I got back three days ago from my trip to the US and am still sludging through my jet-lag, but there are two quick takeaways from the trip I should mention. First, my Washington meetings convinced me (no big surprise here) that, just as it is doing in Europe, the issue of trade is getting more political attention than ever, and the adverse employment impact of the US trade deficit is an issue that will not easily subside. I did not leave Washington feeling that my worries about a rise in trade tensions were in any way exaggerated.
Second, I met with at least 30 different institutional investors, and perhaps the fact that my trip coincided with the twelve labors of Greece, or however many they have, worry over China and the state of the world economy was deeper than on my previous trips. For reasons I have often discussed on this blog, I have never been a believer in the survivability of the euro, and many of the people I met on this trip had heard me over the past decade express my doubts, so meetings that were ostensibly on China often became meetings on whether Greece, Italy, Portugal, Ireland or Spain will be forced to exit. Everyone wanted to know if turbulence in Europe would hurt China (I think it definitely would, especially if it came when there were worries about the Chinese financial system).
In the meetings where we discussed the euro I nearly always made reference to a thesis argued in Barry Eichengreen’s magisterial Golden Fetters (one of my favorite books) that the political enfranchisement after WW1 of very large segments of the population in Western democracies – most crucially the working classes, who historically bore most of the pain of adjustment – meant that the traditional adjustment mechanisms under the gold standard, which were deflation and rising unemployment, meant that we would never return to the gold standard. Politics would make it impossible (and probably a good thing, too).
The pain of adjusting
This has an important implication for the discussion on the euro. Unfortunately the euro today imposes a kind of gold standard on European countries – it forces them to adjust to excessively high domestic prices, large trade deficits, and/or large fiscal deficits in the same way they would have had to adjust under the gold standard, and I don’t think that is politically likely to be acceptable. The countries that need depreciation to regain competitiveness or monetization of the debt to regain control of the deficit will have to choose between adjusting via deflation and high unemployment or exiting the euro. Politics makes the latter more likely.
There is one other way out, perhaps. Martin Wolf discussed it last week in an important Financial Times article called “Europe needs German consumers”. Wolf argued that trade imbalance within Europe helped to create the subsequent and damning financial imbalances, and that without resolving the trade imbalance it is pretty pointless to talk about fiscal belt-tightening and lower wages as the means by which the problems of outer Europe will be resolved.
So long as the European Central Bank tolerates weak demand in the eurozone as a whole and core countries, above all Germany, continue to run vast trade surpluses, it will be nigh on impossible for weaker members to escape from their insolvency traps. Theirs is not a problem that can be resolved by fiscal austerity alone. They need a huge improvement in external demand for their output.
This, of course, is the intra-European version of the global imbalance debate. It is simply another way of saying that policies in major trading nations that constrain consumption and subsidize production – in effect trading off lower household income for higher domestic employment – must have the reverse impact on trading partners who implicitly made the opposite trade-off, giving up employment in exchange for higher consumption. As long as those trading partners were able to use the recycling of surpluses to leverage up domestic demand, and so boost domestic employment through debt-fueled growth, the adverse employment effect was hidden.
Once the leverage process started to unwind, however, the deficit countries would inevitably see a surge in domestic unemployment. The best way to deal with the problem is to have both sides unwind the mechanisms that created the mirror trade-offs. Germany must put into place policies that trade higher consumption for lower employment, and use debt to force employment up, so that deficit Europe can gain employment, albeit at the expense of a lower share of consumption.
Germany might not like reversing this trade-off, which was the source of much of its recent growth (almost 70% of its growth since 1997), but in the longer term it will be much cheaper than bailing out the European countries, or allowing them to exit the euro messily and anyway force the reversal of the trade-off on Germany. You can’t run large trade surpluses if your trade partners are no longer able or willing to run the corresponding trade deficits.
This, by the way, seems to me to be the classic Keynes argument (although not, perhaps, the “Keynesian” argument): In a world characterized by contracting global demand and large trade imbalances, it is the obligation of the large surplus nations (and in the 1930s of course he meant the US) to stimulate domestic demand. Asking the trade deficit countries to leverage up to stimulate demand is counterproductive and would ultimately just postpone the necessary adjustment. Asking them to adjust via unemployment, on the other hand, makes everyone worse off. In other words it is far better for Germany to move aggressively to boost domestic demand than to ask Spain to cut workers’ wages.
In that context I have to say I am very heartened by all this talk in China of pressures to raise the minimum wages in a number of Chinese provinces. This is exactly the kind of thing China (and Germany) should have been doing all along. The South China Morning Post, for example, had an article claiming that factory bosses in the Pearl River Delta now fear a shortage of employees. This month Jiangsu, the third largest exporting province, imposed its first increase in minimum wages (minimum wages are set by local governments in consultation with the central government, and were frozen in late 2008). Shanghai, the second biggest exporter, has also announced increases. More is expected, with Beijing, Zhejiang and Guangdong all in line to announce something soon.
Many analysts expressed some worry that rising wages can set off an inflationary spiral in China. Although I think there is certainly a risk of rising inflation (the relative low CPI number for January, 1.5%, down from December’s 1.9%, was offset by the 4.3% PPI) I am not sure an increase in wages will have such a big impact on inflation because Chinese manufacturing tends to be heavily capital intensive and worker productivity has anyway risen faster than wages in the past ten years (in fact this “suppression” of wage growth relative to worker-productivity growth is part of the mechanism that forces high savings rates and low consumption in China).
In spite of nagging worries about inflation, most observers, as far as I can see, welcomed the possibility of higher wages. I think they are right. The whole concept of rebalancing the economy is completely meaningless unless it means raising household income as a share of GDP. Chinese wage earners have struggled with a number of factors that have made it difficult to raise their wages in line with the increase in national income (GDP), and since the level of household consumption is a function of the level of household income, this has forced a rising gap between the two and has forcibly resulted in a higher savings rate.
But in that sense I think many observers, who argued that raising wages was the best way to rebalance the economy because it is the most direct way to get income into the hands of workers, are missing the point. As I see it there are four main ways to raise household income, and while each of these can have the same aggregate impact, they differ on how the costs and benefits of that impact are distributed.
¨ Raising wages in the coastal areas will shift income from coastal manufacturers and SOEs to coastal workers. It may partially undermine the competitiveness of coastal exporters and will probably increase migration to the coastal areas.
¨ Raising interest rates will shift income from bank loan recipients – mainly real estate developers, large manufacturers, and above all the SOEs – to depositors around the country. By raising the cost of capital it will penalize speculators and the most capital-intensive industries – almost certainly a good thing economically but politically tough to do.
¨ Appreciating the RMB will shift income away from exporters, by reducing their subsidy, in favor of all other companies and households by reducing the cost of imports. I am not sure how the cost of imports is distributed across income classes, but I suspect that the urban poor will benefit the most and the rural poor second, since a rising RMB may put downward pressure on agricultural prices. Of course it will reduce China’s export competitiveness.
¨ Improving the health, education and social safety net – probably the weakest of the four mechanisms but the one that seems to get the most attention – transfers income from whoever is forced to fund it (not households through taxes, I hope) to whoever the recipients are. I suspect that the main beneficiaries are likely to be the urban middle classes and the poor.
The key to which policy is “best” depends on how policymakers want to distribute the costs and benefits. Of course the relative political strengths of the various sectors who may be forced to bear the cost will have an important impact on which policy is chosen, but there is no getting around the fact that any policy that increases the income of the household sector will have an adverse impact in the short term on unemployment. Over the long term, however, as it rebalances Chinese growth towards domestic consumption, its impact on employment should be better.
But this trade-off is inevitable, and there is no point in trying to deny it. Like Germany, China has chosen policies over the past decade that traded off lower household income for higher domestic employment. Because this necessarily resulted in trade surpluses that the deficit countries are no longer or able to tolerate now that their unemployment levels are so high, China, like Germany, must either work towards a reasonably smooth rebalancing or it will be forced into a messy and disruptive rebalancing. If it is to work towards a global recovery and a domestic rebalancing, like Germany today China must put into place policies that trade higher consumption for lower employment, while using debt to keep unemployment from rising too quickly.
The pace of adjustment
How messy and disruptive could the forced rebalancing be? That depends on the adjustment taking place in the US. On the one hand consumption numbers in the US were better than expected for January, but consumer sentiment was not. Here is the Financial Times article:
US retail sales rose unexpectedly fast in January, the government said on Friday, but hopes that consumers will emerge as a driving force in the economic recovery remained muted after a separate survey showed an unexpected drop in consumer sentiment.
…With unemployment at 9.7 per cent and the housing market still in the doldrums, American consumers have not returned to spending as aggressively as they had in the wake of previous recessions. The rebound in growth in the last quarter of 2009 was instead led by higher business spending and a sharp drawdown in inventories.
But Americans are shopping again: modestly but at a growing rate. In January, retail sales rose by 0.5 per cent, which was an improvement over the 0.1 per cent drop recorded in December and the 0.3 per cent gain expected by most economists.
However other indicators were not so good:
Meanwhile, consumer sentiment unexpectedly dipped from a two-year high of 74.4 in January to 73.7 in February, following big gains over the previous two months, according to the Reuters/University of Michigan monthly survey.
Although the recent drop in equity prices was judged to have contributed to the drop in the public mood, consumer sentiment related to current conditions actually increased, while it was expectations for the future that accounted for most of the unexpected decline. At the same time, long-term inflation expectations edged downwards, from 2.9 per cent in January to 2.8 per cent this month.
The big question facing the US economy is whether consumers will use any cash they accumulate as growth returns to boost personal savings. Alternatively, they could spend it on new goods and services, but with consumer credit still extremely tight, many economists believe that Americans will choose the first option and keep hold of their cash.
Meanwhile the key measure of the pacing of the global adjustment, the US trade balance, has shown some pretty rapid change. According to an article in the New York Times:
After years of being told by Asians and Europeans that it had to find a way to reduce its trade deficit, the United States did find a way in 2009. A global recession did the trick, producing the largest decline ever in the deficit.
The recession caused American imports to fall by 26 percent, by far the largest annual drop in imports of goods since the government began keeping trade statistics in 1948. There have been only a few years with any declines at all, with the largest before 2009 being a fall of nearly 7 percent in 1982, another recession year.
Exports also fell, but not by as much, as can be seen in the accompanying charts. The result was a trade deficit in goods of $501 billion, or 3.5 percent of the country’s gross domestic product. That was down from $816 billion, or 5.7 percent of gross domestic product.
Any way you slice that, it was the largest improvement in the trade deficit on record. In terms of G.D.P., the biggest improvement before 2009 was in 1988, when the deficit declined by almost 1 percent. …Even so, the deficit, as a percentage of G.D.P., is larger than it ever was before 1999.
What happens to the US trade deficit, whether caused by changes in consumer confidence or by rising trade tensions, is key.
The fireworks are going off like crazy all through Beijing. Happy Spring Festival and enjoy the year of the Tiger.