We’ve gotten some comments to the effect that, for all the discussion of the financial crisis and the various bailouts, we haven’t looked hard at the underlying causes of the financial crisis and accompanying recession. The problem, as I think I’ve hinted at various times, is that any macroeconomic event of this magnitude is overdetermined, on two dimensions. First, there are just too many factors at play to identify which are the most important: in this case, we have lax underwriting, lax bond rating, skewed incentives in the financial sector, under-saving in the U.S., over-saving in other parts of the world, insufficient regulation, and so on. How many of these did it take to create the crisis? There is no good way of knowing, because the sample size (one, maybe two if you add the Great Depression) is just not big enough. Second, there is still the conceptual problem of identfying the proximate cause(s). To simplify for a moment, we had high leverage which made a liquidity crisis possible, and then we had the downturn in subprime that made it plausible, and then we had the Lehman bankruptcy that made it a reality. Which of these is the cause? Leverage, subprime, or Lehman?
In any case, we’re not going to resolve these issues. But I want to start an occasional series of posts looking at one of the root causes at a time.
Today’s topic was inspired by this week’s meetings between U.S.-China meeting in Beijing, where, according to the FT, “the US was lectured about its economic fragilities.”
Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”
So, the global economy is falling apart, but not in the way people expected. Under the de facto arrangement sometimes known as “Bretton Woods II,” emerging market countries pegged (officially or unofficially) their currencies to developed world currencies at artificially low rates, having the effect of promoting exports and discouraging consumption by emerging market countries and promoting consumption and discouraging exports in developed countries. Of course, the classic example of this was China and the U.S. The U.S. trade deficit and Chinese trade surplus created a surplus of dollars in China, which were invested in U.S. Treasuries and agency bonds, keeping interest rates low and indirectly financing the U.S. housing bubble and consumption binge of the last decade (and, therefore, growth in Chinese exports).
The general fear was that U.S. indebtedness would lead China to diversify away from U.S. assets, causing the dollar to fall and U.S. interest rates to rise, hurting the U.S. economy and making it harder to finance the national debt. This may yet happen someday. But instead of demand for Treasuries collapsing, it’s been demand for every other type of asset that has fallen. Treasury yields have collapsed and the dollar has appreciated about 20%. Still, despite this increased purchasing power, the fall in U.S. (and global) consumption is having a severe impact on growth of the Chinese economy. Even though the Chinese government has signaled that it will do everything in its power to keep growth above 8% per year (down from 11-12% in the past few years), the slowdown has severely constrained the ability of the urban manufacturing sector to absorb internal migration from the countryside, and there are signs of a reverse migration that is aggravating the problem of rural poverty in China. Although China may seem to have all the cards – high economic growth, large foreign currency reserves – it could yet turn out to be a major loser of the global economic crisis.
This is of course just a brief introduction. For more I recommend Brad Setser, among others: some of his posts are here, here, and here.
Other countries can only drool with envy. China today announced a $586 billion stimulus package – that’s 17% of 2007 GDP. Spread through the end of 2010, it’s still more than 7% of GDP per year. By comparison, the US stimulus package earlier this year was just over 1% of GDP, and after causing a small uptick in spending in Q2 it vanished into the sea of bad news; our recent proposal was for 3% of GDP, and that was at the higher end of the range.
Of course, the stakes for China are very high. GDP growth ranged between 11 and 12% in 2006 and 2007, but the IMF recently cut its estimate for 2009 to 8.5% (down from the 9.3% estimate just a month ago), and according to the New York Times article the annualized rate for this quarter could be as low as 5.8%. While these are growth rates that the developed world hasn’t seen for decades, the huge population migration from countryside to city requires high growth simply to keep unemployment in check. So the Chinese government brought out the heavy economic artillery.
The current crisis has proven, if it needed any proof, that even China is susceptible to the fortunes of the global economy. If it can lead to greater participation by China in the global financial system, including institutions like the IMF, that would be one positive outcome.
Posted in Commentary
OK, that may be a bit of a stretch. But there’s little doubt that the global recession will take its toll on China’s double-digit growth rates.
One (emailed) response to our recent Washington Post op-ed criticized us for overlooking the role of China (although we did discuss China in the following Forbes article). In particular, the reader said, “it is my opinion that China holds all of the cards and I believe they will likely play some of them early in the next U.S. administration” – this because of China’s role in financing the U.S. deficits by investing in Treasuries. This may be true in the long run, although of course China cannot try to damage the U.S. economy without also crippling its own export-dependent economy. More immediately, though, China is facing an old-fashioned slowdown of its own.
All Things Considered did a story this past week on the impact of the global slowdown on Chinese exporters. One figure jumped out at me: 80% of the toy factories in Guangdong province have closed.
Also, the Baltic Dry Index, a measure of bulk cargo shipping costs and hence of global demand for heavy stuff (largely commodities) has fallen off a cliff this year (see the second chart in that post) – one reason why the Shanghai Composite Index is down more than 60% this year.
China is a place I won’t claim to understand. But as we all know, the Chinese government relies on an unsteady equilibrium in which it uses economic growth to legitimize the political system and convince the growing middle classes not to question the political order. Tocqueville’s observation (which I alluded to in my previous post) about the tendency of political strife to arise not out of prolonged abject misery, but when increasing expectations are dashed, could turn out to be particularly appropriate for China.
Update: Thanks to Randy for his comment (below). I fixed the error regarding the Baltic Dry Index.
Update: The Economist has a post with almost the same title as this post – but no question mark.