- January 9, 2009by FT
By Michael Pettis
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 verconsumption, 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.
On our local Star Business, P.Gunasegaram writes on tthe same issue: Towards Asian consumption and Western saving
- A couple of serious adjustments need to take place before the global crisis can be sorted out.
THE key to a solution of the latest economic and financial problems facing the world is a double-pronged change – a fall in the currencies of the troubled and traumatised Western world and for Asia to consume more and take over the bulk of spending. Let’s put this in historical context.
The 1997-98 currency crisis started with the fall of the Thai baht. Thailand was borrowing short-term funds internationally and using this to finance long-term projects. Hedge funds geared up to make money from interest-rate differentials, the implicit assumption being that the baht will not fall. But it fell.
The so-called currency crisis spread and South Korea and Indonesia, both of whom borrowed heavily overseas, were similarly affected with their currencies under attack.
The International Monetary Fund or IMF, in return for financial assistance, prescribed the same stock solutions for all – tighten the belt, reduce spending, raise interest rates, let companies go under. In other words – let there be blood on the streets. Those words were actually used.
There was much pain and suffering. With currencies on a roller coaster, interest rates had to be really high to keep funds in – and even that did not work. Imagine – the rupiah swung from 2,000 to 20,000 to the US dollar. Interest rates skyrocketed to well into the double digits.
Malaysia too suffered but it did not need IMF help because it had enough reserves and its companies were not overly exposed to foreign borrowings. But it did follow IMF prescriptions – initially.
The Government reigned spending, or tried to, by 20%, banks restricted credit – you could not get a loan on the security of your own fixed deposit - and interest rates were raised. But the fund managers could not be appeased. The currency came under attack and the stock market as well.
It was very easy for speculators to mount a pincer attack – short-sell the market and the currency by gearing up. Interest rates will be raised to defend the currency, the markets falls, confidence erodes and eventually the currency too will collapse generating huge profits for the hedge funds.
This continued until capital controls were imposed in 1998 in Malaysia which did two important things. One, the Government did not need to use up foreign exchange reserves to defend the currency, and two, it regained control of monetary policy – it could ease credit and bring interest rates down.
Malaysia reversed its economic policies and flooded the system with liquidity, saved its corporations, restructured the loans and recapitalised the banking system.
There was quick recovery in balance sheet terms because the sharply depreciated currencies produced huge trade surpluses in the affected countries. This ensured that the balance of payments (the trade in goods plus the trade in services plus the flow of funds) was in considerable surplus. And the process of accumulation of reserves continued again.
But despite the quick recovery in balance sheet terms, there was a huge lack of confidence, prevailing until today which has snuffed off higher growth in the tiger economies such as Malaysia, Indonesia, Thailand, South Korea, Taiwan and Singapore. The countries are content with much lower growth and the higher growth countries were the likes of China and India – countries insulated from the currency crisis partly because they had rigid capital controls.
Two things were responsible for the 1997/98 financial crisis – one was dubious business practices – basically funding long-term projects, many questionable, with short-term funds, and especially foreign funds. Two, thing were exacerbated by speculators who took the opportunity to whack currencies down, ignoring fundamentals. This is where capital controls helped for Malaysia.
The over-riding lessons were one, that during times of crisis you flood the system with liquidity, not remove it. Two, you save companies, not destroy them, especially the banks. Three, governments must spend to mitigate reduced spending by the private sector. And, four, you do what you can to keep confidence up.
The current crisis is also a problem of excess funds. Asian reserves funnelled into the US resulted in excess money looking for a home and bankers trying to innovate to get more people to borrow. Essentially, bankers invented subprime mortgages which resulted in the subsequent subprime crisis when house prices in the US collapsed. Similar crises erupted throughout the developed world.
When loans turned sour, banks had their capital eroded and they had to be recapitalised. Not just that, governments had to guarantee some of the loans of the banks which in effect saves bank shareholders too. Meantime other companies considered too large too fail – GM etc – were targeted for government help.
All of these were counter to what the IMF advised the Asian tigers to do post the 1997 crisis. But still they are the right measures to put the world economy back on a healthy footing again – the government has to intervene in times of trouble – without too much discomfort to the public at large. A point to remember is that these developed economies are in far worse shape than the Asian tiger economies were in 1997/98 – venerable names are in trouble, big trouble. The US balance sheet is going to get far worse before it gets better because of huge deficit spending – as borrowings increase, and money is printed, inflation in the US will go up and Asia will realise the folly of investing in the US.
There needs to be an adjustment process, somewhat similar to what Asian tiger economies went through to get the balance sheet back in order. At some point, the US dollar would have to depreciate significantly.
That would mean the US would become more export competitive and the Asian countries may have to become consumers to save the world economy just as the US economy has for some time now. The adjustment process means that Asia will have to spend and the US save and produce. How long this will take is anybody’s guess.
For us in Malaysia, the biggest danger to the economy is that we collectively will spend too little. Our banks are not in trouble, most of our companies are still intact and we should ensure that we put enough money in the pockets of people so that they spend. Cutting wages and bonuses will be a mistake just as cutting jobs unnecessarily will be too.
Export earnings are going down but we should not worry too much because imports are coming down, thereby maintaining healthy trade surpluses. A sharp one-off outflow of short-term funds reflecting repatriation of funds resulted in the balance of payments declining but that won’t be the trend. Our balance sheet will continue to be strong, enabling us to spend with little problems for a couple of years.
We should think of other ways to spend instead of through the government. Australia gave money, some A$20 billion to its poor. We should see if something like that is feasible because the government is a very poor and inefficient spender of money with plenty of leakage due to inflated project values.
Our banks must not be afraid to lend. Businesses have need for cash now. Export manufacturers are already badly affected and they need some cash to tide them over the difficult period until demand recovers again.
Overall the greatest danger for Malaysia, relatively insulated this time from the global crisis, is that of tightening the belt too much and pushing ourselves into recession. But even if we enter a recession, it should not be prolonged or severe.
The time has come for Asian countries to spend more and to invest more of their money in the region to foster growth here. And that process will be aided at some time by the declining US dollar as well as the currencies of the developed world as part of the adjustment process towards Asian consumption and Western saving.
There is still growth in the world economy (China will still grow by 8% this year by most estimates) and we should look at ways we can plug into that growth.
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