Dani Rodrik is Letting the Cat Out of the Bag

In the latest posting on his blog, Dani Rodrik is saying things that I have been implying in some of my pieces but have been very reluctant to say explicitly, largely because I don’t like the political implications for international trade.

Rodrik’s post, which is titled “Some unpleasant Keynesian arithmetic”, begins by wondering what the effect will be to the US economy of a fiscal stimulus. The answer depends on the Keynesian multiplier, which is equal to:

1 / (1-the marginal propensity to consume * (1 – the marginal tax rate) + the marginal propensity to import)

He estimates the multiplier to be 1.8 (in other words a $1 fiscal stimulus would increase US GDP by $1.8), and wonders if there were any way to increase it.

In fact you can. It is pretty easy to increase the multiplier; just raise import tariffs by enough so that the marginal propensity to import out of income is reduced substantially (to zero if you want the multiplier to go all the way to 2.8). Yes, yes, import protection is inefficient and not a very neighborly thing to do–but should we really care if the alternative is significantly lower growth and higher unemployment? More to the point, will Obama and his advisers care?

Being the open economy that it is, I fear that the U.S. will have to confront this dilemma sooner or later. In an environment where the dollar has already appreciated against the Euro and even more significantly against emerging market currencies, fiscal stimulus here will produce an even larger current account deficit. If American consumers decide to spend 40 cents of a dollar of additional income on cheap imports from China and other foreign countries, the multiplier will be a mere 1.3. How long will it take before politicians of all stripes cry foul over the leakage through the trade account and the “gift to foreigners” that this represents? And they will have Keynesian logic on their side.

The way out of this dilemma is to get the rest of the world to engage in fiscal expansion at the same time–so that the gift is returned. The good news here is that China is playing along and hopefully the Europeans will too (if they can convince Germans to get over their weird obsession with fiscal conservatism).

Inevitably when I mention Keynes I get hate mail, and I don’t want to discuss whether or not everything Keynes said is gospel truth or vicious lies, but the fact is that even for non-Keynesians the US trade deficit can be seen to spread the effect of any US fiscal expansion out to the rest of the world, via its trade partners. An increase in US demand is shared between US producers and foreign producers to the extent of the trade deficit.

In a simple two-country model of the world, this means that an equal amount of US and Chinese fiscal expansion will contribute more to Chinese GDP growth than to US GDP growth. This is fine as long as no one notices or cares, and as long as Americans are comfortable with running up the fiscal deficits needed to pull both US and Chinese growth, but like Rodrik I find it hard to believe that this is not going to be a source of heated debate in the trade-deficit countries of the world, especially as China continues to lecture the US on repairing its profligate ways. Yesterday’s People’s Daily, for example, reported the following comments by Governor Zhou of the PBoC:

Zhou said excessive U.S. consumption and over-reliance on debt were key reasons for the crisis, and he urged the United States to raise its savings rate and reduce its budget and trade deficits.

Needless to say, he is right, but I am not sure policymakers here fully understand the consequences for China. From the inevitable retort that it was precisely US profligacy that kept the Chinese economy running, it is likely to be a very short intellectual jump to argue that an end to US profligacy must mean an end to the massive US trade deficit, which if that happens means that domestically the US can experience the expansionary impact of rebalancing trade while China will have to deal with is contractionary impact – in payment for the many years in which it benefited.

The fact is that “rebalancing” trade (a code word for eliminating trade deficits, usually through mercantilist policies) is likely to be expansionary for deficit countries and contractionary for surplus countries, and certainly the experience of the world’s leading surplus country in the 1920s, the US, suggests that trade “rebalancing” was a disastrous experience. I have had a number of conversations with US and European officials in the past two weeks, and I get the impression that there is going to be a substantial hardening, especially in Europe, of positions on international trade, and I suspect that European officials are nowhere near as committed to keeping the market for global trade open as American officials are, but even Americans will turn if popular discontent rises enough..

The reason that I am very uncomfortable with the whole line of reasoning Dani Rodrik, I and others have been following is that I do firmly believe that active international trade is in the long-term interests of the world, and especially in the long term interest of very poor countries like China. In the short term, however, I think it would be dishonest to say that reducing trade cannot create any benefits – it can help many trade-deficit countries struggling with insufficient domestic demand by diverting domestic demand that used to go abroad.

I know I am going to be criticized for making this point, on the grounds that I am fanning the flames, but the fact is that the world doesn’t need me to make the connection – already it is starting to be widely discussed, and by next year it will be a major topic of debate. In fact if China does decide to engage in Smoot-Hawley-with-Chinese-characteristics, as the US did in its trade surplus days in 1930, and for which there is a great temptation in China, the results are too easy to predict

Yesterday’s People’s Daily had a call to combat protectionism, but I have the worried feeling that for many Chinese policymakers “protectionism” means things the US and Europe do to limit China’s exports. It does not mean things China does to boost exports, which is seen as a purely domestic issue.

But of course from a global balance of payments point of view all of these things are forms of trade interference. That is why I am so worried that we are going to end up is a nasty trade dispute. Here is the People’s Daily article:

China and the US need to be persistent in their fight against protectionism amid the global economic turmoil, Minister of Commerce Chen Deming said yesterday. The crisis has spread from the financial sector to the non-financial sector, Chen said. And China’s manufacturing and exports sectors have suffered because of the falling demand worldwide since October.

The fight against protectionism, removing trade barriers and pushing forward the Doha round of WTO talks are the top concerns of the two countries at the fifth Strategic Economic Dialogue (SED) in Beijing. The US trade representative Susan Schwab corroborated Chen, saying the US had maintained its stance of trying to remove trade and investment barriers and to combat protectionism at the SED. China’s reform and opening up have helped the country maintain a fast growth rate, Chen said. “WTO members should act against protectionism by adhering to WTO rules.”

“China will continue to show good faith in the WTO, and we hope the US side does the same,” Chen said…China is particularly concerned over four aspects of trade barriers and protectionism – free trade of textile products, expanding high-tech products trade, its market status, and the misuse of anti-dumping and countervailing measures, Chen said.

Meanwhile the Chinese government is still talking about its own fiscal stimulus which, I am absolutely convinced, is the best policy option for China and the world. According to an article in Thursday’s Xinhua:

The government Wednesday unveiled a raft of measures to encourage lending by financial institutions to infrastructure projects, small businesses and potential home and car buyers. Also, an extra credit volume of 100 billion yuan ($14.6 billion) will be provided to three policy banks this year to prop up economic growth amid the worsening global financial crisis.

An executive meeting of the State Council, or the Cabinet, presided over by Premier Wen Jiabao, also said steps will be taken to help financial institutions better ward off risks. Banks, securities firms and insurers should take coordinated action to play a bigger role in supporting economic growth and contributing to industrial restructuring, it said. In the face of the global financial crisis, it is imperative to implement a “pro-active fiscal policy” and “a moderately easy monetary policy”; and the financial sector should play a bigger role in economic development, the meeting said.

There are still a lot of problems with the current fiscal plans and I suspect that they will be significantly expanded in the coming months. Thursday’s South China Morning Post had an article which mentioned some of the difficulties in assuming that the relationship between bank financing and government financing will stay constant:

At first glance the mainland’s 4 trillion yuan (HK$4.5 trillion) fiscal package seems a veritable feast for banks feeling the pinch from a slowdown in the world’s fourth-largest economy. With credible commercial lending targets scarce amid the severest economic downturn for three decades, government-funded projects are theoretically a safe haven for those banks whose profitability relies on loan quality and lending growth. Many of those lenders have publicly expressed their interest in the scheme just as they have pledged to support national programmes to help the country pursue political, economic or social development.

But bankers and analysts argue that the feast on offer is not as big or as appetising as it appears. While banks are expected to compete for some central government-funded projects, they are likely to regard those backed only by local governments with greater caution. “In the past, one yuan of government investment could attract several yuan of bank loans,” said Qiu Zhicheng, a banking sector analyst with Shanghai-based Haitong Securities. “But this time, I’m afraid it might only be able to attract one yuan. Banks will be very cautious to fund local government projects.”

We all worry that the fiscal expansion is not going to be sufficiently large and quick to avoid a downturn, but the real fear, as I discussed in my last blog entry, is the increasing talk of depreciation as one of the ways to get some extra kick in the fiscal stimulus package (via a version of Keynes’ multiplier). Later today the Guanghua Students Monetary Policy Committee is going to debate whether or not China should devalue the RMB, and I suspect that this debate is being held in a lot of other places. The good news is that officially, there is no consideration of such a policy. According to an article in Fridays’ People’s Daily:

The recent depreciation of China’s currency against the U.S. dollar was normal and China won’t rely on a weaker yuan to boost exports, Commerce Minister Chen Deming said on Thursday. “The recent small fluctuation of the yuan against the dollar was completely normal. I’d call it the dollar strengthening, rather than the yuan depreciating,” Chen told reporters at the fifth China-U.S. Strategic Economic Dialogue (SED).

“Dollar strengthening” rather than “yuan depreciating” is a distinction a little too fine for me to understand, but Minister Chen goes on to affirm the strong RMB with some hedging:

The yuan has since gained more than 20 percent versus the U.S. dollar as a result of market forces, Chen told reporters. The currency had been stable since mid-September, when the financial crisis that originated in the United States worsened and increasingly began to affect the world, he noted. It will remain stable if there is no big change in the international economic environment and all countries work together to respond to the crisis, he said.

How to define “all countries work together” is going to be a little tough, but I read this to mean that as long as nothing happens, nothing will happen. This is not totally comforting, but remember that traditionally the Ministry of Commerce ahs been seen as an important constituency for depreciation, so maybe it is only to be expected that he will hedge on the topic. Thursday’s People’s Daily had an article that was a little more complicated. On the one hand it said:

The steep fall of the yuan this week does not signal a major shift in the country’s foreign exchange policy or its long-term currency revaluation trend, analysts said.

“Analysts” is one of those terms the People’s Daily loves to use to confirm views with which it is sympathetic, without specifying who the analysts are, and the consensus here is that this is the newspaper’s way of putting out the official position – by attributing it generically to “analysts” or “experts” (and who would want to disagree with an expert?). But ominously enough, in the same article they say:

But the yuan should not rise too fast because that would hurt exporters, who are already reeling under the impact the global financial crisis, said Lian Ping, chief economist of Bank of Communications.

And at the very end of the article, they bring in the experts:

Experts have said the yuan should be revaluated slowly – or should even be allowed to fall – to help exporters and make the stimulus package more effective.

Commerce experts, surely. Not balance of trade experts.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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