On Friday Chinese stock markets capped one of the best weeks in an awfully long time, with the SSE Composite closing at 1986, up 3.1% for the day and 13.7% for the week. Although a lot of local analysts have been saying that the rally is long overdue and represents confirmation that we have bottomed out economically, I think the rally was caused almost exclusively by the resurgence of rumors about the creation of a major stock market stabilization fund by the government.
The fact is the news coming out of China and the rest of the world continues to be bad and suggests, if anything, that we haven’t seen the worst yet. October retail sales in the US, which were projected to fall by an ugly 2.1%, actually declined by an even uglier 2.8%, which is being reported as the worst number since the data series began, in 1992. Consumer spending in the US, it seems, is slowing much faster than expected.
Remember, as I argued in my November 9 entry, that if US household savings revert to the average level of the last fifty years, this would represent a decline in global consumption equal to 5% of US GDP, or 17% of Chinese GDP, even making the very unrealistic assumption that global income remained steady (in fact the reduction in US consumption would probably be greater). I suggested then that my proposed 5% was likely to be conservative, and so far it seems like it might be. American household savings seems to be rising quickly – certainly as a share of income, although perhaps not so quickly in nominal terms since declining consumption is also likely to mean declining income.
Bad enough as news on the external front is for China – a country with excess savings is not going to welcome a significant rise in US household savings – news on the domestic front isn’t any better. The decline in US consumption was supposed to be mitigated by a fiscally-derived boost in Chinese consumption, but economists are increasingly skeptical about the ultimate demand effect of the RMB 4 trillion fiscal package announced last Sunday. It seems that only about one-quarter of this represents real new fiscal expenditures. The rest is supposed to come from banks, companies, and municipal government spending, even though it seems pretty certain that one of the municipalities’ major sources of revenues, land sales (which account for over 30% of municipal revenues) is likely to decline sharply. The great fiscal package seems to have been more smoke than fire.
As a demonstration of how difficult municipal land sales might be, Friday’s South China Morning Post had an article with the following example of how policy-makers continue to hope that the miracle of leverage will boost demand:
The Shenzhen municipal government will allow the winning bidder at a land auction to be held later this month to pay for the development site in three installments in an attempt to lure cash-strapped developers back to its auction hall.
The extended repayment period will allow the winning developer to complete the land purchase payment in about six months compared with the current requirement of five days. Analysts said the move was aimed at easing the financing problems confronting developers and has followed the withdrawal from auction of a number of government sites this year because of the absence of bidders. Only eight of the 28 government sites offered for sale in the first eight months of the year were sold as lenders imposed tighter credit terms on developers.
Meanwhile, and not coincidently, bank regulators are warning that non-performing loans are rising, although they have been less than clear on the extent of the problem. An article in today’s Bloomberg reports the following:
Chinese banks face rising bad loans and narrowing profit margins as the central bank cuts interest rates to boost expansion in the world’s fourth-largest economy, the banking regulator said. Lenders may suffer further losses on their overseas assets as the global financial crisis remains “far from over,” China Banking Regulatory Commission Vice Chairman Jiang Dingzhi told a financial forum in Beijing today.
…“Bad loans are already showing an upward trend, especially in the property market where the mortgage default risk is growing at an accelerating pace,” Jiang said, without elaborating. “We can’t take this light-heartedly.”
The reference to losses on overseas assets is a little funny (and perhaps characteristic) since the real problem is likely to be domestic assets, especially since regulators have assured us several times that exposure to foreign assets is so low among Chinese banks that even a catastrophic collapse in foreign asset prices wouldn’t hurt the banks directly. The article goes on to say:
China’s banking system remains “in good health” with all major indicators at their best levels ever, Jiang said. Banks’ total assets, 59.3 trillion yuan at the end of September, were five times the level of 10 years ago when the Asian financial crisis happened, he added.
Call me a pessimist, but if NPLs are rising I wouldn’t consider a good thing the fact that total assets are five times as high today as they were during the last crisis. China’s GDP has grown roughly 2.5 times since then, suggesting that every percentage point increase in NPLs is twice as costly in terms of a government bailout today than it was ten years ago. In this environment smaller balance sheets are better.
To turn to something a little weightier and more abstract, I have been re-reading Keynes and the history of the Great Depression – most particularly about the global balance of payments in the 1920s and 1930s – to get a better understanding of the current mess. I am not trying to suggest that we are likely to repeat the 1930s, but it certainly seems that the imbalances that led up to the current crisis were in many ways similar to the imbalances of the 1920s – with a few countries, dominated by one very large one, running massive current account surpluses and accumulating, in the process, rapidly growing central bank reserves. In both cases the main current account surplus countries financed the current account deficit countries with capital exports (this is just a truism – surplus countries always export capital to deficit countries except to the extent deficit countries can draw down reserves).
In the 1920s excess and rising capacity in the US could be exported, mostly to Europe, while massive foreign bond issues floated by foreign countries in New York permitted countries to run large deficits, but as the US continued investing in and increasing capacity without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process, and it was not just the stock market that fell – bond markets collapsed and bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for all but the most credit-worthy foreigners to continue raising money, and by effectively cutting off funding for the current account deficit countries, it eliminated their ability to absorb excess US capacity.
The drop in foreign demand forced the US either massively to increase domestic demand or massively to cut back domestic production. The fact that another consequence of the financial crisis was a collapse of parts of the domestic banking system, leading to banking panics and cash hoarding, meant, as it often does in a global crisis, that the US had to adjust to a drop in demand both domestically and from abroad. But instead of expanding aggressively, as Keynes demanded, FDR expanded cautiously, and in 1937 even decided to put the fiscal house back in order by cutting fiscal spending, thereby stopping the recovery dead in its tracks.
Keynes argued at the time that the villain of the story was excess savings since industrial overcapacity required that we save less and consume more. He also argued, if I understand him correctly, that high savings reduced the multiplier effect of investment on the economy. In that sense it is a mistake to see high savings as something that leads to high investment. As long as some part of income is saved, any increase in investment generates its own savings (this may seem counterintuitive but it is the standard multiplier effect in which investment causes a boost in income, part of which is saved and the rest consumed, which causes a secondary boost in income, part of which is saved, and so on). The higher the savings rate the smaller the multiplier.
I can’t help thinking that there is an important lesson in here for us. In the 1930s it was noteworthy that the current account surplus countries like the US and the net exporters in Latin America suffered more deeply from the crisis than did current account deficit countries, especially, it seems, once barriers to trade were imposed. The extreme case of the latter was Germany. As I understand it Germany imposed trade restrictions early, in which German imports were largely paid for in export credits, so that Germany more or less ran a balanced trade account after many years of large deficits. It was the first country to emerge from the Great Depression – in fact I don’t really think there was a depression in Germany to speak of – in part, I think, because its low savings and high trade barriers permitted the investment multiplier to work very effectively.
The US, on the other hand suffered a deep crisis in the 1930s, and its imposition of trade tariffs made things worse, not just because impediments to trade are costly to the global economy, but rather because it eliminated the ability of the US to absorb expanding demand from other countries and to force other countries to absorb excess US production. Once international trade is eliminated, in other words, US excess production over consumption had to be resolved wholly within the US, and that meant that either the US engineered a substantial increase in domestic demand by fiscal means, as Keynes demanded, or that it adjust via a collapse in production. It did the latter.
I am worried about some of the conclusions I might be drawing. The first conclusion, I think, is pretty clear and I have already discussed it. Demand has to expand and it isn’t like to be households or businesses that do the job. The burden must fall on governments to expand fiscally.
On that point I think most people agree with me generally, but are less convinced than I am that the main role in resolving the global demand problem must fall on the current-account-surplus countries, whose high savings rate must decline. They have produced more than the world is currently able to consume, and if they do not boost demand significantly, they will be forced to cut supply significantly.
Not everyone agrees that this means that China and other Asian countries, more than Europe and the US, must adjust. Paul Krugman recently argued in the New York Times, for example, that the US government and the Obama administration must act dramatically to expand demand. But I worry that the global problem has never been a lack of US demand – it has been lack of Asian demand. The US has already provided a greater share of global demand than is healthy fir etiehr the US or, as we have clearly seen, for the world.
A massive fiscal expansion by the US would certainly boost global demand, but it would do so at the expense of increasing US indebtedness by far more than it increases demand for US goods (much of the expansion in demand would simply be exported to countries that continue to suffer from overcapacity) and of course it would not solve the global overcapacity problem. It might even exacerbate it. The best that one could hope for, if the US took the lead in fiscal expansion, is that Asian countries make heroic efforts to shift their economies as quickly as possible from export dependence to domestic demand dependence, but I have already argued that with the best will in the world this will be a long and difficult process, and I am not sure anyway that most countries have the political will to force the shift. China, for example, is raising export rebates and talking about depreciating the currency – hardly the actions of a country working hard to reduce global overcapacity.
The second conclusion is more worrying – a least to a liberal internationalist like me. It suggests that although a collapse in world trade might be bad for the global economy overall, the pain will not be evenly distributed, and some countries might even benefit, and in that case they may actually move to restrict global trade. Current account deficit countries will suffer much less from anti-trade policies, in other words, and may even benefit because it gives their domestic fiscal policies greater traction. This may encourage them to attack trade if the global economy gets much worse.
As things currently stand, for example, fiscal expansion in the US has a much lower multiplier because in an open economy it is not US savings that matter but rather global savings, and global savings rates are much higher than domestic savings rates. In addition, a boost in US demand is exported through the current account deficit to other countries. Will the US continue to accept these limitations off trade if the UIS is forced to bear the brunt of the effort to increase global demand, or will at some point protectionist legislation become irresistible?
I think this is sort of what happened in the 1930s. The US refused to bear the brunt of the adjustment which, as the leading creator of global overcapacity it should have. Countries like Germany that opted out of the system seemed to bear little of the pain. When the US government enacted Smoot-Hawley, as a way of forcing even more of the US adjustment onto the rest of the world, it made it very easy for the rest of the world to opt out of the trading system, thereby forcing the full adjustment onto the US. In fact the US ended up bearing more than its full share of the adjustment because the decline in international trade actually made things worse for everybody.
The collapse in global trade forced most of the economic adjustment onto countries, like the US, whose excess savings and rapidly rising capacity created the global overcapacity problem in the first place. The Great Depression was brutal for the US and for some Latin American countries, but not nearly as bad for continental Europe and I think barely noticed in corporatist Germany, Italy and Spain (although of course Spain went into civil war in 1936). What if current account deficit countries conclude today, like they seem to have done in the 1930s, that by restricting trade they can force most of the global adjustment onto the current account surplus countries? That would be devastating for Asian exporters and especially China.
My conclusion? I am still trying to get my arms around all of this but I guess it is not terribly optimistic. I would argue that it might not help the world much – except in the very short term – for excess-consumption countries to boost consumption significantly via large fiscal programs. It was their excess consumption that created one side of the problem in the first place, and not only will the required fiscal boost need to be substantial (since much of it will be mitigated by the high savings rates of other countries), but it won’t be sustainable. Debt will rise, and overcapacity will still plague the system.
The real fiscal boost has to come from current-account surplus countries. It is their excess savings that created the other side of the problem, and it is as important for them to boost consumption as it is for the others to boost savings if we are going to return to a healthy global balance of payments. It is far more rational, in other words, not to mention sustainable, for countries with excess savings to boost consumption than for countries with excess consumption to do so. If the latter, it will only store up more problems for later.
What is worse, if the excess-savings countries do not boost domestic demand aggressively, the political and even economic argument for a rise in trade protectionism could become irresistible.