, but politics is politics, and rising unemployment in the US will inevitably lead to the same confrontational attitudes as they seem to have in Europe.

By the way among the dozens of bankers, government officials, academics and businessmen I have met in the past few weeks to discuss trade issues, it seems to me that those of us who have spent the past several months warning about an imminent collapse in trade are getting more and more attention. This is undoubtedly going to become a hot issue next year.

It is not that China isn’t doing anything to address the problem. The slate of bad economic numbers this week and last (trade is down, we are racing towards deflation, investment and consumption growth is down, manufacturing output growth was only 5.4%, electricity consumption was down 8.6%) has confirmed what we all dreaded: things are slowing quickly. The government is trying to do all it can to boost the economy and, especially, employment, but I am afraid they still don’t understand their place in the global mayhem. They continue to see China as an innocent victim of the global crisis – not as one of the fundamental creators of the payments imbalance that led to the crisis – and much of their strategy seems to assume that China can adjust domestically without worrying about the impact on the global market.

For example two days ago I was part of a panel that included a prominent Chinese economist and think tanker who I know and like very much, and as we discussed what needed to be done I got the impression that he hasn’t considered global implications at all (although as we discussed them he acknowledged many of my arguments). For example, much of his currency focus was on how China can retain export competitiveness without encouraging hot money outflows. But that is not the right way to think about it. China needs to think not only about the domestic impact of its currency but also about the global impact of its currency policy, and how that affects the adjustment that trade deficit countries are undergoing. If it makes things worse for them, there is no reason to assume that they will remain indifferent to Chinese domestic policies, and there is even less reason that they will run policies that accommodate China’s needs.

China is making Herculean efforts to get out of this mess. It is doing everything it can to maintain growth and is clearly very worried about the pace of the slowdown. Bloomberg, for example, had this article today:

China’s government plans to lower taxes and reduce the lockup period for home sales to stem a decline in the nation’s property market. Home owners will be waived from paying a sales tax on properties sold after three years of purchase, compared with the previous term of five years, according to a statement today by the State Council, China’s cabinet. The tax will also be levied based on the profit from the sale, instead of the sale price, according to the announcement.

These are all good things because they are aimed at boosting domestic consumption, and to the extent they also affect production positively, they affect non-tradable goods. That is a start. But there must also be recognition that policies that do not bring the trade surplus down sharply are inevitably going to cause trade friction, and that is a game China cannot play. A collapse in trade would force a brutal adjustment here.

Just to get some sense of numbers, with a trade surplus equal to 10% of GDP, what would happen if external trade were to disappear? Even assuming that there are no transition difficulties, Chinese producers would suddenly be forced to deal with the fact that they are producing more than Chinese are consuming by an amount equal to 10% of GDP, and if domestic demand cannot be increased by that amount immediately, Chinese producers must fire enough workers to bring production down by that amount. Of course firing so many workers would also cause demand to contract further, so the country would race downwards and adjustment much worse than even these frightening figures imply.

Of course international trade will not disappear (or, more to the point, the trade account will not quickly balance), so this is not the scenario we need to worry about, but even a small move in that direction would be terrible for growth. Remember that Chinese overproduction today is roughly equal, in global GDP terms, to US overproduction in 1929, and the US had more than six times the share of global GDP then than China has today. This is a much bigger adjustment for China than that of the US in the 1930s.

It will be grim. In the last few weeks there have been lots of new numbers and stories about unemployment. Perhaps it is because I am a university professor but I find myself particularly worried by rising college unemployment. According to a story today in the South China Morning Post:

More than a million Chinese college graduates unable to find work could make coping with unemployment harder now than it was during the Asian crisis, the head of China’s largest vocational training organisation said

…“The employment situation may be worse than the 1990s … This time, college graduates are not finding work, and there are so many of them,” Mr Chen told Reuters. In the late 1990s, China’s government weathered mass unemployment as the Asian financial crisis and bankruptcies of state-owned enterprises slowed the economy to a crawl.

Many college graduates now lacked the skills needed to compete for jobs in a fast-changing economy and were unwilling to take less respected jobs, Mr Chen said. More than six million students will try to enter China’s workforce next year, half a million more than last year. Up to a quarter could have difficulty finding jobs, the Chinese Academy of Social Sciences said on Monday.

In another article today the same newspaper says:

Swarms of migrant workers driven back home by the economic downturn in eastern provinces are putting huge social and employment pressure on the governments in their hometowns. In Yunnan province authorities are not only facing the tough task of creating jobs for 510,000 returned workers, but are also struggling to secure enough food to feed the swelling population in some areas, according to the provincial government’s website.

“The hundreds of thousands of returned rural workers have increased grain consumption by the local population by 500,000 tonnes per day, and we are feeling the strain of preparing enough rice in the bowl,” Liu Guoquan, director of Zhaotong’s Rural Human Resources Development Office, told fellow officials at a provincial meeting to discuss the crisis.

Tags: Germany, Telegraph

“The most striking real economic fact of the past several months is not continued U.S. economic weakness, but that China’s economy has slowed much more quickly than anyone had forecast,” Australia’s central bank Governor Glenn Stevens said this week.

Not quite “anyone”. Quite a few people who read this blog, some of them quite prominent, have been forecasting very grim numbers for China all year, and much of our discussion in the comments section has revolved around how bad the slowdown would be – above 7%, some of us said, or much lower, others have argued. I still say that we haven’t seen the end of downward revisions. By the way, I was just told by a friend two minutes ago that Goldman Sachs has just reduced their projection of 2009 Chinese GDP growth to 6%. I don’t have the citation so it might not be true, but it wouldn’t be surprising to me, and eventually lots of other banks will do the same.

As I have argued for a long time, if you think about China as being one of the two main players, along with the US, deeply linked within the overall global balance of payments, it cannot possibly come as a surprise that the US adjustment was going to require a Chinese adjustment which, given the relative size of the two economies, almost inevitably meant that China was going to get hit harder than the US. Here is a quote from as far back as September, 2005, in an interview with Hamish McDonald of the Sydney Morning Herald, in response to widespread belief at the time that the US was the most vulnerable to a breakdown in the balance of payments relationship:

“My money says the US could survive a disruption in the dependency relationship much more easily than could China,” says Michael Pettis, professor of finance in Peking University’s management school.

I know this sounds like I am tooting my own horn, and I don’t mean to, but the belief that China was protected from a possible crisis affecting the US trade deficit always struck me as weird. Perhaps American paranoia requires a sense of helplessness in the face of a powerful threat, and clearly the rest of the world takes its intellectual clue (and often cluelessness) from the US, but it couldn’t have been such a surprise that a sharp US slowdown would create trouble in a country so reliant on US consumption for its employment growth. Things have always been this way – why should they have suddenly changed?

Because last night I was invited to be a guest on the CCTV current events show, Dialogue, I tried to get my arms around an easier way of thinking about the adjustment so that I could explain it on TV. Let us assume that the US trade deficit will decline by 50%, from 6% of GDP to 3% of GDP – there are some who have argued that it will go to zero next year and others who have even argued that the US will soon be forced to run a small surplus, but I will assume nothing quite so dramatic. I will also ignore any contraction in net demand from Europe and elsewhere.

Since the Chinese trade surplus is equal to up to 2/3s of the US trade deficit, this suggests that within the overall global balance China should, ideally, absorb about 2/3s of this contraction, roughly equal to 2% of US GDP. This is also equal to about 7% of Chinese GDP, which means that either
a) Chinese consumption is going to have to expand by 7% of GDP faster than production,
b) Chinese production is going to have to contract by 7% of GDP more than any contraction in demand, or
c) both will have to happen so that the sum is equal to 7% of GDP.

Clearly the first cannot happen very quickly. The second would mean economic chaos for China, so that leaves the third. In the best of cases China would be given enough time to get as close as possible to the first of the three adjustments, but without a very strong international framework and coordinated action the most likely outcome is for at least some contraction in production.

The problem with all my scenarios is that the numbers are so big it is not easy to make the case for a smooth adjustment, except under the assumption that the rest of the world will do everything it can, including suffer rising unemployment, to pull China out of the crisis. That is unlikely.

That brings us to the terrible trade numbers. Last night, as I was on my way to CCTV to do the show, I got a call from Shang Ning, my Peking University student, about the data release. He told me exports were down 2.2% – terrible news given that economists were confidently predicting a 15% increase as recently as a week ago, but no longer unexpected. By the way Tom Holland in the South China Morning Post claims that in RMB terms, the more relevant measure if you want to judge the pain, exports were actually down 10.1%.

Shang Ning also told me on his phone call that imports were down 17.9%. I immediately called my friend Logan Wright from Stone & McCarthy and asked him about the import numbers. According to Logan, only a part of that decline can be accounted for by lower commodity prices. There was a real contraction in import volume.

This is frankly much more worrying to me than the decline in exports because it suggests that demand in China is contracting quickly. I have no idea what the retail sales numbers are going to say, but last month I complained that it seemed inconsistent to me that imports were contracting while retail sales were implying a healthy expansion of consumer demand. Unless the marginal propensity to import is collapsing, I think I trust the import numbers more. Demand in China is looking very bad.

Finally, and most shockingly, Shang Ning told me on the phone call that the trade surplus was $40.1 billion. At first I thought he was saying $30 billion, and I was surprised that it was so high – it would have been the second-highest monthly trade surplus ever recorded. When I finally understood him to say $40 billion, I couldn’t believe it. That is the main reason I immediately called Logan, to see if my student had made a mistake just before I was going to go on TV to debate the economic outlook.

He hadn’t made a mistake. In October China’s trade surplus was $35.2 billion, the highest every reached by any country at any time in history. In November that record was smashed. In the last three months China’s trade surplus has been $96 billion, nearly equal to the $100 billion from the first six months of 2008.

The headlines in China and around the world have been dominated by the contraction in Chinese exports, and this certainly is a bad number, but it cannot be a surprise and it is not the number on which we really should be focusing. The trade surplus is much more worrying, and soon enough that is what all the headlines will be reporting. Remember that the trade surplus is the measure of Chinese overcapacity that is being exported onto the world economy, but the world economy is looking for ways to increase net consumption, not net production. While demand in the rest of the world is shrinking, China is providing even more overcapacity, which means effectively that not only is China not absorbing its share of the demand/supply adjustment, it is exacerbating the imbalance. Other countries are going to have to withstand a faster decline in production than otherwise.

I know that China is facing a real problem of economic slowdown, one that seriously worries policy-makers. The other guest on the CCTV show last night was the chief economist of a large local securities firm, and he accomplished the not-inconsiderable feat of making me sound like an optimist. But still, it is wholly unrealistic to assume that the rest of the world will accept that they must bear more than 100% of the adjustment in order to pull China out of its trouble.

As a related aside, one of my former Columbia students, currently a government official in Vietnam, just told me an hour ago that Vietnam’s exports are awful. Declining exports are going to be a real problem for a lot of developing countries. With the collapse of the part of the capital markets that financed developing countries, and the resurgence of capital flight, developing-country trade-deficit countries will be forced suddenly to run trade surpluses (via, almost inevitably, a sharp contraction in domestic demand). If that happens, anti-China feelings are inevitably going to rise. If these result in anti-trade acts, China will suffer far more than it would under even the worst of current economic scenarios.

The chief economist who was on the TV show with me last night clearly understood this, as do many others in China (there is a even rumor that one reason the RMB depreciated before the SED meeting last week was that some people in the PBoC wanted to bring the matter to a head), and it is really important that US, Chinese, European and Japanese policymakers fully understand the problem. The major economies must work out a plan in which they provide for a three or four year period during which China can adjust its overcapacity problem, but if China tries to go it alone and allows the trade surplus to remain at anywhere near these levels, it is hard to see how we can avoid trade trouble. To repeat ad nauseum, the Chinese economy absolutely cannot tolerate a world of trade protection.

By the way I talk mostly about the US and China as being fundamental to the current global imbalance, but there is another pair that is also suffering from some of the same problems. Germany is running a huge trade surplus while the rest of Europe is running huge deficits. Already relationships in Europe are fraying. Paul Krugman, in Sweden to collect his Nobel purse, writes about it:

Everyone here seems to be talking about…the German problem. At a time when expansionary policies are desperately needed, the leaders of Europe’s largest economy seem to have their heads in the sand. This is a huge problem: there are large spillovers in fiscal policy among EU nations — that is, a significant fraction of, say, French fiscal expansion ends up promoting employment in Germany or Italy rather than France. So there’s a crying need for a coordinated policy. But the Germans aren’t participating.

The Financial Times explains it a little more colorfully in an article today (“Berlin hits out at ‘crass’ UK strategy”):

Germany’s finance minister has launched a stinging attack on the “crass Keynesianism” pursued by Gordon Brown, the British prime minister, fuelling tensions on the eve of European economic crisis talks in Brussels. Peer Steinbrück accuses Mr Brown in a magazine interview of “tossing around billions” and saddling a whole generation with a bill for paying off British debt.

His comments come as the European Union’s 27 leaders meet in Brussels to debate a proposed €200bn fiscal stimulus package, designed to stop a protracted economic slump. Mr Steinbrück, a Social Democrat in chancellor Angela Merkel’s grand coalition, has previously accused other European leaders of acting like “lemmings”, borrowing billions to fund tax cuts or higher spending. His irritation has been heightened by efforts by Mr Brown to construct a coalition to put pressure on Germany to follow suit.

…Germany has insisted the summit communique, while endorsing a €200bn stimulus package, should include the need to maintain fiscal discipline. A draft statement says the goal of long-term budgetary sustainability “implies a swift return to the reduction of deficits which have been temporarily increased.” Mr Steinbrück, speaking to Newsweek, questions whether Mr Brown’s £12.5bn (€14.2bn) cut in value-added tax will work. “All this will do is raise Britain’s debt to a level that will take a whole generation to work off,” he said.

He added: “The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking.” He said British policy would simply repeat mistakes of previous years in fuelling credit-financed growth.

I don’t want to wade into these very deep waters, but I think Steinbrück is right to warn Britain and France against excessive fiscal spending to get their economies going. Given their trade deficits a lot of their spending is going to be used to pull non-British and non-French workers out of unemployment, as Krugman notes. But on the other hand they are right to insist that German do more to expand fiscally. It is German overcapacity that is now the European problem. Perhaps Germany, like China, should be doing more to rebalance its excess capacity and foist less of it on the rest of Europe – struggling as they are with rising unemployment.

As distressing as it is to say this, I think few things are going to raise more irritation and anger next year than global trade.

Tags: Germany, Krugman