The Great Rebalancing (part 2)

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The central idea of Michael Pettis’s analysis of the global economic crisis is the inescapable connection between a country’s domestic economic policies and its global position as a net exporter or importer of capital and goods. An underconsuming economy–one with savings greater than domestic investment–will export capital and goods. An undersaving economy–one with savings less than domestic investment–will import capital and goods. These two kinds of economies play complementary–but not necessarily sustainable–roles in the global economy. We may praise the first and criticize the second because we associate underconsumption with thrift and moral discipline. But from a macroeconomic perspective, “an excessively high savings rate can be just as debilitating for an economy, perhaps even more so, as an excessively low savings rate.” Either condition can distort an economy and send it down a path toward unsustainable growth.

In today’s global economy, China is the prime example of an underconsuming society. In 2010 household consumption in China was a remarkably low 34% of its GDP. That compares to consumption rates of 60-70% in the United States, most of Europe, and many developing countries. That means that China has an extraordinarily high savings rate, so high that savings exceed domestic investment even though domestic investment is also very high. And since Savings = Investment + Net Exports, as explained in the previous post, China has also been generating “what is probably the largest trade surplus as a share of global GDP in history.”

Pettis does not attribute China’s high savings rate to any cultural tradition of thrift. After all, it wasn’t too long ago that cultural commentators were comparing Chinese cultural values unfavorably to the American emphasis on hard work and thrift. He focuses instead on recent Chinese economic policies that have discouraged domestic consumption in favor of investment. Those policies have encouraged so much saving that domestic investment cannot absorb all the capital available, and that forces the country to export capital and run a trade surplus in order to sustain its growth in GDP.

Although China has carried underconsumption to an extreme, it is hardly the first country to adopt such policies:

There is nothing especially Chinese about the Chinese development model. It is mostly a souped-up version of the Asian development model, probably first articulated by Japan in the 1960s, and shares fundamental features with a number of periods of rapid growth–for example Germany during the 1930s, Brazil during the “miracle” years of the 1960s and 1970s, and the Soviet Union in the 1950s and 1960s.

Countries that adopt such a model make a decision to base their growth on heavy investments in infrastructure and manufacturing capacity, while limiting the production and consumption of consumer goods for the domestic market. Pettis describes three kinds of policies that support this model:

  • Wage constraint: Wages are not allowed to rise as fast as worker productivity. The workers’ share of the national product declines, allowing more of GDP to be saved and reinvested rather than consumed.
  • Undervalued currency: The central bank sets the value of the national currency low in relation to other currencies. This weakens the buying power of consumers, while helping manufacturers compete in global markets.
  • Financial repression: The central bank sets interest rates very low, hurting ordinary depositors but helping producers borrow in order to build infrastructure and expand production. Ordinary Chinese benefit less from low interest rates than Americans do, since China has little financing for consumer expenditures.

Although these policies seem harsh for ordinary workers and their households, they have generated spectacular growth in GDP. That means that national income has risen very fast. Although the share of GDP going into household consumption is low, absolute household income and consumption can still rise. Households are better off than they were before, although still disadvantaged by world standards. This leads many economists to see China as a great success story.

From his long-term, global perspective, Pettis emphasizes the down side. He sees the extraordinarily low consumption rate and the very high trade surplus as signs of “very distorted and unsustainable domestic policies, the reversal of which will be fraught with difficulty.” He believes that this underconsumption model of growth is bumping up against two fundamental constraints. These correspond to the two factors needed to balance the economic equation when consumption is low and savings are high: investment and net exports.

  • Constraint on investment: If economic policies keep providing cheap capital for capital projects while also discouraging consumption, the danger is that fewer and fewer of those projects will add real value to infrastructure or manufacturing capacity. They may actually destroy national wealth by wasting it on useless or environmentally damaging boondoggles.
  • Constraint on trade surplus: China’s massive underconsumption and trade surplus require other countries, especially the US, to overconsume and run up debt. Even before the 2008 financial crisis, other countries were having trouble absorbing China’s surplus, and greater austerity since the crisis is making it even less likely that they will do so.

Part of the “Great Rebalancing” Pettis recommends and expects is that China will have to reverse the policies that have encouraged savings and investment at the expense of domestic consumption. It will need to “raise wages, interest rates, and the value of the currency in order to reverse the flow of wealth from the household sector to the state and corporate sector.” The Chinese would then consume more and export less. This is easier said than done, however, because the economy is very dependent on capital projects and exports for its GDP growth and employment. “Almost certainly it will adjust with much lower growth rates driven by a collapse in investment growth.”

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