With the recent sharp decline in Chinese manufacturing output, the global decoupling theory seems to have died a well-deserved death. The idea that developing countries had become less dependent on US economic conditions, and so were insulated from the US crisis, was based on a potent combination of bad analysis and wishful thinking. In fact the first stage of the crisis has primarily affected trade-deficit countries, which included many of the rich countries. The second stage will see the crisis move to trade-surplus countries, most of which are in the developing world.
The dependence of developing countries on US demand should have been obvious from the global balance of payments data, which show the US trade deficit and developing country trade surpluses rising as a share of global gross domestic product in an almost unbroken line from 1997 to 2007. This suggests that there is a lot more of the crisis to come. To date the crisis has mainly involved adjustment among the large over-consuming countries: the US, Spain, the UK, France, Italy and Australia. In each case the credit crisis has all but eliminated the debt-fuelled consumption binge that enabled their large trade deficits. But that cannot be the end of the story. The global balance of payments must balance, and a reduction of consumption by one sector in the global balance must come with a corresponding adjustment.
There are three ways the system can adjust. One way is for the underlying global imbalances to remain in place. Governments from the US and other trade-deficit countries can borrow and spend aggressively to replace contracting household consumption. But as debt-fuelled consumption by the likes of the US has been one of the fundamental problems, simply replacing one overconsuming American entity by another cannot be a long-term solution.
The second way is for trade-surplus countries to engineer sharp increases in domestic consumption, most likely though massive fiscal expansion, that match the decline in US household consumption and so reduce the overcapacity problem. The problem with this solution is that the scale of the adjustment is beyond the capacity of most countries. A decline in US consumption equal to 5 per cent of US GDP, for example (which is a low estimate), would require an increase in Chinese consumption equal to 17 per cent of Chinese GDP – or a nearly 40 per cent growth in consumption. This is clearly unlikely.
That leaves one other way to adjust – a sharp decline in global production, with massive factory bankruptcies to end overcapacity. The burden of the adjustment will fall on trade-surplus countries, unless trade-deficit countries are willing to absorb a large part of it. But given political realities it is Asian production which is most likely to decline. The economic pain will be high and potentially destabilising.
Before this happens there is a grave risk that individual Asian countries will try to avoid the contraction in demand by increasing their ability to export overcapacity by enacting trade-related measures – export subsidies, subsidised financing, currency depreciation, import tariffs – that enable them to force the overcapacity adjustment on to their trading partners.
This was the US strategy when, under similar circumstances to China today, it was forced to adjust to the 1929-31 crisis. In 1929 it was the US that had the serious overcapacity problem. For much of the 1920s it was able to export overcapacity by running large trade surpluses, but when the 1929-31 financial crisis eliminated the ability of trade deficit countries to finance their absorption of US overcapacity, the US, as the leading overcapacity nation, faced an ugly adjustment.
The US tried to avoid the adjustment by enacting trade tariffs – most notoriously the Smoot-Hawley bill of 1930 – and in so doing force the contraction in production on to the rest of the world. Trade-deficit countries did not co-operate, with the result that international trade all but collapsed. That forced the US into adjusting domestically, which it did via a collapse in production – a process we call the Great Depression.
There is a great risk that we see a repeat of this sorry story. US overconsumption was a fundamental part of the recent global imbalance and one way or the other US consumption must decline and savings rise. But just as US overconsumption must decline, so must Asian overproduction. This can only happen with an increase in Asian consumption or a drop in production. Next year will be difficult for Asia.
Originally published at the Financial Times and reproduced here with the author’s permission.