Key Trends in the World Economy

Germany's 'continental economy' - comparisons to the US, India and China

Data released by the German statistical service shows how much Germany, until this year the world's largest exporter, and still the second largest, relies on its European market - particularly in a period of severe economic downturn such as 2009.

Approximately three quarters of German exports were to European countries. 63% of all exported German goods were delivered to the member states of the European Union.

Asia, the second most important market for German export goods in 2009, trailed far behind with 14% of German exports. The US accounted for 10%.. Africa and Oceania (including Australia) accounted for only 2% and 1% of German exports.

In terms of imports Germany was almost equally Europe dominated. 71% of Germany's imports came from Europe, with 18% from Asia and 9% from the US. Goods from Africa and Oceania represented just 2% and 0.4%, of Germany's imports.

Germany's economy, in short, is not really a balanced 'international' one - in particular in an economic downturn. It is, in export terms in particular, a European continental economy with secondary add ons in Asia and the US.

What implications flow from this?

The first is to reinforce the decisiveness of preserving the Eurozone for Germany - as against somewhat facile talk that the Euro may split or disintegrate. Germany has by far the highest percentage of exports in GDP of any major economy - 47.1% on the eve of the international financial crisis in the 2nd quarter of 2008. This has increased hugely, from 28.0%, since the introduction of the Euro.

The fact that Germany is operating in a continental scale economy, Eurozone Europe, with a fixed exchange rate, allows it to gain or maintain tremendous economies of scale. Conversely introduction of unstable exchange rates,including the possibility for major European trading partners to carry out competitive devaluations, would almost certainly make it impossible for Germany to maintain such a high proportion of exports in its economy - that is it would greatly weaken the 'continental' scale of its economy. The Euro, in short, is not a 'monetary union' but a decisive mechanism for Germany to enjoy the advantages of a continental scale economy. As the gains are great German economic policy, being rational, can pay a major price to maintain the Euro - something to be kept in mind in the coming battles over debt in Greece, Portugal and Spain.

Second, the trade data casts an important light on the optimal size of a modern economy. It is well known that the world's largest and most productive economy, the US, has only a relatively small share of foreign trade in GDP. In the 2nd quarter of 2008, prior to the recent decline in world trade, exports accounted for 13.6% of US GDP and imports for 18.5% - evidently far below German levels. Exports of goods and services were only 5.7% of US GDP in 1929, 3.4% of US GDP in 1938, and 7.0% of US GDP in 1950.

The reason for the far more self-contained character of the US economy, of course, is the fact that it was the first continental scale integrated economy in history. The second continental scale economy was the USSR, which has since disintegrated, the third is China and the fourth is India. Germany's economic configuration is that of the single most important component of a continental scale economy attempting to come into existence in Europe. Whether it succeeds or not of course depends on the future course of European integration.

These parameters also cast a very interesting light on possible future dynamics of China's economy. China's economy is far more open than any economy of its scale has been historically. In real, that is parity purchasing power (PPP), terms China's has already been the second largest economy in the world for several years. In PPP terms China's economy is slightly over half the size of the US - on IMF calculations $7.9 trillion compared to $14.3 trillion. In terms of percentage of GDP, at official exchange rates, China's exports of goods and services peaked at 39.1% of GDP in 2006 - far exceeding the ratio of exports to GDP of the US. By 2008, under the impact of the upward movement in the exchange rate of the RMB, and the beginning of the international financial crisis, exports of goods and services had fallen slightly to 35.9% of China's GDP.

If China's exports in dollars are compared to a parity purchasing power figure for its GDP, however, then  exports are only 20% of GDP. This is still above the figure for the US but not vastly so. It is entirely possible that as the size of China's GDP at official exchange rate grows towards US levels, both through economic growth and revaluation of the RMB, the percentage of exports in China's GDP will actually decrease. Unlike the historical pattern of most economies, which developed on the basis of their domestic markets and then expanded into exports, China may develop on the basis of exports and then statistically partially  'retreat' into a large scale domestic market. This would be a type of economic 'convergence' towards the type of $15 trillion GDP economy which is the scale represented by both the US and the EU.

Such a development would, of course, not be a retreat of China from globalisation - the absolute scale of China's exports, imports and inward and outward investment would continue to rise, but it casts the present rebalancing of China's economy towards domestic demand in not only a tactical but a strategic light. The only proviso that needs to be made, because of some confusions expressed in sections of the press, is that 'domestic demand' for China, as for every country, does not consist only of domestic consumption but also domestic investment. The present rise in the proportion of both domestic investment and domestic consumption in China's GDP, at the expense of its trade surplus, would constitute part of that process.

The process of 'globalisation' should therefore not hide the reality that the present is also an epoch of the integrated continental scale economy - with a common state to sustain a common currency, a unified budget, and the other features of an integrated economy. The US, China, and India have all created this, even if they are at different levels of economic development. Europe has not. Champions of 'national sovereignty' in Europe in fact lead their own nations towards decline. Whether Europe succeeds in creating a real integrated continental scale economy, or retreats into individual country units which are too small to be economically efficient in a modern world economy, will largely determine not only the continent's fate but that of the individual countries within it.

Germany's trade data shows the strength of the forces leading to the creation of a real European continental scale economy. The present parochial state of European politics - increasingly influenced by obsessions about banning minarets, immigrants, discussion of non-existent threats to ' convert Europe to Islam', and other forms of xenophobia and racism - leads the continent and the individual countries within it to decline.

It is a common pattern that a European country reached a peak of power followed by a prolonged period of fall - Italy in the 15th century, Spain in the 16th, Holland in the 17th, Britain in the 18th and 19th. Europe, which for several centuries was the world's most powerful continent, seems on the political level intent on pursuing the same path. 

It remains to be seen whether the forces expressed in Germany's continental scale economy, and the parallel processes in other countries, can reverse the processes of decline which are expressing themselves in European politics.

World share markets have so far regained half their losses

As world stock markets have been rising since February 2009, and the dominant US markets since March 2009, the data below shows it is an appropriate moment to make a balance sheet of how far this recovery has gone, In summary it may be noted that approximately half of the falls since the lows in early 2009 have been regained.

According to the monthly data of the World Federation of Exchanges the international share markets of affiliated exchanges, which count for very close to the totality of world stock market capitalisation, peaked at a combined value of $63.0 trillion in October 2007. This then fell to $28.7 trillion in February 2009 - a drop of $34.4 trillion or 54.6%.

The capitalisation of the New York Stock Exchange (NYSE) declined from a peak of $16.6 trillion in June 2007 to a trough of $7.9 trillion in March 2009 - a fall of $8.7 trillion or 52.1%.

From the trough in February 2009 to the latest monthly figures for January 2010 the capitalisation of world exchanges had recovered to $46.8 trillion - $16.4 trillion, or 26.0%, below their peak levels.

The New York Stock Exchange had recovered to a market capitalisation of $12.2 trillion - $4.4 trillion, or 26.4%, below its peak.

In short both for world exchanges and for the NYSE by the end of January 2010 almost exactly half the losses since world share markets reached their peak have been regained.

It, of course, remains to be seen in the future whether the second half will be regained and over what period.

The world data is shown in the chart below.

China and India – economic growth and the struggle against inflation

India and China are engaged in separate but parallel struggles with inflation. Both have responded by monetary tightening. Such tightening affects inflation via its effect on demand and its interrelation with the supply side of the economy. This article, therefore, analyses macroeconomic determinants of the supply side of China's and India's economies and its effect on inflation and their relative growth rates. In particular it considers the relative efficiency of investment in China and India and the consequences of this for inflation and growth.

As this article is somewhat more statistical than most on this blog it may be useful to summarise its conclusions - readers can turn to the article for the supporting evidence.

1. Analysis of macro-economic parameters clearly confirms other forms of study that both the Chinese and Indian economies are up against or approaching inflationary capacity constraints. Therefore, for example, the analysis that China is facing an overall problem of 'overcapacity' is the reverse of the truth - China is facing an overall problem of constraints on capacity which has inflationary consequences.

2. As China is suffering from inflationary capacity constraints the argument made by some commentators that in 2009, and at present, China's policy makers should aim at increasing domestic demand only via increasing domestic consumption, and not also increasing domestic investment, is false - such a policy, by increasing demand but not tackling capacity constraints, would increase inflationary pressures. The Chinese authorities in 2009 were therefore right to have expanded both domestic investment and domestic consumption. This remains the correct policy.

3. India's domestic savings level combined with a policy of accepting a moderate, i.e. up to 3% of GDP, balance of payments deficit makes it credible for India to aim at a double digit, or close to double digit, economically sustainable growth rate. The projections for India's growth at the latest Indian Prime Minister's Economic Advisory Council, of 7.2% in the current fiscal year and over 8% in the next, appear even moderate compared to the macro-economic potential - indicating that either, or both, India has ample strategic margin to contain inflation or that growth rates will exceed these projections.

4. There is not a statistical basis for the claim that India is able to make more efficient  use of investment than China and therefore that India will be able to match China's growth rate with a lower level of investment. India's efficiency of the use of investment, from the point of view of economic growth, is almost exactly the same as China's and therefore, unless there is a change in this, their relative growth rates will continue to be determined by which country invests a higher proportion of GDP.

5. China, on the basis of the level of of investment achieved in 2009, should be able to sustain the approximately 12% GDP growth which is likely in the early part of 2010 without seriously destabilising  inflationary capacity constraints. However further acceleration, without an increase in the level of investment, would be likely to produce unsustainable capacity constraints and therefore the Chinese authorities are correct to have begun to rein in the rate of acceleration of the economy.

The more detailed analysis of these points follows.

* * *

On 12 February China's central bank raised banks' reserve requirements for the second time in a month. India raised bank reserve requirements on 29 January.

The struggle with inflation in both China and India is complicated by short term inflationary pressures created by climatic effects which have contributed to capacity constraints in food supply.(1) But other more general inflationary pressures are due to capacity constraints in sectors in which additional investment can potentially tackle the problem in the medium or short term.

In regard to capacity constraints in China Geoff Dyer noted in the Financial Times: 'According to Yu Song and Helen Qiao at Goldman Sachs, the most extreme example is in the auto sector, where extra shifts mean factories are running at above capacity. They also see emerging bottlenecks in electricity, coal and even in aluminium and steel which only a few months back seemed to be suffering from chronic overcapacity. "The capacity overhang has been quickly whittled down in major industrial sectors," they wrote in a recent report.'

Analysing the situation in particular industries, while important, is however not sufficient to estimate how serious are overall inflationary capacity constraints. There will always necessarily statistically be examples of 'overcapacity' and 'undercapacity' in an economy, even when overall macro supply and demand are in balance, as it is in practice impossible to exactly match these in all sectors. Pointing to cases of either overcapacity or undercapacity, whether statistical or relying on anecdotes, therefore does not resolve the issue - it will always be possible to find these cases. Only overall consideration of the balance between demand and supply can determine whether deflationary overcapacity or inflationary lack of capacity is dominant.

To look clearly at the root of the issue of capacity constraints it is therefore necessary to look at the overall situation – i.e. at the macro-economy. Examination of this for both China and India reveals major implications for short term anti-inflationary policy and for long term determinants of growth.

China or India cannot increase capacity only via increased efficiency of investment

The first point revealed by examining the macroeconomic constraints is that neither China nor India can significantly increase capacity, to overcome inflationary supply side issues, by simply increasing their efficiency of investment. To overcome current domestic capacity constraints they would both have to raise the level of investment in their economies.

To demonstrate this, ideally fully up to date studies on total factor productivity in the two economies would be used to evaluate investment efficiency. However studies of total factor productivity on India are less frequent than those for China and such analyses by their very detailed nature are also in general not fully up to date.

Studies of total factor productivity which have been carried out for China show clearly that, contrary to myths presumably spread by those who have not examined the figures, China's use of investment is highly efficient in terms of international comparisons as is India's.

Given the lack of, and problem of timeliness of, total factor productivity studies a less statistically precise, but indicative and relatively current, measure is to calculate the correlation of the level of investment with GDP growth – i.e. what percentage of GDP India and China have to invest to generate 1% GDP growth. Such analysis confirms the situation found by the total factor productivity studies and casts a clear light on the situation facing both China and India. Such analyses, in turn, can be brought more fully up to date - yielding a less statistically precise result than total factor productivity studies but one that can be used as a policy tool.

Efficiency of investment in China and India

Taking a five year moving average, to smooth out purely short term fluctuations, China has had to utilize 3.7 percent of GDP in fixed investment for its economy to grow by 1 percent. To give detail, in the five years to 2008, the latest for which there is full data, China's GDP grew at an average annual 10.8 percent, and it invested an average of 40.7 percent of GDP – yielding a 3.7 percent of GDP in fixed investment correlation with 1 percent GDP growth.(2)

India's efficiency in the use of investment in terms of generating growth is almost exactly the same as China's. Over the same period India's economy grew an average 8.5 percent a year and its share of fixed investment in GDP was 31.0 percent – i.e. India also invested 3.7 percent of GDP to grow by 1 percent.(3)

As neither China nor India during the latest five year period suffered intolerable macro-economic imbalances it may be assumed that 3.7% of GDP devoted to investment to generate 1% GDP growth is consistent with sustainable macro-economic stability.

Figure 1 below shows the development of this ratio over a longer time frame. This data shows the dramatic decrease in the percentage of GDP that had to be devoted to investment to generate economic growth in China after the economic reforms starting in 1978 and as a result of the economic opening up in India.

In the case of both China and India the percentages of GDP that had to be devoted to investment fell from around 6% of GDP prior to their economic reforms to the present 3.7% of GDP level – i.e. the efficiency of investment, from the point of view of generating growth, increased by around 50%.

To take an international comparison, at the end of the 1970s China, India and the US each had to invest about 6% of GDP to generate 1% of GDP growth.However after this the efficiency of investment, from the point of view of generating GDP growth, greatly improved in both China and India and it deteriorated in the US - the US, even before the onset of the 2008 recession pushed the figure higher, had to invest 7.8 percent of GDP to grow by 1 percent.(4) Both China and India's efficiency of investment, from the viewpoint of GDP growth, is currently therefore more than twice that of the U.S.

The trends for the three countries are shown in Figure 1.

Figure 1

Historical examination shows both China and India have among the most efficient sustained uses of investment in generating growth in post-World War II history – far better than the U.S., Europe or Japan at present. China and India's economies, in short, grow so rapidly both because they have very high investment rates and because that investment is now used very efficiently – this interaction being multiplicative.

For present purposes, however, the significance of these figures is that China and India have little scope for increasing their capacity, or sustaining or raising their growth rates, simply by achieving efficiencies in capital use - both countries are already up against the boundary of what any country has achieved in a sustained way in this field since World War II. It is implausible that a significantly superior investment to GDP growth ratio can be achieved in either country – although major efforts will be required to maintain what is already a highly efficient use of investment. India's and China's growth rates could therefore only be maintained or increased by maintaining or increasing the allocation of GDP to investment.

A further implication of this data is that as an approximate guide to the macroeconomic situation the 3.7% of GDP investment to 1% GDP growth ratio indicates a macroeconomic balance compatible with overall stability - including avoiding excessive inflation. However if the actual growth rate for China or India is not supported by a level of investment sufficient to maintain the 3.7% of GDP to investment for each 1% GDP growth then macro-economic instability, including inflationary capacity constraints, will occur.

As these ratios have not fluctuated greatly for twenty years they therefore give a rough but relatively robust guidance as to the level of investment required to support any given growth rate.

As both China's and India's efficiency of use of investment, from the point of view of economic growth, is already very high India's and China's growth rates could therefore only be maintained or increased by maintaining or increasing the allocation of GDP to investment.

India's Investment and GDP in 2009

Turning to estimating the implications of the above data for the present situation of capacity constraints in China and India no figures for the breakdown of GDP between investment and consumption are available for either country for the whole of 2009. However for India data is available for the first half of that year and China has published data allowing indirect estimates to be made for the whole of 2009.

For India fixed investment in 2008 was 34.8% of GDP. Given the correlations above, this would sustain a 9.4% annual growth rate. However the 2008 figure was the highest level of investment in GDP recorded.  IMF International Financial Statistics data indicates that the proportion of India's economy devoted to fixed investment fell in the first and second quarters of 2009 - no more recent data is given. In the 3^rd quarter of 2009, the latest available figure, India's GDP growth was already 7.9% and accelerating. India's economy was therefore probably already approaching the rate of growth that was the maximum that could be sustained by its level of investment - acceleration of economic growth was shown by the fact that industrial production in December, for example, was up 16.8% year on year.

Such a combination of accelerating GDP growth of around 8%, and a level of fixed investment which had fallen as a percentage of GDP, at least during the first half of 2009, clearly indicates that India's economy was moving up towards its capacity constraints by the end 2009. To maintain a target of a 9% a year growth rate, for example, India would have to invest 33.3% of GDP – a level achieved in only two years (2007 and 2008). While the Indian authorities stress that at present serious inflationary pressures are confined to food, and are not appearing in manufacturing, nevertheless the economy is beginning to approach its overall capacity constraints.

These benchmark parameters therefore indicate that a 9% a year growth rate is just achievable for India at the highest levels of investment it  has reached, but it is right up against the economy's investment constraints – confirming the recent view expressed by Nobel prize winner Michael Spence that: 'it will be hard to get to 9% and stay there.'

Policies envisaged by the Indian government that would allow sustaining a higher rate of growth by inward investment to finance an increased investment level are considered below.

China's investment and growth in 2009

In the case of China no data for the distribution of GDP between consumption and investment have been published for 2009 but an indirect calculation yielding ballpark figures can be carried out as figures for the contribution of different components of GDP growth in 2009 have been published.

China's year on year GDP growth in the 4^th quarter of 2009 was 10.7% and accelerating strongly – projections of 12-13% year on year growth in the early part of 2010 are not unrealistic. 10.7% GDP growth, using the correlation between GDP growth and investment given earlier, would already require 39.6% of GDP to be invested to be consistent with macroeconomic stability. A 12% GDP growth would require 44.4% of GDP to be invested and 13% GDP growth would require 48.1% of GDP to be invested.

The latest year for which measured data for the proportion of China's GDP devoted to investment are available is 2008 at 41.1% - which would already leave little margin for even a 10.7% year on year growth rate and is quite insufficient to sustain a 12% or 13% growth rate.

It is clear that the proportion of China's GDP devoted to fixed investment increased in 2009 but not by enough to maintain the very high levels of GDP growth that are likely to be reached given that acceleration beyond 10.7% growth is almost certain in the first part of 2010.

The published data is not sufficient to make a detailed calculation of the proportion of China's economy devoted to fixed investment in 2009 - as the figures for the contribution of the share of different components to GDP growth that have been issued do not give a breakdown between fixed investment and accumulation of inventories and are in constant and not current price terms, However the published figures are adequate to give an overall grasp of trends.

The published data show that the shrinkage of China's trade surplus in 2009 meant declining net exports deducted 3.9 percent from GDP growth. China's domestic consumption contributed 4.6 percent of GDP growth and domestic investment contributed 8.0 percent. The two together mean China's domestic demand increased by 12.6 percent in 2009 – one of the highest increases in world history.(5) While exact translation of these figures into current price terms cannot be made, if it is assumed that inventories remained constant as a proportion of GDP, and that the consumer and investment price deflators did not diverge excessively, then they imply that consumption probably rose to around 49% of China's GDP and fixed investment to around 45%.

Such an increase in the level of fixed investment in China, as it came on stream, would be counter-inflationary as it would increase supply by removing capacity constraints and increasing productivity. However it is clear that, on the basis of earlier data, such a figure for investment would be scarcely enough, or insufficient, to maintain the likely rate of expansion of China's economy at the beginning of 2010 - to recapitulate the figures above, to sustain a 12% growth rate would require investment of 44.4% of GDP, a 12.5% growth rate would require fixed investment of 46.3% of GDP, and a 13% GDP growth rate would require fixed investment of 48.1% of GDP. China is therefore clearly already approaching, and may soon exceed, the rates of GDP growth consistent with macroeconomic stability even after the increase in investment that occurred in 2009.

Conclusions

What conclusions, therefore, flow from the situation in China and India noted above?

1. The macroeconomic examination of capacity constraints evidently clearly underlines the correctness of the Indian and Chinese authorities estimates that they face significant inflationary pressures.

2. Claims made in 2009 that China faced a decisive problem of 'overcapacity', as outlined for example in a European Chamber of Commerce in China report that was picked up in an editorial in the Financial Times, were the reverse of the truth. The dominant situation emerging in China's economy was capacity constraints and not overcapacity – as the Goldman Sachs report noted earlier rightly outlined.

3. Regarding China,the proposal made by some economists that China should concentrate simply on increasing domestic consumption, without also increasing domestic investment, is clearly wrong and would significantly increase inflationary pressures.

Both increased domestic investment and increased domestic consumption achieve the desirable goal of reducing China's exposure to fluctuations in international demand/reduce China's trade surplus. However consumption, by definition, does not add to supply whereas investment does – thereby lessening capacity constraints. Increasing China's domestic demand only by increasing domestic consumption, without increased domestic investment, would therefore fail to lessen domestic capacity constraints and, other things being equal, would thereby increase inflationary pressures.

China's actual economic policy in 2009, which increased both domestic investment and domestic demand, was therefore a superior policy to one of only increasing domestic consumption both from the point of view of the short term struggle with inflation and from long term growth. The Chinese authorities were correct to have implemented a balanced development of consumption, investment and trade. The 2009 stimulus package, which increased domestic demand via both consumption and investment, has left China better placed to confront inflationary pressures in 2010.

4. In India Prime Minister Manmohan Singh has frequently stressed the investment level as the decisive determinant of growth and it is therefore almost certain that India's economic policy will be oriented to ensuring that the lowering of the investment level in GDP, compared to the previous year, seen in the first half of 2009 is reversed. The general consensus behind such a policy is indicated by the editorial call in the Economic Times, India's most influential financial newspaper, for the government to 'reallocate expenditure away from consumption towards investment.'

Discussion with Indian authorities confirms that a policy instrument to achieve a higher level of investment, to sustain a higher growth rate includes an acceptance of a moderate balance of payments deficit. As  such a deficit is necessarily equivalent to a net inflow of savings from abroad it would raise the total finance available for India's investment. Ballpark figures indicate that double digit economic growth should be achievable on this basis of India's domestic savings plus such a sustainable balance of payments deficit.

In 2007, the latest year for which full data is available, IMF International Financial Statistics figures show that India's measured savings level was 37.7% of GDP – although indirect calculation shows this is likely to have slightly fallen in 2008. If a 3% of GDP balance of payments deficit is added to the 37.7% figures, this, creating a domestic and international savings rate of 40.7% of GDP then, based on the correlations of investment and GDP growth, this would theoretically support an 11.0% growth rate. Given India's likely inflow of foreign investment a 3% of GDP balance of payments deficit should be sustainable. In short, India's attempt to achieve a double digit growth rate would appear to be realistic if it can regain its previous peak domestic savings level and supplement this by a containable balance of payments deficit.

Interestingly the latest Indian Prime Minister's Economic Advisory Council projected growth rates, 7.2% in the current financial year and exceeding 8% in the next, which are significantly below these which appear possible from this macroeconomic data. This indicates either that India has ample margin to control inflation or that the projections will turn out to be conservative and India's actual economic growth will be higher than these projections.

5. China is able to finance all its investment on the basis of domestic savings. A 45% investment rate of the type that probably existed in 2009, on the basis of the correlations previously given between investment and growth, would equate to a 12.2% growth rate. Given the extreme recessionary pressures at the beginning of 2009 it is unsurprising that such a growth rate was not achieved last year but it will be interesting to see if this approximates to the growth rate achieved at least in the first part of 2010. Preliminary projections indicates that China's growth rate in likely to be relatively close to this figure – which would confirm that the macroeconomic correlations indicated above continue to operate.

6. There appears to be no statistical basis for the claim that India utilises its investment more efficiently than China. The statistical data shows that the efficiency of the use of investment, from the point of view of economic growth, is almost exactly the same in India and China.

A consequence of the preceding point is that India will not be able in a sustained way to match or exceed China's levels of growth without matching or exceeding its level of investment. If the efficiency of the use of investment, from the point of view of growth, is essentially the same in China and India then the growth rate of GDP depends on the relative levels of investment in the two economies. Unless the efficiency of use of investment in China declines, or its level of investment in GDP decreases, then as long as India continues to invest a lower proportion of its GDP than China its growth rate will be lower.

7. The final conclusion is evidently that, on the basis of the above data, both India and China have sufficient macroeconomic room for manoeuvre to contain inflationary pressures while maintaining their high growth rates. Any inflationary threat appearing to seriously threaten the ability to contain inflation would seem to have to be one coming from the international arena. Even if China's growth rate in the first quarter of 2010 is around 12% this would not appear to seriously threaten, on the basis of domestic pressures, a level of inflation that was not containable - although acceleration beyond that point would hence Chinese policy makers are clearly correct to be taking measures to rein back inflation and further economic acceleration. India is locked in a short term struggle with food price inflation but the present predictions for economic growth at the Prime Minister's Economic Advisory Council appear even rather modest compared to macroeconomic fundamentals and it would be unsurprising to see India attain a higher rate of growth in the next financial years than these projections.

Notes

1. In China severe winter weather helped increase vegetable prices by 16 percent in a single month in December. Within the 1.9 percent increase in the consumer price index in the year to December the highest rate of increase – 5.3 percent – was for food. China's annual consumer price index fell in January to 1.5% but food supply constraints still exist. China's producer price index rose by 4.3% in January.

In India the worst monsoon since 1972 helped produce a 18.0% year on year increase in the main staple food prices in the week to 6 February. India's benchmark wholesale price index was 8.6% in January, with India's chief statistician projecting that inflation could reach 10% by March.

In regard to short term food shortages only a limited amount can be done to lessen the effect of these domestic capacity constraints - India, for example. has been allowing duty free imports of certain items and releasing food from stocks.

2. Calculated from China Statistical Yearbook 2009.

3. Calculated from IMF International Financial Statistics.

4. Calculated from IMF International Financial Statistics.

5. This is higher even than the 11.2% increase in domestic demand this blog had estimated using earlier data and very conservative assumptions. The fact that China's domestic demand increased in 2009 even more than such preliminary and conservative calculations of course confirms even more strongly the points made in the post 'China's dramatic surge in domestic demand' of the huge scale of China's increase in domestic demand in 2009.

Big business in the US and European Union

The Financial Times carries an article, by Richard Milne, on the situation of small and medium business in Europe during the international financial crisis. This contains some interesting information on economies of scale and productivity in Europe and the US.

In the US 45% of employment is by enterprises with more than 250 employees, compared to only 33% in the European Union (EU). The definition of a small and medium enterprise (SME) used was that it employed less than 250 people, a small enterprise was defined as employing 10-49 staff, and a micro-enterprise as one with under 10 employees.

The EU contained 20.4 million SMEs and only 43,000 large companies. Of the SMEs 92% were micro-enterprises.

Taking the ratio of SMEs to population the country with the smallest ratio of SMEs to population was Germany – Europe's most successful economy.

The average productivity of labour in European small and medium enterprises was significantly lower than in large enterprises. EU SMEs in 2005, the latest year for which data is available, accounted for 67% of jobs but only 58% of value added. Because of lack of economies of scale EU SMEs had a productivity that was only 86% of the EU average.

The conclusions which flow from this are evident.

First, the higher productivity of the US compared to the EU remains correlated with its higher proportion of the workforce employed in large enterprises – putting another nail in the coffin of 'small is beautiful' confusions.

Second this is almost certainly not only a correlation but a causal connection. If US large enterprises are more productive than SMEs in the same way as the EU pattern, which is highly likely, then the greater proportion of large scale enterprises in the US compared to the EU helps explain the US's higher productivity.

The same pattern appears if the number of SMEs in a country is looked at. Germany, Europe's most competitive economy, had only 20 SMEs per 1,000 inhabitants compared to around 25 for the UK, 40 for the average for the EU, 65 for Italy and 80 for Portugal.

The talk that 'small and medium enterprises' are the key to the economy', 'the future lies with small and medium enterprises' is simply not true – no matter how much it is an ideology which allows right of centre political parties to appeal to the small enterprises which form a key part of their electoral support. The key to high levels of productivity remains, as it has always been, the creation of large scale enterprises. Not for nothing was the US, the world's most productive economy, the home of 'big business'. It is one of the weaknesses of the teaching of academic economics that it has failed to sufficiently integrate the work of Alfred Chandler and other classic historians of US company and industry structure.

The conceptual caution that must be made is first that, as every industry is specific, large scale company development has to be a development of market, or quasi-market, forces and cannot simply be imposed administratively - as was attempted in the former Soviet system. Second, size of company must not be confused with the physical size of units of production. A company may include several physical sites of production – and it is company size, not physical size, which is crucial.

The data in the Financial Times however clearly confirms the correlation of scale of enterprise and productivity. Large scale enterprises, not small and medium ones, continue to represent the 'wave of the future' - the most powerful instrument for raising the productivity of an economy.

Note

In addition to the main theoretical interest of the article noted above it also analyses the squeeze on small and medium enterprises (SMEs) in a number of European countries – for example in Portugal the number of SMEs has fallen by 45% from 489,000 in 2005 to 267,000 at present.

Barclays Capital, John Maynard Keynes and Hyman Minsky

A report for Barclays Capital on recoveries in share prices after severe falls, such as in 1982 or 2009, is important for stock market investors. But it also throws a light on economic theory.

As John Authers notes in the Financial Times: 'Looking for the key factors driving such recoveries, Barclays found that economic growth and profits were not particularly important. Instead, the strongest link was with credit spreads. Provided credit continued to get cheaper (as shown by the extra spread for corporate debt compared to government debt), then relief rallies could continue. Once credit spreads widen, equities cannot make much headway.' Authers' video on this, which contains further statistical illustration, is well worth watching.

What is expressed in this data is not only changes in evaluation of risk but a rather good practical illustration of changes in liquidity preference. Keynes in The General Theory of Employment Interest and Money clearly explained that for investment to take place it is not sufficient for the rate of profit to exceed by a minimal fraction the rate of interest. There is an advantage in holding flexible assets, cash or near equivalents, compared to non-flexible ones. For investment to be take place it is therefore necessary that the rate of profit equal at least the rate of interest plus whatever rate of return is necessary to induce the investor to forego the advantage of liquidity. The rate of return sufficient to create an inducement to forego liquidity, that is to offset liquidity preference, changes according to circumstances. Hyman Minsky, of course, analysed some consequences of this when, as in a modern economy, investment is carried out on the basis of credit. Risk is a factor influencing the rate of return that must be offered to overcome liquidity preference.

While Keynes was analysing the development of effective demand in the productive economy, and shares are far more liquid than productive assets, nevertheless the same process is clearly working. The Barclays Capital data is therefore of interest not only practically from the point of view of stockmarket investing but from the viewpoint of illustrating and validating economic theory.

The Economic Times on the fight against inflation - lessons that apply to China as well as India

The Economic Times is India's leading financial newspaper. Today it carries an editorial on India's current fight against inflation. But lessons drawn in the editorial apply far more widely than only India.

Regarding India itself the Economic Times notes that the wholesale price index, used as the country's benchmark inflation rate, has risen to 8.6% in January. It however believes that this number is so far not as serious as it appears at first sight as it is based in short term pressures on food prices, worsened by the very poor 2009 monsoon, and upward price shifts that have appeared in some manufacturing sectors,  But it concludes: 'That said, the threat of core inflation accelerating in the months ahead as economic activity and demand pick up, remains.'

In the light of this latter consideration the editorial, regarding monetary policy, supports the tightening started by India's central bank raising reserve requirements in January. Regarding fiscal policy the editorial argues the Indian government must contain the budget deficit and 'reallocate expenditure away from consumption towards investment,'

This means that the Economic Times understands the general fight against inflation more accurately than do some other commentators. Containing inflation requires measures not only on the demand side (tightening monetary policy, preventing excessive budget deficits) but also on the supply side - increasing supply by removing capacity constraints. Removing supply side blockages requires investment - hence the correctness of the editorial's call for a shift of expenditure from consumption into investment,

When capacity constraints are appearing in an economy a policy only of increasing consumption, which by definition does not add to capacity/supply but only to demand, is inflationary. Investment, which adds to supply as it comes on stream, on the contrary strategically contains inflation by removing capacity constraints.

The country to which this point applies particularly clearly at present, in addition to India, is China. China has seen the emergence of clear inflationary capacity constraints. Some commentators have been calling for China simply to increase domestic demand by increasing domestic consumption and not also to increase domestic investment.Such a policy of increasing domestic consumption, without an increase in investment, under conditions of capacity constraints, would add to inflationary pressures.

The Economic Times editorial is correct on this point regarding India. But it also applies to China.

This issue is of great importance in looking at the present economic situation in both China and India and this blog will be coming back to it. Meanwhile the Economic Times editorial deserves consideration more widely than only in India.

The myth of the decline of the US consumer

A widespread myth about the international financial crisis is that what is taking place is a serious reduction of consumption in the US, with the knock on consequences that would flow from this for the world economy. The present article shows that this myth is factually untrue. No major downturn of US consumption has taken place. Therefore such a non-existent downturn in US consumption cannot be the driving force of either the US or international  ‘Great Recession’. 

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The claim that a key driving force of the present international 'Great Recession' is a major downturn of US consumption is a frequent one. We will take as an example of this argument Stephen Roach’s book The Next Asia - all page references therefore refer to this work. Roach, president of Morgan Stanley Asia, is chosen because he is a coherent economist who spells out this mistaken claim more lucidly than many far less serious economists who make it.

According to Stephen Roach what is taking placed is the 'capitulation' of the US consumer. Thus Roach refers to, ‘America’s postbubble compression of consumer demand.’ (p378).

This alleged reduction in US consumption is then cited as the driving force of the economic downturn. As Stephen Roach put it:‘The current recession is all about the coming capitulation of the American consumer.’(p20) Therefore: ‘The main event… is the likely capitulation of the overextended, savings-short, overly indebted American consumer.’(p42). Roach concludes that: ‘After a dozen years of excess, the overextended American consumer is finally tapped out… Hit by the triple whammy of collapsing property values, equity wealth destruction, and an ongoing unemployment shock.’(p325)

As a result of this situation a major reduction in the share of consumer spending in the US economy is foreseen. Stephen Roach concludes: ‘the US consumption share of real GDP, which hit a new record of 72.4% in the first quarter of 2009, needs, at a minimum, to return to its prebubble norm of 67% ... the die is cast for a protracted weakening of the world’s biggest spender.’(p32) The situation is therefore that: ‘the US consumer [is] most likely in the early stages of a multi-year contraction’ (p79) Indeed: ‘Despite the unprecedented contraction of consumption in late 2008, there is good reason to believe the capitulation of the US consumer has only just begun.’ (p385)

It is this alleged reduction of US consumption which, it is asserted, will cause the slowdown in the world economy: ‘The postbubble shakeout stands to be dominated by a protracted adjustment of the US consumer – providing powerful and lasting headwinds on the demand side of the global economy for years to come.' (p396)

The problem for this thesis is that it is factually incorrect. No such major reduction of US consumption has taken place. The share of consumption in US GDP has expanded and not contracted. And, as no significant reduction of US consumption has taken place, it therefore cannot explain any of the current trends in the world economy

To show the factual situation Figure 1 graphs the percentage change in the major components of US GDP between the 2nd quarter of 2008, the last before the US recession began, and the most recent available data - that for the 4th quarter of 2009. During this period US GDP contracted by -1.9%. However the reduction in US personal consumption was only -0.6%. Government expenditure, consumption and investment taken together, increased by 3.1%.

Compared to the relatively small fall in US personal consumption the really large declines were in US residential fixed investment, which dropped by -21.2%, and in US non-residential fixed investment, which declined by -20.3%, In other words, as regards the US domestic economy, what occurred was not a consumer decline but a large investment fall.

As regards the external relations of the US economy there were also declines in exports, down -7.7%, and a major drop in imports - by -12.3%.

Compared to these major shifts in investment and trade the decline in US consumption was extremely small and played almost no role in the economic contraction.

Figure 1

To show the real shifts in the US economy even more starkly, and illustrate further that the 'decline of US consumption' is a myth, Figure 2 shows the shifts in the major components of US GDP from the 2nd quarter of 2008 to the 4th quarter of 2009 in monetary terms - i.e. in current prices.

In this period US GDP fell by -$34 billion. However US personal consumption actually rose by $56 billion. In contrast US residential fixed investment fell by -$129 billion and US non-residential investment dropped by -$362 billion. The total decline in US fixed investment was -$490 billion. The breakdown of these figures is important as it shows that the downturn in investment was concentrated in non-residential, and not simply residential, sectors.

Over the same period inventories rose by $9 billion. Net trade, that is the trade balance, improved by $298 billion. US government expenditure, consumption and investment combined, increased by $92 billion.

In current price terms, therefore, there has been no fall at all in US consumption, indeed it has increased. It is US fixed investment that has fallen sharply.

Figure 2

 

What has made possible these shifts is that the proportion of the US economy devoted to personal consumption has not fallen, as Stephen Roach and others believed it would, but it has on the contrary increased. This is shown in Figure 3. US personal consumption was 70.3% of GDP in the 2nd quarter of 2008, immediately before the recession started, and it had risen to 70.9% of GDP by the 4th quarter of 2009.

Figure 3

In summary, the claim that the 'Great Recession' is rooted in a decline of the US consumer, and of US consumption, is a myth. No such decline has taken place. The economic decline in the US is a fall in investment, not in consumption.

Theories that the present situation in the world economy is driven by a decline in the US consumer and US consumption are therefore equally false. A process cannot be driven by something which has factually not occurred.

A myth is not made truer by repeating it. Therefore the claim that the 'Great Recession' is rooted in a decline of the US consumer, and US consumption, should be abandoned as factually unfounded.

New US and China trade figures show error in Martin Wolf's analysis of global imbalances

The US and China have published new trade figures – the US for December 2009 and China for January 2010. These show another increase in the US trade deficit and a further reduction in China's trade surplus.

Both sets of figures are  important data in themselves regarding the state of the world economy. However they also again reveal the error of one of the most influential theories of the present international economic situation – that probably most prominently promoted by Martin Wolf in the Financial Times and at book length in his Fixing Global Finance. 

According to this theory the US balance of trade deficit is not principally caused by excessive consumption in the US but is forced on the US by excessive saving by Asian countries – notably China. Variants of the same thesis have been presented by Stephen Green of Standard Chartered, by David Cohen of Action Economics, by Brad Setser, by Michael Pettis of Peking University, and other authors.

The issue at stake in this is not primarily bilateral trade, which is affected by many elements, but the overall development of 'global imbalances' - i.e. the excess of China's domestic saving over domestic investment, reflected in its balance of payments surplus, and the shortfall of US domestic saving compared to its domestic investment which is represented by its balance of payments deficit.

If the theory is correct that the trade deficit is not primarily created by US excess consumption but is 'forced' on the US by the trade surplus of China then this has clear factual implications. A fall in China's trade surplus should lead to a shrinking of the US trade deficit, while a widening of the US trade deficit should be accompanied by an expansion of China's trade surplus. 

The theoretical errors of such an analysis have already been discussed elsewhere on this blog. The theory however is also clearly empirically refuted by the recent trends in the trade of the US and China.

Considering first China, its trade data for January 2010 show a shrinking of China's monthly trade surplus to $14.2 billion from $18.4 billion in December 2009 and $19.0 billion in November 2009. This is shown in Figure 1.

However it would evidently be unwise to rely simply on individual months data. Therefore Figure 2 shows a three monthly moving average for China's trade balance. 

The pattern of development of China's trade is clear. Prior to 2005 China did not run a significant trade surplus. A surplus then developed which peaked at the end of 2008/beginning of 2009. Since then China's trade surplus has sharply fallen.

China's monthly trade deficit, measured by a three monthly moving average, rose from $16.9 billion at the beginning of 2008 to $39.4 billion in January 2009, then began declining from February 2009 and had fallen to $17.2 billion by January 2010.

Figure 1

Figure 2

Turning to US trade data, the figures for China show that the latter's trade surplus shrank from February 2009 onwards. Therefore if the US trade deficit was being 'pushed' by China then the US deficit should have been contracting during almost all of 2009. In fact this did not occur - as can be seen in Figure 3 which charts the US monthly trade deficit. The US monthly trade deficit, having peaked in April 2008 at $62.1 billion, shrank rapidly to $26.6 billion in February 2009. It then reached its low point in May 2009 at $25.8 billion, and subsequently began to expand - reaching $40.1 billion in December 2009.

Figure 4 also shows the monthly US trade deficit calculated using a three month moving average in order to make it strictly comparable to the figures for China shown above.Taking a three monthly moving average the US monthly trade deficit reached a low point of $27.1 billion in June 2009 and then began to expand again - reaching $36.6 billion by December 2009.

However during this period when the US trade deficit was expanding China's trade surplus was falling. Therefore the expanding US trade deficit could clearly not have been 'pushed' by an expanding China trade surplus - as the latter did not exist.

Figure 3

Figure 4

The conclusions that flow from such trade figures are clear. A theory of global imbalances which claims that the US trade deficit is 'pushed' by excessive saving by China, rather than pulled by excessive consumption in the US, is theoretically false - for reasons analysed elsewhere. But it is also refuted by the factual data. The fact that the US trade deficit has been expanding during a period when China's trade surplus has fallen shows clearly that the US deficit is not being 'pushed' by China, it is being 'pulled' by excessive consumption in the US.

Martin Wolf is one of the world's outstanding economic commentators. However on his analysis of the origins of global imbalances he is unfortunately wrong.

China and the fight against inflation in 2010

This author of this blog author has a new article up at China.org.cn. It analyses how China is placed to deal with the threat of inflation in 2010. In considering how likely China is to be able to deal with inflationary capacity restraints it contains an analysis of the efficiency of investment in China and India.