Key Trends in Globalisation

US - world's no.1 capitalist country is currently creating no capital

A previous post noted an article by this blog's author on china.org.cn demonstrating that for the first time for a century and a half the US had lost its position as the country producing, in gross dollar terms, the greatest amount of finance for investment - i.e savings. The US has been overtaken by China. In short the world's number one capitalist economy no longer produces the most capital. The New York Times noted this as Newsweek did later.

The 3rd quarter US GDP figures published this week however confirm another extremely striking statistic, this time concerning net creation of capital - that is savings minus capital consumption. This shows that in net terms the US, the world's number 1 capitalist economy, is currently producing no capital at all - currently US capital consumption exceeds capital creation. The US is at present subtracting from the world's stock of capital not adding to it.

This situation shows how deep has been the impact of the financial crisis on the US. The open visible wounds are the recession and rapidly rising unemployment, but hidden financial injuries under the skin of the US economy appear more serious.

The factual situation is shown in Figure 1. This illustrates US gross saving compared to capital consumption. As may be seen US saving, that is capital creation, has been declining for a prolonged period but had hitherto since World War II had remained above the level of US capital consumption.

The impact of the financial crisis has however driven US saving precipitately downwards. The Bureau of Economic Analysis statistics show US gross savings in the 3rd quarter of 2009 were $1.483 trillion or 10.4% of GDP. US fixed capital consumption was $1.852 trillion or 12.9% of GDP. Even given that saving and capital consumption are among the harder figures in GDP to compute the $369 billion gap leaves no doubt that at present the US is consuming more capital than it is creating. In net terms, the world's number 1 capitalist country is simply not creating any capital.

Figure 1

While there is no precedent in the last 150 years for the US falling behind another country for gross creation of capital, as has now occurred with China, there is actually one for the US consuming more capital than it creates. But this comparison illustrates strikingly the significance of the present situation of the US economy. The previous period when the US was literally creating no capital in net terms was in the depth of the Great Depression in 1931-34.

This trend is shown in Figure 2 which shows US net saving/capital creation - i.e. gross saving minus capital consumed. As may be seen for four years during the worst period of the Great Depression the US consumed rather than created capital. In every post-World War II recession prior to the present one however, even at the worst point of the downturn, the US remained a net capital creator - US gross saving exceeded US capital consumption. Net consumption of capital however reappeared in 2008 after 74 years, that is for the first time since 1934, and the situation significantly deteriorated during 2009.

Figure 2

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Such trends show even more strikingly than the scope of the the fall in production that the current US downturn is something quite different to even a severe normal cyclical downturn. The fundamental financial heart of the US, its simple ability to generate capital, has been deeply damaged.

It is evident that such a situation whereby the US is a net consumer of capital cannot last for a prolonged period. It means, first, that currently the US is entirely dependent on flows of finance from abroad for capital accumulation.

Second, it is hard for the US to overcome the present situation. Due to financial factors, and the increasing speed of technological progress, consumption of fixed capital, that is its obsolescence and wearing out, tends to increase slowly with time - it has risen from 10.2% of US GDP in 1950 to 12.9% of US GDP currently. It is almost impossible to lower the rate of capital consumption - which means that the US has to save 12.9% of GDP simply to maintain existing capital stock at a constant level.

Finally, capital investment is the most important overall input into US economic growth - accounting for more than 50% of US growth throughout the period since World War II. A situation where the rate of capital formation in the US is severely depressed, therefore, will lock the US economy into a pattern of low growth - given such data the anemic US 3rd quarter growth figures, which at 2.8% were far lower than any usual US recovery, are unsurprising and will continue. As long as the above situation continues the US will remain, at best, on a low growth trajectory.

Such trends are inevitable when the world's number one capitalist economy, as a statement of fact, is simply not creating capital.

US trade imbalance has stopped narrowing

One of the main consequences of the international financial crisis was an extremely rapid reduction of the US trade deficit. The monthly deficit fell by more than half during only seven months between August 2008 and February 2009 – from $64.9 billion to $26.6 billion. This 59% reduction was equivalent to an annualised reduction from $779 billion to $319 billion.

As the US trade deficit was one of the major global imbalances held responsible for the financial crisis, according to a widely held theory, it is therefore a matter of significance that since February the US trade deficit has ceased falling. In the figures for the last three available months, May – July 2009, the deficit has actually widened slightly. Taking a three month moving average, to smooth out merely short term fluctuations, the monthly deficit reached its lowest point in May at $28.1 billion and has since increased marginally to $28.6 billion. The long term trend is shown in Figure 1 and the shorter term immediate one in Figure 2.

Figure 1

Figure 2

Relating this trend in the trade deficit to domestic developments in the US economy, it is evident that during the second quarter of 2009 the decline of US GDP was decelerating and it is possible/likely that the US economy expanded during the third quarter of 2009 – industrial production turned up in both July and August after having declined since December 2007 and the service sector is likely to have been more robust. The trend in the US trade figures, therefore, gives an indication of the likely behaviour of the US economy as it stabilises or begins to recover from the downturn.

The first feature which is clear is that the halt to the shrinking of the trade deficit confirms that the US economy is not competitive at the present dollar exchange rate – or probably anything near the current exchange rate. Despite the most severe economic downturn since World War II the US is still running an annualised deficit of over $300 billion or 2.4% of GDP in the second quarter of 2009. This may be compared, in terms of relative competitive strength, to the recession of the early 1990s – when the US actually moved into a small trade surplus. If is therefore likely that as the US economy begins to recover the US trade deficit will increase again.

Second, the fact the trade gap has ceased to close has major implications for the structure of the domestic US economy. A number of commentators incorrectly argued on the basis of the narrowing of the US balance of trade deficit, that an increase in the US savings rate was taking place. As the US balance of payments deficit, which is dominated by the trade deficit, is necessarily identical by an accounting identity to the shortfall of US domestic savings compared to US domestic investment, it was therefore suggested that as the trade deficit had narrowed US savings were rising. This blog has already pointed out that this was factually incorrect, and confused the rise in household saving, which has indeed occurred, with the movement of total US savings – that is the sum of household, corporate and government saving. What actually occurred during the financial crisis was that both US savings and US investment fell but investment fell even more rapidly than savings – producing the narrowing of the trade gap.

The February-July trade figures however show, given that the balance of payments figures are likely to mirror them, that the gap between US savings and investment has ceased to narrow. For national accounting purposes accumulation of inventories are counted as investment and may have risen during the third quarter, but there is appears little indication that fixed investment has risen. Overall US investment therefore is unlikely to have increased very greatly, if at all, during the third quarter and as the trade gap has ceased to narrow this would also mean that US savings are not rising significantly or at all. The preliminary estimate of US 3rd quarter GDP will not be released until 29 October and will cast further detailed light on these trends.

To illustrate the process which has been taking place in the internal structure of the US economy, Figure 3 shows the detailed trends in components of US GDP in the period between the start of the economic downturn in the third quarter of 2008 and the second quarter of 2009 – all figures are in current price terms. This shows clear trends. In essence a huge transfer of resources from US private investment into US net exports has taken place - with consumption, in relative terms, far less affected.

Figure 3

The $584.1 billion fall in US private fixed investment is actually larger than the $403.4 billion decline in GDP. It also substantially exceeds the $223.5 fall in personal consumption, and the $138.0 drop in inventories combined - the decline in US government consumption and investment is a minor $14.6 billion. The US recession, in short, is  dominated overwhelmingly by the fall in fixed investment.

Nor is this decline in US investment primarily due to housing. The decline in US residential investment over this period was $122.4 billion while the decline in non-residential private investment was $323.7 billion. In short, for example, the claim made by Paul Krugman during a panel discussion with the present author that the decline in US GDP was not primarily due to a fall in investment, and that the latter was essentially due to a decline in residential investment, is incorrect.

The statistical reason that US private investment can be larger than the total fall in US GDP is because of the large rise in US net exports – which increased by $418.8 billion. This was the second largest change in major components of GDP after the decline in private fixed investment, and this combination confirms the essence of the shift in the US economy under the impact of the financial crisis – the massive transfer of resources from private fixed investment to net exports. Or, to put it another way, in order to narrow the trade gap private fixed investment has fallen drastically. This fall in investment is both cyclically the primary driving force of the economic downturn and undermines medium and long term US economic performance - given that increased fixed investment is the primary source of overall economic growth.

This shift in the structure of US GDP clearly poses a number of future choices – all of which are to some degree unpleasant.

The first possibility is that US investment remains permanently lowered – i.e. the course which has taken place since the beginning of the financial crisis is consolidated. But in that case, as fixed investment is the primary lever of economic growth, this means a lowering of the US potential growth rate.

If, however, fixed investment is to be raised, but the US trade deficit is not to expand, then the proportion of US GDP devoted to consumption will have to be proportionately cut in order to release more resources for investment. This would be to reverse the trends that have so far taken place during the financial crisis and evidently poses the question as to which sectors of consumption should be proportionately reduced in GDP –personal consumption, in which case it is likely the political popularity of the Obama administration will fall sharply? Or government expenditure –in which case in which areas?

The third possibility is that, in order to avoid reducing consumption but in order to rebuild investment, the US trade deficit widens again. This appears to be a trend which is indicated by the halt in the shrinking of the US trade deficit in the last five months. But in that case one of the fundamental global imbalances will at a minimum cease to correct itself and will probably widen again.

None of these variants, nor their possible combinations, is particularly easy. They mean that the release of the next US trade figures on 9 October will be even more than usually significant in indicating trends within the US economy.

New York Times recognises success of China's economic stimulus package

The international discussion on China's economic stimulus package has taken a specific form in the US. In addition to representatives of US international financial institutions such as Jim O’Neill, chief economist of Goldman Sachs, the US economist who has most clearly argued that China's economic stimulus package would be successful was Mark Weisbrot of the Centre for Economic and Policy Research. Most US economists and writers predicted failure for China's package.

It is therefore a matter of considerable interest to note that on 17 September the New York Times printed a front page article by Keith Bradsher with the self-explanatory title 'Recovery Picks Up in China as U.S. Still Ails'. This article notes:

‘Just eight months ago, thousands of Chinese workers rioted outside factories closed by the global downturn.

‘Now many of those plants have reopened and are hiring again. Some executives are even struggling to find enough temporary staff to fill Christmas orders.

‘The image of laid-off workers here returning to jobs stands in sharp contrast to the United States, where even as the economy shows signs of improvement, the unemployment rate continues to march toward double digits.

‘In China, even the hardest-hit factories — those depending on exports to the United States and Europe — are starting to rehire workers. No one here is talking about a jobless recovery.

‘Even the real estate market is picking up. In this industrial town 90 miles northwest of Shanghai, prospective investors lined up one recent Saturday to buy apartments in the still-unfinished Rose Avenue complex. Many of them slept outside the sales office all night...

‘The confidence stems from China’s three-pronged effort — a combination of stimulus, liberal bank lending and broad government support for exports.

‘The Chinese central bank said the country’s economy surged at an annualized rate of 14.9 percent in the second quarter. The United States economy shrank at an annual rate of 1 percent in that period.

‘“So often China and the U.S. are mixed together as being in the same situation, and that is totally wrong,” said Xu Xiaonian, an economist in Beijing with the China Europe International Business School...

‘‘But with more centralized economic planning than the United States, China has been able to disburse its stimulus much faster, turning it into new rail lines and highways.

‘China’s finance ministry announced in late June that half the $173 billion in central government spending had already been allocated to specific projects. The White House said in early July that a quarter of the spending authority and tax cuts in the $789 billion American stimulus had been allocated or used.

‘But even more key to China’s recovery, economists say, are two other government efforts that are paying big dividends: looser lending and export supports.

‘The state-controlled banking system here — which breezed through the global financial crisis with minimal losses as American financial institutions reeled — unleashed $1.2 trillion in extra lending to Chinese consumers and businesses in the first seven months of this year. That money is financing everything from a boom in car sales, up 82 percent in August from a year earlier, to frenzied factory construction.

‘Beijing also has given huge tax breaks and other assistance to exporters...

‘Indeed, subsidies abound at all levels of government: the Wuxi municipal government just offered up to $146,000 to each local business that increases exports in the last three months of this year...

'China’s well-capitalized banking system allowed for rapid investment.

‘Chinese banks came into the crisis with enormous excess reserves, the result of three years of tight regulatory limits on lending to prevent the economy from overheating. When those limits were removed, and authorities urged bank executives to lend, the total value of loans outstanding shot up more in the first seven months of this year than in the previous 24 months.

‘By contrast, total loans and leases outstanding at financial institutions insured by the Federal Deposit Insurance Corporation actually fell $249 billion, or 3.2 percent, in the first half of this year.

‘Though Washington has used taxpayer money to bail out American banks, it does not have Beijing’s power to force banks to lend that money to businesses and consumers.

‘As much as a third of the extra bank lending in China appears to have gone into real estate and stock market speculation. But the bulk has gone into investments by companies and local governments, with tangible results'

The article states various short and medium term concerns - not all employees laid off last year have been re-employed yet, there is a danger of some asset bubbles etc. Some of these latter statements are accurate and some are somewhat exaggerated. Neveretheless, overall, the article is a fair and relatively accurate assessment of the fact that China's stimulus package, and recovery from the international financial crisis, is far more successful than the US. For a leading US newpaper to print so prominently such a frank assessment is both intellectually honest and striking.

There is now a quite clear shift in international opinion on China's stimulus package. This blog's author has outlined both here and elsewhere  the reasons why China's stimulus package would be successful. This is rooted in a correct overall strategy, followed by China and in a different form by some other Asian economies, and is based on correct understanding of the most important long term trends in the world economy. Writers such a Martin Wolf, chief economics correspondent of the Financial Times, argued that China's economic stimulus package would not be successful but have since reveresed their view. The new article in the New York Times indicates a similar process. The fact that China's stimulus package has been successful is now becoming accepted - with only a decreasing number of hold outs such as Morgan Stanley's Stephen Roach, Michael Pettis of Peking University, and Dylan Grice of Societe Generale continuing to argue the opposite.

However while a number of authors have now revised their previous positions, and agree that China's economic stimulus package will be successful, they have not re-evaluated the analytical frameworks that led to the previous errors. This means that such frameworks are likely to continue to produce mistakes regarding the evaluation of new events. Discussion of China's stimulus package, and economic strategy, will therefore continue to be an issue not only of great practical importance for the world economy but of considerable analytical and theoretical importance for assessing future economic events.

Martin Wolf changes evaluation of the success of China’s stimulus package

For almost a year an international debate has taken place regarding the success, or otherwise, of China’s economic stimulus package to confront the international financial crisis. It has been intertwined with a debate about the so called ‘Asian growth model’. This blog, together with others such as Jim O’Neill, chief economist of Goldman Sachs, Professor Danny Quah of the London School of Economics, and Mark Weisbrot have, naturally for different reasons and with different emphases on scale, assessed this package as successful.

Probably the single most widely heard voice on the other side has been  Martin Wolf, chief economics commentator  of the Financial Times. As Martin Wolf has a well deserved reputation as one of the world’s leading, and most statistically informed, economic commentators it is therefore a matter of significance that in today’s Financial Times he puts forward his new evaluation of China’s stimulus package. The article should evidently be read in full but its conclusions are clear. Martin Wolf writes:

‘China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?...

‘How has China responded to the crisis? Is its resurgent growth sustainable?...

‘The answer to the first question is: astonishingly. According to data reported at the end of last week, industrial output expanded 12.3 per cent in the 12 months to August, up from a 10.8 per cent increase in July...

‘Behind this is growth of bank credit at close to 30 per cent, year-on-year, since March 2009. It is no surprise, then, that fixed-asset investment has also been growing at over 30 per cent, year-on-year, since March and by 33 per cent in the year to August. Year-on-year growth for the second quarter of 2009 was 7.9 per cent, up from 6.1 per cent in the first quarter. Third-quarter figures seem sure to be higher still.

‘The expectation now is that China will achieve the 8 per cent target by a comfortable margin...

‘Is this growth surge sustainable? In a word, yes. Inevitably, the torrid growth of bank credit and money is spilling over into asset prices, particularly equities. But there is little danger of excessive inflation in an economy with an appreciating currency, fully embedded in a world economy still threatened more by deflation than by inflation, at least in the near term. Moreover, the government is solvent. As premier Wen Jiabao noted in Dalian, “we... kept budget deficit and government debt at around 3 per cent and 20 per cent of the GDP respectively”. Should bad loans increase, China is well able to recapitalise its financial system...

‘China’s response to this crisis is globally significant. It has prospered, while advanced countries have floundered. China has noticed. So must its partners.’

Martin Wolf argues that China’s economy is not large enough to pull the world out of recession by itself, which is certainly true, and he still raises issues regarding the nature of this growth which are still erroneous.  However it is a considerable act of intellectual honesty to now so straightforwardly state the success of China’s stimulus package.

There of course remains the more general discussion of the analysis which led to the failure to  accurately foresee the success of China’s stimulus package. The present author would argue that this is due to errors in the framework in Martin Wolf’s book Fixing Global Finance.  Discussion of these more general issues regarding ‘global imbalances’ will of course go on. But in the famous phrase attributed to Keynes, and it is a compliment: ‘When the facts change, I change my mind. What do you do?’

The facts of the success of China’s economic stimulus package now speak for themselves. Discussion should now focus on the fundamental reasons for that success.

The worsening structure of US GDP

The immediate media focus on US GDP concerns whether its decline will halt in the third quarter of 2009. Given the huge scale of US government intervention since September 2008, and the growth recovery in China, which is on course to become the world’s largest visible trading economy, it would be extraordinarily serious if US GDP continued to decline. At least minimal US growth is likely. But examination of the detailed revised 2nd quarter US GDP figures shows that the underlying structure of the US economy is continuing to deteriorate with consequent negative cyclical and medium/long term consequences.

As noted previously both major global 'imbalances’, China’s balance of payments surplus and the US balance of payments deficit, have shrunk sharply during 2009. But they have done so for opposite reasons and with opposite results.

China’s balance of payments surplus has so far undergone a ‘benign’ correction. China’s investment level has moved up towards its savings level. As a balance of payments surplus is necessarily identical to the amount by which domestic investment falls short of domestic savings, the result of China’s rising investment has been simultaneously to maintain domestic growth and reduce its trade surplus – a beneficial combination both for China and the world economy.

For the US, however, a ‘malign’ reduction of the balance of payments deficit has occurred. The US balance of payments deficit is necessarily identical to the degree by which US domestic investment exceeds its domestic savings. But this deficit has not been cut in 2009 by US savings rising towards its investment level but US by investment collapsing downwards towards a saving level which has itself fallen further.These trends are confirmed by the revised 2nd quarter 2009 GDP data.

This decline in investment is shown in Figure 1, which charts US total fixed investment - private and government. As can be seen US fixed investment in the second quarter of 2009 declined to the lowest level since World War II - 14.7% of GDP.

Figure 1

The consequences of such a severe fall in investment will have short, medium, and long term negative consequences for the US economy. Cyclically the fall in investment is the major factor depressing GDP. In the medium term, unless growth in fixed investment is resumed, it is hard for the US to resume expansion. In the long term, as investment is the most important factor input into economic growth, such a severe decline in investment will reduce the US growth rate.

A consequence of the investment decline is that the proportion of US GDP devoted to consumption has actually risen under the impact of the financial crisis – as may be seen in Figure 2.  As previously pointed out on this blog claims that US consumption has been falling, and saving rising, are erroneous because they confuse a rise in household saving, which has occurred, with total US savings - which have declined further under the impact of the growing budget deficit.

Figure 2

A ‘perverse’ structural shift is thereby occurring whereby US consumption, which is already the highest of any major economy in the world, is actually rising further as a proportion of the economy and US investment declining sharply. It is for this reason that the internal reshaping of the US economy indicates a 'malign' closing of the gap between US savings and investment reflected in the declining trade deficit.

Such a decline of investment will further undermine the competitivity of the US economy at its present exchange rate. At present the deep  recession is severely depressing US demand for imports. The last time the US balance of payments deficit contracted, in the early 1990s, it was by the same mechanism of a recession. As soon as the US economy began to expand again the balance of payments deficit widened very sharply again. Given the proven inability of the US economy to compete at its present exchange rate it is therefore extremely probable that as the recession slows down, and growth resumes, the US balance of payments deficit will expand again. It is notable, as a confirmation of this likelihood, that since February improvement in the US trade deficit has essentially ceased - the trade deficit was $26.1 billion in February and still $27.0 billion in June.

Structural trends in the US economy have therefore deteriorated. Investment has fallen sharply and so far there is no indication that the US can move out of recession without the balance of payments surplus widening again.

New China economic data shows declining trade surplus and accelerating economy

The new data for China's foreign trade for July strongly confirms the trend analysed in a previous post on this blog of the strong decline of China's trade surplus.

China's trade surplus in July was $10.6 billion – a fall of 54% compared to the same month in 2008.

This drop reflected the continuing trend whereby China's imports, $94.8 billion in July, have declined much less rapidly under the impact of the financial crisis than its exports - $105 billion in July. In terms of year on year changes China's exports have fallen 23.0% while its imports have only fallen by 14.9%.

There was a small month on month increase in China's surplus compared to June's $8.3 billion, but this was well within the range of expected monthly variations and the 3 month moving average of the surplus declined sharply from $17.3 billion in June to $12.5 billion in July.

The annualised 3 monthly moving average of China's trade surplus was $270.2 billion at the time of China's peak exports in August last year, it rose temporarily under the impact of the financial crisis to a $457.1 billion in January, and is now running at an annualised $150 billion. China's trade surplus has therefore fallen by almost half from the pre-financial crisis levels.

These trends can be seen clearly in Figure 1, which shows China's monthly trade surplus, and Figure 2 which graphs, in order to eliminate purely short term fluctuations, the 3 monthly moving average for China's trade surplus.

The decline of China's trade surplus means that both major 'global imbalances', the other being the US balance of payments deficit, are falling sharply. The reason the US deficit is declining is because US savings are declining but US investment is falling even more rapidly - the result of the sharp US recession. In China investment is rising as a proportion of GDP shrinking the trade surplus and accelerating the economy.As this issue is extremely important for understanding the key trends in the world economy readers may wish to read the article on it on this blog.

While China's trade surplus has shrunk China's year on year growth in the first quarter was 7.1% and accelerating - year on year growth in the second quarter was 7.9%. China's statistical services do not produce official figures for quarter on quarter GDP growth, because it states its seasonable adjustments to economic output are not yet accurate enough, but private economic organisations estimates of annualised growth in the second quarter were 13-15%.

China's official projection for GDP growth this year remains at 8.0%, and other Chinese experts are projecting 8.3%, but Goldman Sachs has increased its prediction of this years GDP growth to 9.4%. While the stimulus package is clearly having a powerful effect the external environment for trade remains very negative and while the Goldman Sachs prognosis certainly cannot be discounted it would appear premature to take as a central perspective that China's growth will significantly exceed the 8.0% central projection.

What the combination of accelerating economic growth and sharply dropping trade surplus does refute is the analysis of those such as Professor Michael Pettis, V. Anantha Nageswaran and others who believe that China's growth is due to an 'Asian model' dependent on large trade surpluses.

China is quite right to aim at a high proportion of exports in GDP, which allows it to benefit from efficiencies flowing from the international division of labour and economies of scale, and this is an integral and necessary part of its growth model. However a large trade surplus, that is a high level of exports unaccompanied by an equivalent high level of imports, does not flow from any economic theory and is not required by China's economic growth - as is confirmed by Figures 1 and 2 which show that the large trade surplus appeared only after 2005 and is now rapidly declining. China's rising rate of investment with its stimulus package is simultaneously allowing its economy to expand rapidly and its trade surplus to shrink.

Figure 1

Figure 2

The real reason global imbalances have declined - factual economic trends in the US and China

One of the most publicised theories regarding the current state of the world economy, and the causes of the international financial crisis, is that regarding 'global imbalances'. This thesis has been presented at book length by Martin Wolf in Fixing Global Finance, as well as in numerous articles in his position as the Financial Times chief economics commentator, by Stephen Green of Standard Chartered, by David Cohen of Action Economics, by Brad Setser, by Michael Pettis, Professor of Finance in Peking University, and numerous other authors.[1]

This theory has however been described as erroneous by Asian leaders. That they are right in this opinion will be shown below. Specifically there is a logical incoherence in the theory in that its policy prescriptions are not entailed by its analysis. This in turn leads to it not being in accord with the facts of the world economy as the global imbalances it describes are shrinking by quite other mechanisms than the ones it outlines. As a result it is wrong in its policy proposals - as shown by the fact that the most rapid economic growth is being enjoyed by an economy, China, which is pursuing policies which are the opposite of those prescribed by this theory.

A theory which is deficient in coherence, and which fails to foresee the possibility of reducing global imbalances by mechanisms which are actually occurring, is evidently a theory which is erroneous.

Given the wide range of those supporting variants of what will be termed the 'global imbalances hypothesis' this theory naturally has a number of secondary variations. But they have a common core consisting of an analysis coupled with a policy conclusion which it is alleged is entailed by it.

On this theory, the well known problems of the US financial system are outward signs of a much more fundamental malaise of imbalances in the world economy. In the words of Martin Wolf: 'Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter…. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn.'

The core analysis of this theory is that the world economy has been characterised by two global imbalances, the first being the US balance of payments deficit – ascribed to US lack of saving/over consuming, the second being China's balance of payments surplus – allegedly caused by China 'over saving'. The policy conclusion which allegedly follows from this is that the US save more and China save less.

As Brad Setser put it: 'the global economy prior to the crisis was characterized both by high levels of both savings and investment in Asia and the oil exporters and by high levels of consumption and low levels of savings in the US. 'Therefore, as Robert Skidelsky phrased it: 'emerging market economies need to spend more and save less, and mature market economies need to spend less and save more.'. As Martin Wolf put it specifically regarding China: ''does it make sense for China to save so much or, for that matter, to invest so much?... Higher consumption today would surely be desirable.'

It is unclear in some variants whether this theory is being put forward merely prescriptively or whether it is stated that the trends it proposes as desirable are actually occurring – or a combination of the two. However it is clear that a number of its supporters believe that the proposed policy prescriptions of this theory are actually occurring. Thus for example Robert Skidelsky argued in July: 'In fact the present financial meltdown is producing the market-led adjustment that has eluded policy makers. Willy-nilly Americans are having to spend less and save more.'

The 'global imbalances hypothesis' has become so prevalent it may be described, in the phrase popularised by JK Galbraith, as a 'conventional wisdom'. Unfortunately, like many other previous conventional wisdoms it is not true. There are a number of further aspects of the 'global imbalances hypothesis' which are wrong, and which have earlier been analysed on this blog. But if a theory, as will be shown, is inconsistent and factually wrong that constitutes adequate grounds why it should not be maintained. A new, more correct, conventional wisdom is required.

Inconsistency of the theory

The economic inconsistency of the 'global imbalance hypothesis', that is that the policy prescription does not logically follow from the analysis, is easily demonstrated. A country's balance of payments is, by basic accounting identity, equal to the difference between its domestic savings and its domestic investment - the US deficit is exactly equivalent to the degree that US savings are lower than its domestic investment, China's surplus is exactly equivalent to the degree that its savings are higher than its domestic investment.

It immediately follows from this identity that the only way to correct such imbalances, if that is set as the overriding goal of policy, is not at all, as the 'global imbalances hypothesis' suggests, for the US to save more and China to save less. It is equally possible to solve these imbalances, again if this is set as the policy goal , by the US investing less and China investing more. Furthermore it is this latter process affecting investment, not the ones foreseen by the 'global imbalances hypothesis', that is actually occurring and leading to the lessening of the global imbalances.

To take this in detail, factually global imbalances are indeed rapidly declining – the US balance of payments deficit is shrinking and China's balance of payments surplus is declining. But they are doing so for reasons that are the the opposite to those outlined in the theory above.

Far from US saving rising it is declining. The US balance of payments deficit is therefore not shrinking because US saving is rising but because US investment is falling even more rapidly than US saving. China's balance of payments deficit is not declining primarily because it is consuming more but because it is investing more – that is, because China is moving its investment level up to its savings level, and in so doing generating the most rapid rate of growth in the world .

These factual trends have previously been outlined both regarding the US and China on this blog. The latest data which allows a major testing of the different theories is the publication of the second quarter US GDP figures together with data for the equivalent period for China's trade and GDP. All US data below therefore, unless specifically stated otherwise, is calculated from the tables accompanying the US second quarter 2009 GDP figures published by the US Bureau of Economic Analysis. The data shows clearly that the trends taking place in the world's two largest economies are not those in the 'global imbalances hypothesis'.

The rise in US consumption

Taking first the fundamental trend in US consumption, it is clear that under the impact of the international financial crisis US consumption has not fallen but risen further as a percentage of GDP. This is shown in Figure 1.

As may be seen total US consumption, the sum of personal and government consumption, rose rapidly as a proportion of GDP from 1997 until the end of 2003, then stabilised until the end of 2007, and then began to rise sharply again from the beginning of 2008 under the impact of the developing financial crisis.

Figure 1

Taking precise figures, between the last quarter of 2007 and the second quarter of 2009 US consumption rose from 85.8% of GDP to 87.6% - an increase of 1.8% of GDP. Between the second quarter of 2008, the last before the opening of the entirely open financial crisis with the collapse of Lehman's, and the second quarter of 2009 US consumption rose from 87.0% to 87.6% of GDP. Between the first and second quarters of 2009 US total consumption rose from 87.2% to 87.6% of GDP. The trend of rising US consumption under the impact of the financial crisis is therefore clear. More detailed breakdown of this rising share of consumption in US GDP may be found in the footnote. [2]

If US consumption has risen as proportion of GDP why, therefore, has the US balance of payments deficit been shrinking? By accounting identity this deficit is necessarily equal to the shortfall of US savings compared to domestic investment. Therefore shrinkage of the deficit means the gap between saving and investment is narrowing despite consumption rising. The explanation is that US savings are not increasing but falling, but US investment is falling even more rapidly than US saving.

The decline in US investment and saving

Analysing first investment, for which the necessary detailed data is available in the US second quarter GDP figures, these show that US total investment fell between the fourth quarter of 2007 and the second quarter of 2009 from 19.1% of GDP to 14.8% - a decline of 4.3% of GDP.[3] In the period between the second quarter of 2008 and the second quarter of 2009 US investment fell from 18.3% to 14.8% of GDP.

Turning to savings, ideally one would wish to have direct measurement of total savings for the second quarter of 2009, which were not published with the GDP figures, and figures for the US balance of payments for the same period – which are also not yet published. Fortunately, however, the shifts in the US trade balance are so large that it is relatively easy to work out the trends.

Savings equal the sum of total investment, for which full US figures are available, minus the balance of payments deficit – for which second quarter figures are not yet available. But shifts in the US balance of payments are dominated by changes in the trade balance. Provided, therefore, that it is being used to establish a qualitative direction of change, and is not projected as an exact statistical calculation, it is perfectly possible to use the major shift in the US trade balance to show the change in the direction of US savings.

If 2008 is taken as the year in which the financial crisis unfolded then the US balance on trade in goods and services fell between the last quarter of 2007 and the second quarter of 2009 from 4.9% of GDP to 2.5% - an improvement of 2.4% of GDP (see Figure 2).

Figure 2

It follows from the data above that US investment has fallen by 4.3% of GDP since the beginning of the financial crisis while the US balance of trade has improved by only 2.4% of GDP - a difference of 1.9% of GDP. If all other components of the balance of payments had remained the same then this would necessarily mean that US savings had also declined by 1.9% of GDP – if savings had remained static, and other components of the US balance of payments had remained constant, then a 4.3% of GDP fall in investment would have translated into a an equivalent 4.3% improvement in the balance of payments figures. The 1.9% of GDP gap between the 4.3% decline in investment and a 2.4% fall in the balance of payments would necessarily mean that US savings had fallen by 1.9% of GDP.

Evidently no such precise quantitative assertion can be made as what is being calculated above is the trade balance and not the overall balance of payments. But it means that for US savings not to have fallen components of the US balance of payments other than trade would have had to improved by 1.9% of GDP or $269 billion. This is completely implausible and it is therefore evident that US savings have been falling.

This is confirmed by taking the latest figures for which there is measured data on total savings, that is for the first quarter of 2009. Between the fourth quarter of 2007 and the first quarter of 2009, US total savings fell from 13.9% of GDP to 11.5% of GDP. These trends of falling US savings are shown in Figure 3.

Figure 3

The reason some media commentators have claimed US saving is rising, when it is actually falling, is because they confuse household saving (which rose from 1.1% of GDP to 4.0% of GDP between the last quarter of 2007 and the second quarter of 2009) with total saving (the sum of household, company and government saving). The rise in US personal saving is however being more than offset by the decline in company and government saving – hardly surprising given the scale of the US budget deficit. Robert Skidelsky's statement, cited above, that US saving is rising is therefore inaccurate - it appears he may be making an incorrect generalisation from personal saving to total saving.

Michael Pettis claims that US consumption is falling more rapidly than GDP, which would imply saving is rising, but unfortunately makes two errors – first he confuses personal consumption with total consumption, and second he fails to note that shifts in relative prices mean that although in volume terms US personal consumption fell more rapidly than GDP in the second quarter of 2009 it increased as a percentage of GDP. From the point of view of global imbalances, that is the US balance of payments deficit, it is the proportion of GDP devoted to consumption which is determining and not movements in volume.

It is therefore clear that the first part of the 'global imbalances hypothesis' regarding the US is wrong. The imbalance of the US balance of payments deficit is not falling because US saving is rising but because US investment is falling even more rapidly than US saving is falling. Now consider China.

China's rising investment and declining trade surplus

While the macro-economic data available for China for the second quarter of 2009 is not as detailed as for the US nevertheless, again, the shifts are so large it is relatively easy to ascertain the trends.

The first trend is that China's investment is rising as a percentage of GDP. Second China's balance of payments deficit is declining. These will be considered in that order.

First, taking the rise in China's investment as a percentage of GDP, the components of the 7.1% rise in GDP in the first half of 2009 were 6.2% rise in investment, 3.8% rise in consumption, and minus 2.9% fall in net exports. Unless China's savings were increasing equivalently such a rise in the percentage of investment in the economy necessarily means that China's balance of payments surplus must fall.

As with the US balance of payments figures for China for the second quarter of 2009 are not yet available. But the drop in the trade surplus, which dominates China's balance of payments position, is of sufficient magnitude  that it is clear that China's balance of payment surplus is falling.

Figure 4 shows China’s monthly trade surplus since 1992 up to June 2009. Figure 5 shows the same data calculated as a three monthly moving average in order to avoid any purely short term distortions.

Figure 4

Figure 5

The trend is clear. China’s trade surplus rose steadily from 2005 onwards and then temporarily rose even further under the impact of the onset of the international financial crisis in September 2008. The peak was reached in January 2009 with a monthly surplus of $42.1 billion. Since then China’s surplus has fallen steadily. The surplus for June was $8.25 billion.

Expressed in terms of three monthly moving averages China’s monthly trade surplus was $22.5 in August 2008, immediately before the collapse of Lehman brothers, rose to $38.1 billion in January 2009, and has since dropped to $12.5 billion.

Shifts in other components of China's balance of payments sufficient to offset the rapid decline in the trade surplus are not credible so it is clear that China's overall balance of payments surplus has shrunk - meaning the gap between China's savings and investment has narrowed.

While savings figures are not available for China at present it is clear from the data above that they have not risen to match China's rise in investment. There are reasons to believe China's savings may have declined somewhat – China's budget is projected to move into a 3% of GDP deficit, profitability of export and other industries is under pressure from the international financial crisis, and given a 15% rise in retail sales there is no reason to believe household saving has risen significantly (if at all).But it is clear that China is fundamentally responding to the financial crisis by raising its rate of investment. The result has been the most rapid rate of growth in the world.

The logical lacunae in the global imbalances hypotheses, that it did not point out that China could just as much reduce its balance of payments surplus by increasing investment as by reducing saving, is therefore the actual course of China's economic policy - with the most successful results of any country in the world.

Indeed it is quite probable that this year, in net terms,the whole of world growth will be accounted for by the expansion of China's economy. Compared to this level of economic success all discussion of 'green shoots' in other economies is insignificant.

The errors of the 'global imbalances hypothesis'

For the reasons set out above it is therefore not material that the 'global imbalances hypothesis' is conventional wisdom - many things that are conventional wisdom turn out to be false, nor that a number of those supporting it are outstanding economists, nor that Martin Wolf is one of the world's outstanding economic journalists with a deep knowledge of economic statistics etc. A theory which lacks internal coherence, which is factually wrong, and which leads to wrong policy prescriptions is a theory that does not meet the test of scientific rationality. It should therefore be set aside.

Instead the realities of the world economy should be recognised. The US balance of payments deficit has been shrinking not because US saving has been rising but because US investment has been declining more rapidly than US saving has been falling. China's balance of payments surplus has been declining primarily because its investment level has been rising. That is, the logical gap which existed in the 'global imbalances hypothesis' corresponds to the actual course taken by the world economy. As always when the facts and a theory do no coincide it is the theory which should give way.

Notes

[1] The wide circulation of this analysis may be traced to a speech by Ben Bernanke, now Chairman of the Federal Reserve,

[2] Breaking these figures down into their detailed components US personal consumption rose from 69,9% of GDP to 70.6% between the fourth quarter of 2007 and the second quarter of 2009. In the period from the second quarter of 2008 to the second quarter of 2009 US personal consumption rose from 70.3% of GDP to 70.6%. US personal consumption increased between the first and second quarters of 2009 from 70.4% of GDP to 70.6%.

To calculate precisely how much US government consumption has risen it is necessary to note that the US is unusual in that in its main aggregate GDP statistics it groups together government consumption and government investment – most countries statistically treat government investment simply under overall investment. If the two components (consumption and investment) of US government expenditure are taken together they increased from 19.2% of GDP in the last quarter of 2007 to 20.7% of GDP in the second quarter of 2009. It is necessary to eliminate from this the rise of government investment from 3.3% of GDP to 3.6% of GDP in the same period. Government consumption rose from 15.9% of GDP to 17.0% of GDP. In the period since the second quarter of 2008 US government consumption has risen from 16.4% to 17.0% of GDP.Government consumption rose from 20.3% to 20.7% of US GDP between the first and second quarters of 2009.

Considering, therefore, both total consumption and its breakdown the rising proportion of consumption in US GDP since the beginning of the financial crisis is clear – indeed consumption has risen as a proportion of US GDP both as regards personal consumption and government consumption.

[3] Private fixed investment declined from 15.8% to 12.3% of GDP, inventories fell from plus 0.1% of GDP to minus 1.1.% of GDP, and government investment rose from 3.3% to 3.6% of GDP.

Danny Quah on the analysis of Asian and Chinese growth

Earlier this month I shared a joint platform on Asian economic growth with Danny Quah, Professor of Economics at the London School of Economics. Professor Quah I knew principally from his writings on international comparisons of growth such as Empirics for Growth and Distribution, Twin Peaks: Growth and Convergence in Models of Distribution Dynamics, and The New Empirics of Economic Growth. Recently I had also read with considerable interest his analysis of Post-1990s East Asian Economic Growth which deals extensively with Asia’s recovery from the 1997 debt crisis - and can be strongly recommended to readers of this blog.

I had, however, not personally met Professor Quah before and preparing for the discussion gave an opportunity to catch up with a number of his other writings. These include criticism of the myth that the cause of the international financial crisis is over-saving by Asian countries. He has therefore urged the need to, ‘rebalance the global economy by all means, but with an eye to fostering aggregate supply as much as aggregate demand.’

This point is crucial given that, all other things being equal, reduction in Asian savings/investment rates will necessarily lower the rate of international economic growth – which will not aid global economic recovery.

Such analysis led Professor Quah into a discussion with Martin Wolf of the Financial Times - who precisely proposes radical reduction in savings by Asian countries to eliminate their balance of payments surpluses. Danny Quah noted, against Martin Wolf: ‘the appropriate policy is not what you propose for the surplus countries to do. Instead, it is that the deficit countries need to improve their supply-side productivity - they should get workers and business back to work, through restoring confidence and making credit again available for normal business operations - thereby raising national output, and lowering the current account deficit. The surplus countries will then have their trade surplus automatically decline. World output will increase, and global balance again restored.’

Such arguments, evidently expressed from a somewhat different viewpoint, parallel a number of issues discussed on this blog. The panel was a highly interesting exchange. Since then Danny Quah has posted a piece on his blog analysing China’s 1st half 2009 GDP growth.

All highly recommended reading.

China's 1st half GDP growth should settle the dispute on the correctness of its approach to the financial crisis

On 16 July, as was widely reported, China announced very strong economic growth in the first half of 2009. GDP was up 7.1% year on year for the six months to June. Growth was 7.9% for the second quarter of 2009 compared to the same period in 2008.

Economic acceleration was evident as China's year on year growth rose from 6.1% in the first quarter to 7.9% in the second. Industrial production in June was up 10.7% year on year. In terms of annualised quarter on quarter growth, official figures for which China does not publish as it considers its data on seasonable adjustments are not yet sufficiently accurate, the Wall Street Journal notes private economist estimates of 15% annualised GDP growth in the second quarter.It therefore appears highly likely China will hit its 8% annual growth target this year.

Despite this rapid growth there was no sign of inflationary pressures in consumer or output prices due to overheating - on the contrary year on year consumer prices in June were down 1.7% and the producer prices declined by 7.8%.

These are evidently stellar figures in the context of the international financial crisis - by far the best results of any major economy. They also cast clear light on the debate that has been taking place internationally on the correctness, or otherwise, of the policies being pursued by China in dealing with the international financial crisis. Such first half GDP figures evidently indicate great success, and countries  pursuing objectively guided policies would study China to see carefully what lessons could be learned from this.

This is particularly important as China is not pursuing a course based on running a large budget deficit. Such policies, which are generally mistakenly referred to as 'Keynesian' in the US and Europe, are dominant in those countries' recovery packages - 'mistakenly' because Keynes own views were focused on monetary economics, and based on the priority to reduce interest rates by measures such as quantitative easing, not on expansion of budget deficits, as writers such as Turner and Tily rightly point out. A policy of meeting the financial crisis through large budget deficits might be correct, as Paul Krugman argues, or it may be incorrect. but it is not actually a 'Keynesian' policy in the sense of being the one advocated by Keynes.

Contrary to some mistaken claims in the financial media, China's stimulus package is, however, not based on a large budget deficit. This is clearly confirmed by the figures. China's deficit is projected to expand this year but only modestly, from balance to a deficit of 3% of GDP.

China's stimulus package is instead focused on two measures. The first is direct methods to raise, that is control, investment - thereby avoiding the precipitate fall in investment which is the driving force of an economic downturn.

The largest part of China's $585 billion stimulus package is going into urban fixed investment which rose 33.5% year on year in the first half of 2009 and 35.3% in the year to June. As, in the same period, producer prices were falling sharply it is likely that the real increase in investment in fixed assets approached 40%. China is able to achieve this due to its large state company sector which can be issued with 'administrative' instructions to increase investment, thereby countering any downturn.

The second part of the stimulus package is expansion of bank lending. M2 was up in China by 28.5% year on year in June with bank lending rising by RMB 1.5 trillion ($220 billion) in June and RMB 7.37 trillion ($1.1 trillion) in the first half of 2009. The fact that China's banks are state owned allows them to be instructed to increase lending - whereas in the US and Europe only indirect, so far relatively ineffective, methods can be used to attempt to persuade banks to counter-cyclically expand their lending.

This combination of direct measures to expand investment and rapid increase in bank lending explains the success of the stimulus package and therefore China's rapid economic growth in the first half of the year. This model is evidently quite different to, and far more successful, than the policies based on large scale budget deficits being pursued in the US and Europe.

A number of non-Chinese commentators have accurately judged that the Chinese stimulus package will be successful - the most prominent probably being Jim O'Neill, Goldman Sach's chief economist. In contrast theorists that China is 'oversaving', and must change its economic model, who are given frequent extensive coverage in sections of the the media, such as Martin Wolf of the Financial Times and Michael Pettis, have been proved inaccurate.

It would be hoped that as economic theory has not led writers such as Wolf and Pettis to change their analysis facts might now lead to an acknowledgement their analysis is wrong. As, however, they have maintained views which are false from the point of view of economic analysis, and from the point of view of economic facts, for many years it is probably unlikely there will be any change in light of the latest data. Indeed Pettis in his latest post, commenting on China's GDP figures bizarrely, in the light of the facts, claims: 'I think China will be among the last countries to escape from the effects of the global crisis,'  This is roughly the economic equivalent of continuing to believe that the world is flat despite the fact that all evidence shows it is round.

Fortunately for the health both of China's and the world economies the Chinese authorities have continued to pursue their own policies and ignore such advice from outside. The latest GDP data confirms just how right they were to do so.

China's rapidly shrinking trade surplus

One of the areas where most media commentary is lagging behind events is regarding China’s trade surplus. Articles dealing with China’s surplus, one the key international trade trends, have been a regular feature of economic analysis ever since it first appeared in 2005-6. What has not received equal commentary are the signs of a very rapid drop in China’s surplus this year.

This trend is so recent and so strong that the usual year on year comparisons do not capture it adequately. Figure 1 therefore shows China’s monthly trade surplus since 1992 up to the latest available figures for June 2009. Figure 2 shows the same data calculated as a three monthly moving average in order to avoid any purely short term distortions.

Figure 1

Figure 2

The trend is clear and striking. China’s trade surplus rose steadily from 2005 onwards and then temporarily rose even further under the impact of the onset of the international financial crisis in September 2008. The peak was reached in January 2009 with a monthly surplus of $42.1 billion. Since then China’s surplus has fallen steadily and rapidly. The surplus for June was $8.25 billion.

Expressed in terms of 3 monthly moving averages China’s monthly trade surplus was $22.5 in August 2008, immediately before the onset of the financial crisis and the collapse of Lehman brothers, rose to $38.1 billion January 2009, and has since dropped to $12.5 billion.

The trends behind China’s shrinking trade surplus are clear. Under the impact of the financial crisis both China’s exports and imports have declined. But its imports have declined far less than its exports. Since the peak month of August 2008 China’s exports have fallen by 28.0% but its imports have only declined by 18.5%. China’s net trade position is therefore acting as a locomotive for the rest of the world economy.

Indeed this change in China’s trade position, if the trend continues, is a significant stimulus. The net turn around in China's trade for the latest month, compared to August 2008, is $18.5 billion – its monthly trade surplus having shrunk from $26.7 to $8.3 billion. This is equivalent to an annualised $220.9 billion.

This trend in China’s exports and imports would be by itself insufficient to offset the depressive effect on world trade of the fall in demand from the US. Between August 2008 and May 2009, the latest available figure, the US trade deficit fell by $34.9 billion a month, declining from $60.9 billion to $26.0 billion - equivalent to a net negative shock for other countries' trade of $418.8 billion. Nevertheless it does mean that, if this trend continues, China is capable of taking up about half the slack in world trade created by the downturn in the US – a far from negligible effect. This trend in China’s trade must therefore be watched carefully if world trade begins to recover.