Will China Once Again Save Us from the Fed?

They’ve done it once already. In late 2008 an excessively tight monetary policy in the US caused:

1. Soaring real interest rates
2. Soaring dollar/euro exchange rates
3. Housing prices to fall in non-subprime areas
4. Commercial real estate prices to fall sharply
5. Plunging commodity prices
6. TIPS spreads to briefly fall into negative territory

Of course all of these flashing red signs of ultra-tight money were completely ignored by 90% of our elite macroeconomists, who seemed to think the Fed was “doing all it could.”  Fortunately for the US, the Chinese took decisive monetary action, stopping their program of yuan appreciation.  As a result of a stable yuan and extremely fast productivity growth, the yuan effectively depreciated against the dollar in 2009.  China began an extremely fast recovery around March 2009, pulling the rest of East Asia, Australia, and parts of Latin America up with it.  China’s hunger for natural resources quickly stopped and reversed the sickening slide in commodity prices, which in the dark days of early 2009 had led to fears of a worldwide deflationary depression.  Then Chinese capital goods imports boosted economies like Germany.

Investors in the US quickly realized that if the world economy was beginning to recover, it was unlikely that the US would suffer a deep depression.  Hence stocks rallied strongly almost every time bullish data came out of China in the spring of 2009, even before the real economy in the US turned around in mid-year.  Of course the level of stock prices have remained far below 2007 peaks, as the Great Recession we have entered is bad enough, even if we avoided outright depression.

The Fed botched the spring 2010 eurozone crisis in the same way they botched the 2008 financial crisis—passively allowing increased demand for dollars to depress assets prices and economic growth.

Will China save us again?  September started off with a bang, as the Dow jumped several hundred points on the opening on news of strong growth in China.

Stocks rallied right out of the gate as investors welcomed a rebound in Chinese manufacturing and robust economic growth in Australia. The advance kicked into high gear following an unexpectedly strong report on U.S. manufacturing activity.

The manufacturing data boosted industrial names and companies in the materials sector. Caterpillar (CAT, Fortune 500), United Technologies (UTX, Fortune 500), Boeing (BA, Fortune 500) all gained between 2% and 4%. Energy producers Exxon (XOM, Fortune 500) and Chevron (CVX, Fortune 500) also rose as oil prices spiked 3%.

But the rally was broad-based. Six stocks gained for every one that fell on the New York Stock Exchange. All 30 Dow components closed higher, with Bank of America (BAC, Fortune 500) gaining over 6%.  (Italics added–showing it wasn’t just China plays.)

There had previously been fears that China was slowing on government attempts to slow real estate speculation.   Today I woke up to the following news:

NEW YORK (AP) — Stock futures rose sharply Monday as investors gained confidence in the banking sector following the passage of new global regulations and China’s economy continued its robust growth.

.   .   .

Fresh signs of strong economic expansion in China also added to market strength Monday. New economic reports showed growth in the world’s second-largest economy continues to accelerate at a time when economists were expecting it to slow. Strong growth in China is considered vital to a global recovery because if demand remains high there, it will offset sluggish growth in the U.S. where economic expansion is not as strong.

Thank God that China did not take Paul Krugman’s advice in 2009, and sharply revalue the yuan.  A weaker Chinese economy would be a disaster for the world economy, just as a weak US economy in 1932 and late 2008 (caused by a strong dollar) was a disaster for the world economy.  The income effect is far more powerful than the substitution effect.  Krugman has correctly diagnosed the key problem—monetary policymakers who are spinning their wheels because rates are zero, and who are too conservative to take unconventional steps.  But what he doesn’t seem to realize is that faster world growth speeds up the day when world real interest rates will be high enough to pull us out of the zero rate trap.   As Woodford and others have observed, current AD is powerfully affected by changes in future expected AD.

World AD and world growth are not a zero sum game.  Even at the zero bound. Chinese growth is good for China, and good for the global economy.

PS.  Some attribute strong Chinese growth to the stimulus package—and indeed that may have played a role (fiscal stimulus is easier to do in a 50% command economy.)  But a weak yuan was a sine qua non for a robust Chinese recovery.  China is more fragile than it appears to outsiders.  For instance, a strong yuan put deflationary pressure on the Chinese economy in the late 1990s.