The post-1997 global balance is breaking down, and the world is lurching drunkenly to find a stable new balance. Until now, Chinese overproduction has balanced US overconsumption, leading to China’s massive trade surplus and capital account deficit. Inevitably, however, a reduction in US overconsumption, a necessary consequence of the financial crisis, must force a corresponding reduction in overproduction elsewhere, and China, like it or not, will have to bear the brunt of the adjustment. The US and Europe must design their fiscal and monetary policies in part to ease China’s adjustment, which will otherwise be extremely difficult.
For most of the past 60 years US household savings rates have varied between 6 per cent and 10 per cent of gross domestic product. In the early 1990s the savings rate began declining, virtually collapsing after 1997 to well under 2 per cent of GDP. If American households rebuild balance sheets by raising household savings rates only to the historical mid-point, their savings must rise by roughly 6 per cent of US GDP.
Something must happen to equilibrate the corresponding decline in US household consumption. Either other US consumption, i.e. government spending, or foreign consumption must expand by that amount. To the extent that neither happens, global overproduction, which consists mainly of Chinese overproduction, must decline by that amount. This is just a way of saying that if net American consumption declines, either consumption must rise somewhere else, or production must fall.
In the best possible world Asian consumption would rise by exactly the same amount as US consumption drops, and we would quickly reach a new stable balance.
Given that the US economy is about 3.3 times the size of China’s, and China’s trade surplus is roughly equal to one-half to two-thirds of the US trade deficit, the increase in Chinese demand needed to equilibrate the increase in US household savings is equal to roughly 10-15 per cent of China’s GDP. With consumption accounting for less than 50 per cent of China’s income, Chinese consumption will have to rise, in other words, by more than one-quarter. This is clearly unlikely.
The way Chinese production adjusts to the adjustment in US consumption will be the most important story of 2009. This is not the first time the world has required such a massive balance of payments adjustment. In the 1920s the US played the role that China plays today.
The US economy had been plagued in the 1920s with overcapacity and, as a consequence, ran large trade surpluses equal to 0.4 per cent or more of global GDP (China, with an economy one-sixth the relative size, runs trade surpluses of roughly the same magnitude).
The 1929 crash in effect cut off funding for countries with trade deficits, eliminating foreign ability to absorb US overcapacity, and so required a countervailing US adjustment. Either the US had to increase domestic consumption, or it had to cut back domestic production.
There was unfortunately more to the crisis than simply the drop in foreign demand. With the collapse of parts of the domestic US banking system, domestic private consumption also fell. The slack in demand should have been taken up by US fiscal expansion, but instead of expanding aggressively, as Keynes demanded, President Roosevelt expanded cautiously. When the credit crunch came and the world was awash in American-made goods, it was unreasonable, Keynes argued, to expect the rest of the world to continue purchasing US goods.
Since US production exceeded US consumption, the need for demand creation, according to Keynes, most logically resided in the US. But the US had other ideas. Rising unemployment pressures in the US prompted US senators to respond in 1930 with the notorious Smoot-Hawley Tariff Act.
Washington tried to create additional demand for domestic producers by diverting demand for foreign goods and so force the brunt of the adjustment onto trading partners. Not surprisingly, the trading partners retaliated, and international trade declined by nearly 70 per cent in three years.
This shifted the brunt of the adjustment back onto the US. Without global trade each country had to adjust domestic supply to domestic demand, but in an overcapacity crisis trade-surplus countries are more vulnerable to trade contraction than trade-deficit countries. A contraction of trade implies an expansion of production in the latter and a contraction in the former, and in the 1930s it is noteworthy that trade-surplus countries suffered more deeply from the crisis than did trade-deficit countries once trade barriers were imposed.
China today faces a similar problem. Today it is China who is exporting overcapacity and it is the US who is consuming too much. With the collapse of bank intermediation US households and businesses are cutting consumption, but like in the 1930s, if there is a drop in global demand, the trade-surplus countries will need to adjust more than the trade deficit countries.
Because of the importance of the export sector to domestic growth and employment, and because of the strong positive correlation between exports and domestic investment in countries such as China, if exports drop quickly there may be significant political pressure for these countries to engineer moves to expand exports.
Might China and other Asian countries repeat the US mistake? China already seems to be in the process of engineering its own efforts to defend its ability to export over-capacity. Although there has been an attempt to boost domestic spending, most analysts argue that this has been too feeble to matter much. But China has also tried to protect and strengthen its export sector by lowering export taxes, constraining wage rises, and reducing interest costs, which lowers the financing cost for producers while increasing household savings rates.
While the impetus behind these policies is understandable, this strategy cannot work for long. The world suffers from overcapacity, and as net US demand declines, overcapacity will only rise. The proper place for new demand to originate is, as in the 1930s, in trade-surplus countries. They should be expanding demand, not expanding supply. If they attempt to export their way out of a slowdown, there will almost certainly be a trade backlash, as there was in the 1930s, in which case the full force of the adjustment will be borne by the trade-surplus countries, again as in the 1930s.
Originally published at the Financial Times and reproduced here with the author’s permission.