U.S. Asks China Not to Destroy World Economy

As efforts to contain economic damage stumble,  fail, around the world , it's time to revisit a post from November 2009.   I've updated with a few notes added in blue (below).  China's sustained effort to increase its exports through subsidies (via its currency peg/manipulation) -- which also raises the prices of American goods in China -- have greatly worsened devastating global trade imbalances.

The effect of these gigantic trade surpluses are widespread joblessness and gradual economic collapse in the western world.

But global trade imbalances maintained by currency pegs, like stress in the earth, must eventually release.  We now are witnessing the escalating quakes in Europe as both austerity and ability to borrow are failing.  These are like the little tremors and the medium sized tremors before the big one.

One wonders how long China will drag its feet to rebalance its own economy as the world economy falters.  Will it wait until exports collapse and it sees riots in its own cities?

But then, rarely are people willing to realize, to comprehend, the harmful effects of actions they believe benefit themselves, especially if the illusion can be maintained a little longer....

They don't want to know that their export model is slowly destroying the world economy, via their sheer size and manufacturing investment. Not any more than Germans would like to understand that their prosperity has come in large part from a currency peg against the rest of Europe via the EMU (European monetary union -- the Euro).  Were a (reestablished) German Deutsche Mark and the Chinese Renminbi allowed to freely float, so that their exchange rates were freely set by markets, nations like Greece, Italy, Ireland, Portugal, Spain, the U.K....and the U.S., to name a few, would quickly feel a fresh breeze of new economic activity and hope.

In fact, we could change course away from a very dark future (see this post).

But Germany has experienced record low unemployment (as the world economy deteriorates).  Why would Germans want to recognize reality?

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November, 2009:

Finally, after years, even economists like Krugman are publicly recognizing that the Chinese peg of their currency to the dollar is more than a nuisance or a developing-country tactic. It's a profound handicap placed on American manufacturing.

(2012: During the last year, the understanding of the effects of the Chinese peg has become widespread.)

The peg threatens American recovery. It is in effect a Chinese trade war against America, ongoing for years.

Many economists haven't yet really wrapped their minds around the reality that if exports are heavily subsidized (relative price held down) by a currency peg during an imbalance, then it is no longer "free trade."

We do not have free trade with China.

"Free trade" is effectively an ideology in recent times. Economists understand the advantages of free trade -- how it increases most everyone's absolute wealth (buying power in goods). It's understood the disruption and economic damage the raising of trade barriers would cause. All true.

But not enough. The thinking simply needs to continue beyond this basic level of understanding.

When a government intentionally bends a nation to accomplish an international goal of gaining manufacturing jobs at the expense of other nations (at the expense of jobs in other nations), this is a kind of powerful trade interference. It becomes in effect a trade war.

Damage to the U.S. isn't the only result of this managed effort. The peg actually threatens Chinese stability by extending a reliance on an unsustainable imbalance.

But more, the Chinese peg threats global economic stability.

(2012: Witness Europe)

And that raises an open question.

Does China have the smarts to recognize that both alternatives that could follow from maintaining the currency peg are quite harmful to China itself?

It's a multi-trillion dollar question.

Here are the two alternative scenarios I see if China maintains the peg.

Either:

A) As Martin Wolf points out, the U.S. is truly forced, without choice, to initiate major tariffs within a few years:

“Yet we do not have that much time. If the US domestic economy remained weak and unemployment high, while our trade deficit soared, particularly our bilateral deficit with China, the pressure to ‘do something’ would become irresistible. I would have to consider the sort of actions that Richard Nixon took in 1971. To force revaluations by Germany and Japan, he threatened a 10 per cent import surcharge. With great regret, I might feel obliged to do the same. I would then argue that China’s determination to thwart needed adjustment in exchange rates had become intolerable. The US is entitled to protect itself against such mercantilism. The trading system would be terribly damaged. But the alternative would be unbearable.”

OR

B) If somehow the U.S. government delayed such a response for little longer based on "free trade" fallacies, then the buildup of political pressure in the U.S. due to joblessness would only lead to a more drastic final U.S. response than the one Martin suggests.

Ideology -- the mental error of trying to maintain "free trade" when the U.S. faces in reality a kind of ongoing trade war -- can only withstand a contrary reality up to a certain limit, at which point the ideology, or illusion, collapses and great political energy is released. America could actually be pushed into a genuine change in ideology.

China by nature should be a natural ally of the U.S. Only the paranoid right has needed to see China as a serious rival.

That could change.

So this question is really a question of smarts. Are they smart enough to see the train coming down the track? Are we smart enough to sound the horn instead of patiently waiting for China to answer a diffident phone call?

It has become evident that conditions similar to the 1930s could arise... (2012 update: have arrived.  We have economic depression in several nations in Europe now, and are seeing a dramatic rise of nationalism.  We are progressing on the list towards a much darker time I reluctantly laid out in the link above.)  ... if these trade imbalances persist, which could lead to a increased risk of economic wars and even a general destabilization of currently peaceful parts of the world, with risk of major warfare.

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Update (2010):

Cui Tiankai, a Chinese vice foreign minister who is in charge of preparing for the G20 summit, said the yuan was "China's currency, so I don't think it is an issue that should be discussed internationally.

Regardless of internal Chinese politics/signals, the exchange rate of the yuan to the U.S. dollar, which China is massively intervening to control, is with the U.S. dollar and directly intervenes in U.S. exports by controlling U.S. export prices to China and many nations.

China is controlling U.S. export prices by directly controlling the value of the U.S. dollar.

Is that an "international" issue? Yes.

The U.S. dollar is the currency of the United States, so interventions that affect the dollar are central to U.S. economic health, and fully within the purview of the federal government of the United States.

Germany -- Fortunate?

Very nice piece on Germany below indirectly tells us a lot about the seeming economic success of Germany.

Germany, see, is heavily dependent on exports, as its own citizens are not willing to spend freely enough to consume as much as they produce.

(In part this is maintained by keeping foreign goods artificially more expensive relative to wages in Germany than a free market would set them due to the German efforts to lower wages by preventing natural raises in wages for years -- Germany created a low wage rate, then locked this artificially low wage rate in place via the Euro (common currency);  this is effectively a currency peg, similar to China's export subsidy/import-controlled market via Chinese currency controls/peg.)

The result of regions in an economy consuming much less than they produce (Germany, China in the global economy) is that other regions (nations) must then consume (and/or receive in foreign investment) correspondingly more than they produce. 

The sum total of the export surpluses of trade surplus nations must exactly equal the sum total of the export deficits of trade deficit nations plus capital flows (investments in foreign nations).

Exactly.

Capital flows are only the outcome of the trade imbalances, just the result.  For instance, if China has a trade surplus of $100 billion over a period of months, during that same time it must save or invest that surplus in some manner -- some combination of  accumulating cash (savings) in foreign currencies or purchasing foreign assets or investing abroad.

So, trade surpluses depend entirely on trade deficits somewhere else.

The export "success" nations are entirely, fully dependent on the "profligate", the trade deficit nations.

Just so. They are two sides of the same coin.

I explain the why, how, and the consequences of global savings in excess of consumption/sound-investment most clearly here in a short story: The Savings Conundrum. (Also, a recent update: The Savings Conundrum Writ Large -- hitting on a global scale.)


The seemingly fortunate son (of the moment):

Watch In Greece Bail Out, Germans Eye 'Functional, Surviving Euro' on PBS. See more from PBS NewsHour.

2012 Approaches, But U.S., German Consumers Still Spending

A variety of important economic news of the last 2 months shows some hopeful possibilities and some increasing dangers to the world economy.

As the holidays approach, let's quickly lay out the dangers and move on to the hopeful.

Dangers:

The Chinese land price bubble looks like it is beginning to burst, and much Chinese investment and economic activity has relied on this bubble. Investment has been necessarily huge (and unprecedented) as China only consumes about 35% of it's output (compare to 70% for the U.S. (Paul Krugman offers an accessible summary) As Europe tightens and reduces consumption, China faces a likely hard landing. But, since Chinese imports from the globe are modest, an internal Chinese downturn is less important than bigger factors like US consumer spending.  China continues to need a powerful social safety net, so that private households will feel it is safe to spend more and save less.

Much European debt is due to rollover in 2012, so that European debt stability will be strongly tested.

The U.S. may or may not renew such powerful economic boosts as the payroll tax cut for 2012; and worse, we could always see a renewed push to cut governmental spending more now, when our consumer-debt-paydown-slowed recovery is still sluggish, not yet self-sustaining. Shades of 1937, when the U.S. tried to reduce it's federal deficit and a sharp new downturn hit the U.S. economy in response, are possible in such a push. (The real solution is debt-reduction, and here's what we need to do exactly.)

Ok, that's enough to worry about. Let's consider some better-than-expected news:

U.S. consumers have continued to spend and the U.S. recovery has continued, with some signs of improvement from very slow to just-slow. While not yet in full swing, this recovery is doing much to keep the global economy afloat.

And helpfully, German consumers also have been confident and open with their wallets. This is significant, even a hopeful sign, exactly because Germany has a large trade surplus. Much trade earnings flow into Germany, therefore Germans must spend to keep the European economy going. If German consumers cut back, Europe would sink -- just like that. But, they are spending!

Also, a dramatic aid in the European debt crises has arrived via the ECB, which has at least temporarily given Europe breathing room on sovereign debts by allowing a means for European banks to purchase governmental bonds. (AEP provides a competent summary, again).

Now, if China will be ready to respond to the Chinese economy with new efforts as needed and in sufficient scope, and Chinese consumers would pick it up a couple more notches....

A lot of ifs, but if...then we could see signs of a more pleasant way through this stormy-looking 2012.

The Savings Conundrum Writ Large -- Global Depression Threatens

As the first breezes of a gathering storm of great depression begins touching many shores, awareness of the driving forces is starting to spread.  For instance, in this link Ambrose Evans Pritchard nails our current situation -- we are in a global spiral into depression.

This is a good time to reprise and refine views I've presented before.  You see, all of this economic tumult around the globe is but the simple, straightforward outcome of a single dynamic.

When I first wrote on this dynamic, I called it the Savings Conundrum.   We are now beginning to see what happens when the Savings Conundrum operates on a global scale.


We are in the early stages.

Many large nations around the world are tightening budgets, reducing spending, while too many consumers are still cautious to spend and businesses still slow to invest. Only China and Germany --  the nations with the largest trade surpluses (created via currency pegs such as the EMU) -- are in a strong position to change this tune.

When government, business, and households together reduce their spending on net, the result is a vicious economic spiral -- a feedback loop -- that won't let up until some major event (like a world war) or massive intervention (like FDR's) break the spell.

The global economy will shrink if nations around the globe cut spending together, and the economic unraveling would continue not for months or one or two years, but for many years.

There is an explanation why this is no quickly passing storm we sense but is instead the menacing outer bands winds of a massive circling maelstrom -- we are looking at the Savings Conundrum writ large.

As I wrote about a year ago, The World Is Not On A Pleasant Course.

...

An end is now in sight, an absolute end of our current world order. The beginning of the end of this period of stability we've know most of our lives.

AEP's prediction of the rise of a new protectionist American trade bloc -- free trade among cooperating nations behind high tariff walls to exclude currency manipulators like China -- this is a best possible scenario.

It's a best scenario. A hopeful one.

One that has hope of avoiding the spiral into increasing economic desperation and the resulting rise in demagoguery, and then of demagoguery's children, that would result from general global economic downturn.

Let me be clear. I'm talking about not only global economic depression, but further, the possibility of the rise of power-seeking nationalists who would use external enemies to bend nations to their will, resulting in increasing tensions that could set the stage for large wars.

Widespread wars become possible in that world, like we haven't seen since the 1940s.

That's the less favorable possibility than that of AEP's new American Trade Bloc (which ends trade with China as it has been under the currency peg/subsidy/tariff).

Readers may notice this post is more alarming than posts I've written before. This is because the mistakes of nations around the world are all aligning in the same direction and negative momentum is building rapidly.

The last-chance alternative to these radical changes is for the major surplus nations -- China, Germany and Japan -- to increase their governmental spending as necessary to run governmental deficits roughly equal to all of their trade surpluses each year so as to create increased demand, income, and a circle of spending at home.

Chinese and German spending could rescue the world we've known: improved retirement stipends, infrastructure investments, consumption incentives, and even purchases of goods from deficit nations. For example, China (which still has a significant sector of command economy) might buy additional airplanes, locomotives, software, and more.

Or China could do something more dramatic and necessary in the long run -- simply move to free trade. That is, begin to have a freely floating currency without a peg and without currency controls.

That would be a very different situation than we have now.

But even today with the currency peg, China could immediately take big steps to improve the global economy by: A) ending domestic piracy of foreign goods such as US software and movies, B) greatly increasing their move to establishing a social safety net and retirement system, and C) creating more incentives for domestic consumption. China could easily implement these economy-saving changes now.  (See, China itself, dependent on big exports, is one of the most vulnerable nations to a global depression.)

These steps might save the current world order, but the more basic adjustment is ultimately needed.

An end to the Chinese trade-war via currency peg and to the German trade-war via European Monetary Union would tremendously benefit the global economy, and in turn would benefit China and Germany on net relatively quickly, certainly within years.

In fact, only such true free trade (with freely floating currencies) has any chance of creating truly healthy global growth, which China and Germany need to thrive in a sustainable way.

It's in their national interests.

But that doesn't mean they will see it.  Psychology and mythology normally rule over reason and facts.

As global riots haven't been sufficient yet and economies still sputter along for a while, China and Germany are likely to continue to maintain comfortable national illusions for now, and perhaps until we have irreversibly entered a different and more dangerous world.

They will most likely drive the world into collapse, and most of their citizens -- good Germans, good Chinese of good will -- will wonder to themselves why most of the other nations and peoples in the world are so irresponsible and wrong....

That it is still the greater likelihood, for now -- that the storm will intensify, that a global depression is coming.

Ultimately this is driven by the "global imbalances," by the great excess of Chinese and German savings over consumption.

This can put an end to the current world order of relative peace and relative safety most of us have known all our lives.

The End of the World Order We've Known -- Great Depression Threatens

At a moment when the first stirrings of a gathering storm of global depression/economic collapse is now touching onto every shore, Ambrose Evans Pritchard nails our current situation -- a global spiral into depression created by current policies of a few nations alone. He summarizes much that has appeared in this blog, with new details.

Governments around the world are tightening budgets, reducing spending, at the same moment that consumers are still slow to spend and businesses slow to invest.  (Update end of October: later data show the US consumer has been saving less lately and spending somewhat more, so this situation is still salvageable if governments avoid simultaneous deep budget cuts.  But, it appears cuts are in the cards.  Only China and Germany, those nations with the giant surpluses, are in a good position to change the tune.)

Everybody together spending less results in an economic death. 

It's the Savings Conundrum writ large.

As I wrote, The World Is Not On A Pleasant Course.

An end is now in sight, an absolute end of our current world order. The beginning of the end of this period of stability we've know most of our lives.

AEP's prediction of the rise of a new protectionist American trade bloc -- free trade among cooperating nations behind high tariff walls to exclude currency manipulators like China -- this is a best possible scenario.

It's a best scenario. A hopeful one.

One that has hope of avoiding the spiral to increasing hostility that would result from general global economic collapse.

Let me be clear. I'm talking about not only global economic depression, but further, the possibility of increasing tensions that would set the stage for large-scale wars between major nations.

War like we haven't seen since the 1940s.

That's the less favorable possibility than a new American Trade Bloc which ends trade with China on current terms.

Readers may notice this post is more alarming than posts I've written before. This is because the mistakes of nations around the world are all aligning in the same direction and negative momentum is building rapidly.

The last-chance alternative to these radical changes is for the major surplus nations -- China, Germany and Japan -- to spend roughly the equivalent of all of their trade surpluses in ways that will create income and spending at home.

Chinese and German spending could rescue the world we've known: improved retirement stipends, infrastructure investments, consumption incentives, and even purchases of goods from deficit nations. For example, China (which still has a significant sector of command economy) might buy more Boeing airplanes, and much more. Or simply move to free trade.

Especially, China could end domestic piracy of foreign goods and thus allow US software and movies to earn their fair returns in the Chinese markets.

That would be very different. That would be just normal trade as most people understand it -- you pay for what you get, instead of stealing it.

There is a more basic opening that is ultimately needed.

An end the Chinese trade-war via currency peg and the German trade-war via European Monetary Union would tremendously benefit the global economy, and therefore benefit China and Germany in short order (within years).

In fact, only such true free trade (with freely floating currencies) has any chance of creating healthy global growth, which China and Germany need to thrive.

It's in their national interests.

These changes are the only method of preserving the current world order.

But that doesn't mean they will see it. Psychology normally rules over reason and facts.

As global riots haven't been sufficient yet and economies still sputter along for a while, China and Germany are likely to continue to maintain comfortable national illusions for now, and perhaps always.

They will likely drive the world into collapse, and most of their citizens will wonder why all other peoples in the world are so irresponsible and wrong....

Thus it is more likely the current world order will end.

Expect the death throes to be painful.

What We Really Need Now (Updates: Martin Wolf; Krugman and Rogoff)

(Update 8/23: Krugman and Rogoff at bottom)
(Update 8/2: see Martin Wolf below)

7/29 -- As the popular American dialogue -- which our media blows into a theatrical crisis of the day/week/month -- tends to obscure reality, I thought it would be useful to remember where we really are.

We are on an economic bridge -- a support of deficit spending/investment on education/infrastructure/unemployment benefits -- over a deep economic chasm. Reality is more dramatic than the popular fiction this time.

Here's the normal outcome from a credit/debt/asset bubble-and-collapse such as the one the U.S. has experienced. From the abstract of Kenneth Rogoff and Carmen Reinhart's paper on the normal aftermath of such bubble-and-collapse:

This paper examines the depth and duration of the slump that invariably follows severe financial crises, which tend to be protracted affairs. We find that asset market collapses are deep and prolonged. On a peak-to-trough basis, real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Not surprisingly, banking crises are associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls an average of over 9 percent, although the duration of the downturn is considerably shorter than for unemployment. The real value of government debt tends to explode, rising an average of 86 percent in the major post-World War II episodes. The main cause of debt explosions is usually not the widely cited costs of bailing out and recapitalizing the banking system. The collapse in tax revenues in the wake of deep and prolonged economic contractions is a critical factor in explaining the large budget deficits and increases in debt that follow the crisis. Our estimates of the rise in government debt are likely to be conservative, as these do not include increases in government guarantees, which also expand briskly during these episodes.

And this is the average from bubbles both large and medium sized (big enough to put much of a nation's banking system into real trouble/insolvency). And an average that includes especially the last 100 years where governments acted to mitigate the crises, instead of allowing them to slowly grind out (as the US did in the nineteenth century, such as 1870s-1880s long depression).

Since Ronald Reagan's massive deficits ignited a new debt binge, we have experienced an unusually large credit/debt bubble:

From the wiki on the economy of the US:



We are far from getting out of the aftermath: Total public and private debt in the US is still at higher levels vs total US income (GDP) than at the peak of the Great Depression.

And after the asset bubble bursts (housing prices in our case), then households respond to their high debts by cutting spending for many years, even decades if nothing changes. This reduces or eliminates job growth.

That's where we are.

...

In order to recover from this massive debt overhang that would reduce consumer spending and job growth for decades without intervention, household debt vs income ratios must be sharply improved.

When debts become smaller in ratio to incomes, people will feel safe in purchasing more goods and services (much of which will be new style green goods and services -- economic growth and consumption can be environmentally favorable).

In short, for US recovery, people must have less debt and/or more income, including less mortgage debt.

That can only happen by three, make that four, means:

1) Rising incomes
2) Debt restructuring
3) Debt forgiveness

4) Or a lot of time treading water (if very slow growth is even possible -- if economic collapse doesn't ensue!) and such stagnation means a lot of people suffering for a long time

Since rising incomes can only happen via inflation or economic growth (and growth requires more consumer spending), it is obvious, necessary that we need significant help from restructuring and forgiving debts.

Foreclosures and bankruptcies are the two of the most rapid means of forgiving debt.

For this reason, current foreclosures and bankruptcies are especially beneficial to the US economic future.

Instead of a bad sign for our economy, these are a very good sign. They will help the US economy enormously.

(Yes, it is notable how incompetent so much commentary is -- suggesting that what actually helps us the most is a drag on the economy!)

If we had a lot more bankruptcies and foreclosures, quickly, we would get a quicker return to a good economy.

Economic growth also relies heavily on investment, both public and private.

Economic growth happens in response to new products, rising productivity/wages, and rising consumer spending.

Productivity and new products, key to growth, require investment.

Because the private sector is afraid to invest significantly now, deficit spending for public investments -- education (investment in people), infrastructure, technology, and science -- is indispensable to the future economy of the US.

Public investment will kickstart increasing private investment.

Without such public investment, we won't remain among the world's leading economies.

We should therefore focus federal spending, now, on education, infrastructure, science and technology, and require a level playing field in trade with all trading partners (this requires an end to the Chinese export subsidy/import tariff via currency peg).

For a good future, we must have public investment and fair trade. These are the real priorities.

Instead of the current media melodrama about whether the world's strongest economy is a good credit risk (whether US treasuries are a good investment, as the market clearly thinks).... we need to focus on reality and make good decisions now.

It's time for Obama to step up to the microphone in a more dramatic, clear way.

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8/2: Martin Wolf lays out the big picture succinctly:

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8/23: Paul Krugman and Ken Rogoff on how to get out of this "Great Contraction" (Great Depression) (hat tip to Mark Thoma). Rogoff's idea of mortgage debt relief is one of the most powerful steps we could take to shake off the decades long fallout a credit/debt bubble such as our entails.
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