Key Trends in Globalisation

China is winning the new global industrial contest

The international financial crisis brought about a radical change in the structure of international industrial competition, and China is winning this new contest. That is the only conclusion that can be drawn from the pattern of industrial expansion and contraction in the major industrial centres in the five years since the beginning of the international financial crisis in 2008.

As taking comparisons only for single years can obscure this fundamental trend, Figure 1 shows the changes in industrial output during the entire last five year period in the world’s four major industrial centres – China, the U.S., the European Union (EU) and Japan. The pattern is clear and striking.

• U.S. industrial production on the latest data, for February 2013, remained 1.3% below its level five years previously – essentially stagnating over the five year period taken as a whole.
• Industrial output in the EU remains at 12.2%, i.e., significantly below its level five years ago. EU industrial production has fallen since February 2011.
• Japan’s industrial production remains at 19.2%, i.e., substantially below its levelof five years ago and has also fallen since February 2011.
• China’s industrial output is 76.1% above the level five years previously.

Figure 1

 

China’s industrial production therefore increased by over three quarters during a period when U.S. industrial production stagnated and EU and Japanese industrial production significantly declined. That is a conclusive victory by China in this competitive struggle.

Extending the comparison to other developing economies, there is no individual industrial centre matching the four major global ones. Figure 2 therefore shows aggregated data for developing economic regions. As statistics for all developing economies are not available for February 2013, the period January 2008 to January 2013 is considered. Data for China is also shown. As no separate China data was published for January, due to the Spring Festival holiday, China’s January data is taken as the mid-point between December and the combined January-February statistics.

Again the pattern is clear over the five year period.

• China’s industrial production grew by 77.9%.
• Total developing Asian industrial production expanded by 53.9% – China accounting for the largest part of this.
• Latin American industrial production increased by 3.0%.
• Eastern Europe and the former USSR’s industrial production increased by 2.0%.
• Industrial output in Africa and Middle East fell by -0.2%.

Figure 2

 

China was therefore successful in industrial competition not only with developed but with developing economies. As the increase in China’s industrial production was over 75%, and it was already one of the world’s main industrial centres, this constitutes a major shift in the balance of world industrial production in China’s favour.

What conclusions follow from these developments?

First, the claim of some Chinese commentators that there is a great revival of U.S. industry and China is lagging behind is factual nonsense. Not only has China’s industrial growth far outperformed that of the U.S., but U.S. industrial production has not even yet recovered to pre-financial crisis levels. Their arguments, based on citing purely individual examples such as that Apple will manufacture a few Macs in the U.S., are based on one of the most elementary and worst forms of statistical distortion – citing individual anecdotes and not overall trends.

Second, these differences in development have long-term consequences spreading to outside industries. Productivity increases in the industrial sector are much greater than in non-industrial sectors. Therefore China’s success in industrial competition raises its overall rate of productivity growth relative to less successful competitors.

These factual trends do not mean China will not face major future challenges within the industrial sector. China has already successfully shifted the centre of gravity of industrial production from low technology products (textiles, toys etc.) into medium technology (construction equipment, smartphones, personal computers, ships etc.). But China’s transition to very high technology industrial production still lies ahead – outside non-market sectors such as military and space production.

But it is not abnormal that China’s industry is currently dominated by medium, not yet high, technology production. China’s GDP per capita is approximately that of Japan in 1966 or South Korea in 1988. At those times Japan and South Korea had successfully made the transition from agricultural and low value added industrial economies to dominance through medium technology sectors – ship building, steel etc. Today China globally dominates the same industries. But at that time the period of domination of Japan and South Korea by high technology product innovation – Sony’s PlayStation and Walkman, Samsung’s high-end televisions and mobile phones – lay 10-15 years ahead.

As Lin Yifu, former chief economist and senior vice president of the World Bank rightly stresses, it is impossible for an economy to develop market sectors greatly out of line with its overall level of development. The full transition of China’s industry to dominance by high technology production lies a decade ahead. The key fact at present is that comparison of trends in the major industrial centers shows that in the intensified global competition created by the international financial crisis China is clearly winning.

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This article was originally published in Chinese at Sina Finance and in English at China.org.cn. 

US economic recovery is only one eighth of its rate in previous business cycles

A convenient statistical coincidence shows just how slow US economic recovery is in this business cycle compared to previous ones. The new US GDP data for the 1st quarter of 2012 is for the 17th quarter since the peak of the previous business cycle in the 4th quarter of 2007. In all US business cycles since 1973 by the 17th quarter in the cycle the economy had expanded by almost exactly 10.5% – as can be seen in the chart. In this cycle US growth since the previous peak has been only 1.3%. That is the US economy has been growing at only 12.6%, one eighth, of its rate in previous business cycles.

New US GDP figures are not 'disappointing' - they confirm long term deceleration in the US economy

The new US GDP data was widely seen as 'disappointing'. But the most important trend is not the short term figure of 2.2% annualised growth for 1st quarter of 2012 but the confirmation of the long term deceleration of the US economy. The charts below show that the moving average for US 20 year GDP growth has fallen to 2.6% and the moving average for 10 year US GDP growth has fallen to 1.6%. In both cases the declining long term trend for growth is clear from the charts.

It is because there is a persistent long term slowing of the US economy that the US growth data is consistently seen as 'disappointing'. In fact the problem is a wrong perception. Analysts are surprised by new data only when they have not internalised or built into their models this long term deceleration of the US economy. A more fundamental and longer term analysis of this long term slowing of the US economy can be found here.

PS for those interested more detailed analyses of the new US GDP figures will be found on my Sina Weibo - the Chinese equivalent of Twitter. Having used both Weibo is a better product than Twitter for economists as it has built in facilities for showing charts. Posts are in both English and Chinese. My Weibo is here.

Figure 1 – 10 year moving average of US annual GDP growth

Figure 2 – 20 year moving average of US annual GDP growth

Globalization not protectionism remains the main trend in the world economy

Protectionist measures by the US government have received considerable publicity. These include tariffs against China's solar panel exports, the dispute over rare earths, a bill against "subsidized" exports passed by both houses of the US Congress and other steps.

These measures are real. But it is also important not to exaggerate them. Protectionism is not the main trend in the global economy. This is shown both by factual economic trends and considering the underlying forces at work. Protectionist measures affect trade at the margins but do not alter the core of world trade which continues to expand.

To show this first consider the facts. The volume of world trade fell severely during the international financial crisis, declining by 19.7 percent between April 2008 and May 2009. But it then more than recovered. According to the latest available data, by January 2012 the volume of world trade was 4.8 percent above pre-crisis levels - Figure 1.

Figure 1

 

After the financial crisis US imports fell sharply, from 15.7 percent of GDP in the third quarter of 2008 to 10.6 percent of GDP in the second quarter of 2009, but then recovered to 14.8 percent of GDP by the fourth quarter of 2011.

Regarding relations between China and the US, frequently seen as the main area of protectionism, in dollar terms China's exports to the US rose 22 percent between their pre-crisis peak in September 2008 and the same month in 2011, well above the 15.4 percent increase to the EU, and not far behind the 27 per cent increase to Japan. In short, US post-financial crisis trends showed trade recovery, not deepening protectionism. Nor was protectionist actions even the main trend in trade between the US and China.

Claims that protectionism is the dominant trend in the world economy are therefore factually exaggerated, and take individual developments out of context without examining their overall weight.

Analysis of fundamental economic forces confirms why protectionism is not the main trend. Modern production is on such a large scale that it cannot find an adequate market for its volume of production, at efficient levels, purely within a national economy. That is why, for example, China's reform and opening-up was necessary, but exactly the same pressures affect the US.

Even in 1929 serious retreat into protectionism led to disastrous economic decline and crisis, culminating in economic and political destabilization of all countries and finally world war. Today, when production is on a far larger scale than 1929, the economic results would be more catastrophic. This is why all major economies have so far rejected large-scale protectionism.

Fundamental economic analysis therefore confirms what the facts reveal, that certainly there will be some protectionist actions, but these will be at the margins, and globalization, not protectionism, will remain the main trend in the world economy.

Nor is protectionism likely to be the main instrument of US 'neo-cons' or a Republican president. US neo-cons have much experience in how to slow Asian economies. This was successfully achieved against Japan and then the South East Asian "Tiger" economies during the 1997 debt crisis. In neither case was protectionism the main weapon.

The first 'neo-con' strategy was to transfer disputes from the economic realm, where the US is gradually weakening, to the military and political fields, where the US remains much stronger.This tactic is followed in the US 'pivot' toward the Asia-Pacific region.

Within the economic realm the main methods US 'neo-cons' used were forcing other countries to overvalue their currency, forcing cuts in investment levels, which slow economies, and lower foreign inward investment to reduce technology transfer. All these methods are being attempted against China. Protectionism is not dominant in any of these methods.

Attention must certainly be paid to real protectionist measures but exaggerating the degree of protectionism is factually incorrect, not based on analysis of the world economy's main forces, and fails to identify the main economic tactics used by US 'neo-con' circles. 

Competition within globalization, not protectionism, is still the world economy's main trend.

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An earlier version of this article appeared, in Chinese and English, in Global Times.

Changing perceptions of China in Europe

Chinese Vice-President Xi Jinping's visit to Ireland last month highlighted the way in which the impact of the international financial crisis is bringing about a change in the perception of China in Europe.

It is useful to go back four years, in the run-up to the Beijing Olympics, to see the difference. At that time, according to a poll in the Irish Times, a campaign for an Olympic boycott, promoted by figures from most Irish political parties, had the support of 43 per cent of Ireland’s population – compared to 57 per cent favouring participation. In comparison, during Xi Jinping’s visit, every major party and newspaper spoke in favour of closer links with China.

Taking another example, in early 2008, French President Sarkozy threatened to boycott the opening ceremony of the Beijing Olympics, the 11th meeting of the EU-China summit was postponed because of Sarkozy’s attacks on China, and the mayor of Paris was saying he would hang a banner outside his office denouncing China. In contrast, when President Hu Jintao visited France in November 2010, President Sarkozy did him the unusual honour of meeting him personally at the airport.

Trade between key European countries and China has advanced in the intervening period - Germany now exports more to China than the US. China’s investments in Europe have moved beyond bond purchases to Chinese companies signing significant deals – particularly in infrastructure. China’s Three Gorges Corp bought a 21 per cent stake in EDP-Energias de Portugal SA for $3.5 billion, and China Investment Corp, China’s sovereign wealth fund, bought a 9 per cent stake in the holding company of the UK’s Thames Water. In finance, in January the UK signed an agreement with the Chinese government for London to act as an offshore centre for RMB transactions.

What in most European countries has essentially become an all-party welcome for closer economic ties with China contrasts with the political atmosphere in the US. Vice-President Xi was treated respectfully by President Obama’s administration during his US visit - although no major agreements were arrived at. But leading Republican presidential candidate Mitt Romney declared he would designate China as a currency manipulator on his first day if elected president.

In contrast to Europe, the US has adopted a position blocking Chinese inward investment. The most famous case was China’s National Offshore Oil Corp being prevented from purchasing Californian oil company Unocal. But China’s Huawei, the world’s second-largest telecommunications equipment manufacturer, has effectively been blocked from bidding for US contracts.

There are are of course those in Europe opposing better relations with China. Britain’s Daily Telegraph, for example, carried a headline regarding Vice-President Xi’s visit to the US that ‘China’s upcoming leader Xi Jinping has been wined, dined... and warned.’ But in contrast, the UK’s Guardian newspaper carried an editorial headlined, ‘Chinese economy: headaches to die for,’ arguing: ‘Any appraisal of China's prospects must begin by admitting that the Middle Kingdom is the most astonishing development success story in the world today.’ Even a tabloid newspaper, such as the UK’s Daily Mirror, carried a major story emphasizing the positive role of UK trade relations with China.

It is clear that the political atmosphere for China’s trade and investment in Europe is currently more favourable, and enjoys far wider support, than in US politics.

This situation is significant not only for China but for Europe and the US themselves. Trade growth between both the US and China and between the EU and China is larger than between the US and EU.

Comparing the latest available data, for the 4^th quarter of 2011, with the 4^th quarter of 2007, before the financial crisis, U.S. exports to the EU increased by an annualized $21 billion and EU exports to the US by an annualized $8 billion. US exports to China, however, increased by an annualized $47 billion, while EU exports to China grew by an annualized $83 billion. Growth of US exports to China, therefore was more than twice those to the EU, and EU exports to China grew by more than 10-fold those to the US. This data also shows the EU gained more from increased exports to China than the US.

A parallel investment pattern exists. Europe is now the largest destination for Chinese companies’ foreign investment. It also accounted for 34 per cent of China’s outward investment in mergers and acquisitions in 2011. In contrast, China’s investment in the US fell from $4.2 billion in 2010 to $3.2 billion last year.

Naturally there are downs as well as ups in Europe’s economic relations with China – a current down is the row over the EU’s airline tax. But overall the current types of deals being done are well founded because they are mutually beneficial. The Economist magazine noted: ‘In welcoming China, Europe is swimming with the tide of history; America is struggling against it.’

The reason that at present the EU is gaining more from trade and investment with China than the US is certainly not due to China’s political bias – China’s government must consider its relations with the US as the world’s most important bilateral one. But, in addition to the different scale of openings being offered them, China’s companies have to evaluate ‘political risk’ just as much as Western ones do. ‘Political risk’ is clearly now lower in Europe.

Good relations between Europe and China are evidently capable of generating what China characterises as 'win-win' outcomes. China is a huge market for technologically advanced and high-value exports from the EU, as Germany’s export success shows, which improves China’s industry, while the EU also gains from China’s continued support for the euro.

The change in the perception of China in Europe is not merely a success for China’s diplomacy but has economic foundations.

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An earlier version of this article appeared in China Daily.

US workers dropping out of the labour force, not jobs creation, dominates in this US business cycle

Considerable publicity was given to the decline in the official US unemployment rate to 8.3 per cent in January 2012 and the creation of 243,000 non-farm payroll jobs. The problem is that, as usual, no baseline or serious study of overall trends was given to evaluate this monthly data.

The reality is the number in US non-farm employment still remains 5.6 million, 4.1%, below its peak level in January 2008 (Figure 1). But this figure very substantially flatters as since then the US population has grown by almost 4%.

In fact there has been no significant increase in the percentage of the US population of working age in employment since the depth of the recession, and the participation rate in the labour force of the US population of working age continues to drop.

Figure 1

 

The sharp drop in the participation of the US participation of working age in the total labour force (i.e. employed and unemployed) is shown in Figure 2. Between January 2008, the peak of US non-farm employment, and January 2012 the participation rate in the US labour force of the population over the age of 16 fell by 2.5 per cent – from 66.2 per cent to 63.7 per cent.

Figure 2

 

 

Regarding those actually in employment the situation is worse. The percentage of the US population over the age of 16 in employment fell by 4.4 per cent, from 62.9 per cent to 58.5 per cent, between January 2008 and January 2012. There has been essentially no significant recovery from the low point of 58.2 per cent in December 2008 to the 58.5 per cent in January 2012 (Figure 3).

Figure 3

 

US GDP recovery is the slowest in this business cycle of any since World War II, and in December 2011, the latest available data, US industrial production was still 5.4% below its level in the previous business cycle. As productivity growth means that less workers are required even when previous peak levels of output are regained it will be a substantial period before the US regains its previous employment level. Paul Krugman therefore noted the situation accurately: ‘the gap remains huge. Suppose that we need 100,000 jobs a month to keep up with population growth, and that we’re 10 million jobs in the hole — both conservative estimates. Then we need about 7 years of growth at this rate to restore full employment.’

It remains to be seen whether US employment growth can continue at its present rate for seven years, But the fundamental trend so far during this business cycle has not been a decline in real unemployment but an increase in the proportion of the US population dropping out of the labour force.

The myth of US industrial revival

Currently a number of attempts are being made to claim a major revival of US industry is taking place. For example Harold L. Sirkin, of the Boston Consulting Group, writes: ‘A resurgence of U.S. manufacturing seems to be in the offing. With production costs rising in China, some companies are bringing their manufacturing back to the U.S…. That's partly confirmed by the data: The Institute for Supply Management (ISM) recently reported that U.S. manufacturing had expanded for 24 consecutive months. Likewise, the Federal Reserve reported a 0.6% increase in manufacturing in July 2011, with a year-on-year gain of 3.8%.’ Washington Post columnist Vivek Wadha claims: ‘America is destined to once again gain its supremacy in manufacturing, and it will soon by China’s turn to worry.’

It is therefore important to be clear that these claims are a myth. As may be seen in Figure 1 US industrial production has not even regained pre-financial crisis levels. In December 2011, the latest available data, US industrial production was 5.4 per cent below its peak in the previous business cycle. Equally striking, for the long term, is that since June 2000, the peak of the last but one business cycle, average annual US industrial growth has been only 0.3 per cent. In short, far from a ‘rebirth’ of US industry occurring, US industrial production has scarcely grown for over a decade and so far in the present business cycle it has not even regained its previous peak level of output. On the latest monthly data it would take US industry two years to regain its previous peak output.

Figure 1

 

Sirkin presents as evidence to justify his claims: ‘Volkswagen, for example, recently opened a new $1-billion factory in Chattanooga, Tennessee; Embraer, the Brazilian manufacturer of mid-size commuter jets, recently opened an assembly plant in Melbourne, Florida; and Mitsubishi Nuclear Energy Systems, which builds nuclear power plants and components, is locating a new engineering center in Charlotte, North Carolina.’ Publicity was given by others to a US company exporting chopsticks to China.

Unfortunately presentation of individual examples proves nothing. Industrial production is an aggregate, an average of different movements by companies. There will therefore always necessarily be cases above and below the average. Finding individual companies which are expanding, whether in chopsticks or anything else, therefore doesn’t constitute proof – even if US industry were sharply declining individual expanding companies may well exist.

Sirkin’s statistic that US manufacturing has been expanding for 24 months also doesn’t prove anything. Choosing particular starting dates, rather than considering the overall trend, has a well understood effect in distorting analysis. For example take 1933, the depth of the Great Depression, as a starting point for measuring US economic growth during the 1930s. By 1939 the US economy had expanded by 50 per cent. Solely from this one might conclude that the 1930s were a period of prosperity, whereas actually they were the worst decade in US economic history. The statistical distortion is to measure from the lowest point of the business cycle, ignoring the enormous fall in US GDP which took place in 1929-33. To avoid such statistical distortion economic analysis must state what points in the business cycle it is comparing and consider the economic process as a whole.

To see how this error distorts perception of US industry note that by the time US industrial output reached its bottom in the present recession, in June 2009, it had to grow by 21 per cent to regain its previous peak output. By December 2012, which indeed was after two and a half years of expansion, the increase was 14 per cent. Such an expansion of 14 per cent might sound impressive – it is a growth of over five per cent a year. But such an 'optimistic' conclusion distorts the reality – because 21 per cent growth was required to even regain the previous peak level of production!

Apple’s Steve Jobs stated the reality of US manufacturing reality at a dinner with President Obama last February. Asked what would shift iPhone production to the US, Jobs bluntly replied ‘those jobs aren’t coming back’.

US manufacturing ‘rebirth’ can only be claimed when there is statistical evidence to support it, not when output has not even regained previous peak levels.

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An earlier, non-technical, version of this article appeared in Global Times.

 

China and developing economies will determine the chances for world growth in 2012

China’s economic growth has become a key factor not only for itself but for world markets. As the scale of China's impact is still too frequently underestimated it should be noted that, measured in current dollars and at market exchange rates, i.e. in terms of actual effective demand, in the three years following the start of the international financial crisis China contributed 33.4 per cent of global market growth – more than four times as much as the US 8.1 per cent (Table 1). While final data for 2011 is not yet available, it is already clear from the first three quarters figures that China’s market last year expanded by over $1 trillion – approximately twice as much in dollars as the US, despite US growth having resumed. Table 1 makes clear no other economy has approached China in terms of market/global aggregate demand expansion.

It is therefore a key question whether China will continue essentially the same scale of market growth in 2012. The answer is ‘yes’  - but because of the issue’s importance the reasons should be clearly outlined. Interlinked with this is the decisive role played by developing economies in recovery from the financial crisis – the interlinking being that China is by far the largest developing economy, while the developing economies have become China’s largest trade partners.

In the three years covering the period from the beginning of the international financial crisis to the latest available annual data, i.e. in 2007-2010, developing economies accounted for 78.6 per cent of world market growth and developed economies for only 21.4 per cent. Considered from another angle, simply taking different classifications, either the BRIC economies (Brazil, Russia, India and China), or China plus Latin America, contributed the majority of world market/effective demand expansion – either of these groupings accounting for more than twice as much market expansion as the developed economies.

Table 1

 

Turning to more detailed trends, the first feature determining China’s continued dominant position in world market expansion, one the consequences of which are insufficiently frequently noted, is that as China’s economy becomes larger a similar percentage yearly growth necessarily turns into an increasingly large annual absolute market increase - in inflation adjusted terms, China’s economy expanded by 2.3 trillion RMB in 2008, 2.4 trillion RMB in 2009, and 3.1 trillion RMB in 2010.

But even frequently cited constant price growth figures underestimate the expansion of China’s position in the world market. Actual sales, and therefore changes in aggregate demand, use real money which is affected by exchange rate shifts and inflation – further figures in this article are therefore at current market exchange rates and prices unless otherwise stated. In 2009, when China froze the RMB’s exchange rate due to the international financial crisis, China’s economy grew by $469 billion – compared to a US contraction of $353 billion. In 2010, when China allowed the RMB exchange rate to rise, its annual economic expansion rose to $935 billion and the figure will be over $1 trillion in 2011 – roughly twice US market expansion.

Table 1 also makes clear the second reason China’s market will continue  its expansion. World growth is now dominated by developing economies and China is their most rapidly expanding trading partner.

Considering trends among developing economies, China accounting for 33.4 per cent of global market expansion. Latin America was second – constituting 17.3 per cent of world growth, with Brazil accounting for 58 per cent of this. China and Latin America together accounted for 50.7 per cent of world market growth..

Among other developing economic regions, South Asia contributed 8.0 per cent to world market growth, with India accounting for 84 per cent of this. Developing East Asian economies, excluding China, accounted for 7.0 per cent of world growth – Indonesia constituting 54 per cent of this. The Middle East and North Africa accounted for 6.1 per cent of world growth with no single dominant regional economy – the largest contributor, Egypt, constituted only 19.9 per cent of the total. Developing countries in Europe and Central Asia accounted for 4.5 per cent of world growth – of which 55 per cent was Russia. Sub-Saharan Africa grew rapidly, but due to its low starting point only contributed 2.1 per cent of world growth.

Turning to developed economies, Japan illustrates the importance of currency movements for shifts in markets measured in dollar terms. Due to the yen’s sharp exchange rate rise, Japan contributed 14.9 per cent of the dollar expansion of the world market despite Japan’s economy contracting in inflation adjusted terms. The US contributed 8.2 per cent to world market growth, despite the US not having grown in constant price terms, due to the dollar rising against other currencies,

The ‘disaster area’ for world markets was the developed European economies with a decline of $668 billion - equivalent to subtracting 9.2 cent from world growth.

It is already clear 2012 will show no fundamental change in this pattern. Developed European economies will again be the worst performing region – suffering a recession possibly magnified by a low Euro exchange rate. The US should expand, but slowly compared to previous upswings in US business cycle. Therefore if the world economy is to grow this will again have to be primarily due to developing  economies.

Fortunately, the large developing economies are slowing but still growing substantially more rapidly than developed ones. China, the dominant factor in the equation, even on pessimistic estimates is likely to grow by at least 7-8 per cent in real terms this year which, after increases in the exchange rate of the RMB and inflation is take into account, means an expansion of its market of probably 12-15 per cent in dollar terms. Minimum real growth estimates for India are at least seven per cent.

It is also clear from the pattern in Table 1 why BRIC economies will again dominate world growth – in 2007-2010 they contributed 52.5 per cent of world market expansion. Not only are the BRICs individually the largest developing economies but each is the centre of a major regional economic area. While Brazil has slowed, Russia’s economy has been accelerating, and it is in any case China and India which are the dominant dynamic BRIC economies.

This overall situation clearly interrelates with China as it already carries out the majority of its trade with developing economies – 54 per cent of total trade, 49 per cent of exports and 60 per cent of imports.

The implications for China’s markets are clear. China has not only the world’s most rapidly expanding domestic market, and declining inflation gives it extra room for domestic economic loosening/stimulus in 2012, but its biggest trading partners are the most rapidly growing regions of the world economy. It is this combination of domestic and international factors which determines that  China will continue to remain the world’s most rapidly expanding market/supplier of increased aggregate demand in 2012. Given the negative prospects in Europe, and slow growth in the US, it will then be the situation in the developing economies, which is increasingly related to the situation in China, which will necessarily determine the overall prospects for world growth in 2012.

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This is an expanded version of an article which originally appeared in Shanghai Daily.

China's pivotal role in the world economy in 2012

In 2012 the world economy will continue to struggle with the international financial crisis. There will be recession in Europe, world trade was already declining in September and October, and international commodity prices are falling sharply - a sensitive indicator of the state of the world economy. The only unknown is the severity of the slowdown - in particular, will the US be pulled into recession or merely continue to grow slowly, and by how much will the large developing economies such as Brazil, India and Russia decelerate? China's premier Wen Jiabao predicted, regarding that country’s perspectives, that next year's international economic situation would be "complicated and tough."

Entering such a situation, a major issue is to assess with the maximum possible accuracy the position of China in the global economy - this affects both the rest of the world economy and China. Well known statistics, such as that China's is the world's second largest economy, are insufficiently accurate to suffice for this. For reasons indicated below they underestimate the role of China in the world economy's development and are not fine grained enough to accurately judge economic policy. Analysis shows China will play a pivotal role in the world economy in 2012 - Goldman Sachs's Jim O' Neill, coiner of the term BRIC, estimated in the Financial Times: "While the financial and business world continue to hang on every twist and turn in eurozone politics, I think the biggest issue for the world in 2012 will be...China."

The first reason for this is that China's high growth rate results in its contribution to world economic expansion being much greater than its percentage of world GDP. In 2007, the last year before the international financial crisis, China accounted for only 6.3 per cent of world GDP on World Bank statistics. But in the following three years the world economy expanded by $7.2 trillion while China’s economy grew by $2.4 trillion - i.e. China accounted for 33 per cent of world growth. In contrast, in 2007 the US accounted for 25.1 per cent of world GDP, but in the next three years the US economy grew by only $0.6 trillion. Therefore in the last three years China’s economy contributed four times as much to global growth as the US. The EU, to make a comparison, contracted by $0.7 trillion during the same period.

The second key factor is China’s financial role. The key feature of this is not, as is sometimes supposed, China’s $3 trillion foreign exchange reserves. These have been accumulated over a significant period and, because a large part is an emergency reserve, only a small amount can be utilized at any point. The key element is the finance China generates each year for investment – i.e. its total company, household and government saving. In 2007 US total finance generated for investment was $2 trillion and China’s was $1.8 trillion – that is, the US was slightly ahead of China. By 2010, under the impact of their economies, different responses to the crisis, total finance available for investment in the US was $1.6 trillion and in China $3.1 trillion – i.e. China’s finance available for investment is now almost twice that in the US, a dramatic change in three years.

Turning to international trade, US imports have still not regained pre-financial crisis levels. Taking a three-month average, to avoid distortion by purely short-term fluctuations, up to the latest available data, for October, US imports were an annualized $17 billion lower than the pre-financial crisis peak level in July 2008. Therefore in the last three years the US market for exports has contracted. In contrast, compared to the pre-crisis peak in July 2008, China’s imports from other countries have increased by an annualized $575 billion. China therefore now plays a much greater role as a market for increases in exports than the US.

Finally is the structural position China occupies in the changing pattern of the world economy. The Economist magazine recently emphasized that 2012 will see a fundamental change in the world economy: for the first time the majority of world imports will be by developing economies. In 2008-2010 low and middle income, i.e. developing, economies accounted for 78 per cent of world economic growth.

China already carries out a majority of its trade with developing countries. In the three months ending in October, 54 per cent of China’s trade was with developing economies - 49 per cent of exports and 60 per cent of imports.

The rate of increase of China’s trade with developing economies is also significantly stronger than with developed economies. Between July 2008 and October 2011 China’s exports to developed economies rose by an annualized $107 billion and its imports from them by $145 billion. With developing countries, China’s exports rose by an annualized $143 billion and its imports by $204 billion. China was the hub of a rapid expansion of trade by developing economies.

This trade situation is directly linked to the new technological position China occupies in the world economy. A number of developing economies have passed from being merely suppliers of raw materials to exporting more technologically developed products – India’s success in software and Brazil’s in regional range aircraft are examples. But no other developing country has such a wide technological range of internationally traded products as China. Such trade originated in low technology labour intensive industries, spread through a rapidly widening range of medium technology products such as excavators, domestic goods and personal computers, up to the higher technology telecommunications equipment of Huawei and other companies.

This capacity of China to export across a wider range of the technology spectrum than any other economy creates its increasingly key position in world trade. China exports low, medium and some high technology products to developed economies, while its exports are increasingly on a higher technology level from the point of view of developing economies. China’s financial resources make it able to follow this widening range of exports with direct investment.

It is the combination of these features - the single biggest contributor to the increase in world GDP, the largest source of finance, the biggest potential increase in export markets for other economies - which results in China’s impact on the world economy being much greater than its pure percentage of world GDP. To put it in technical economic terms, developments at the margin, that is contributions to change, must be considered as well as averages.

Concerning the issues that will dominate 2012, China's economy by itself is not yet large enough to pull the developed economies out of recession - although it can play a potentially significant role in collaboration with others. But in relation not only to Asia but to a widening range of developing countries the growth of China’s economy is crucial. As developing economies now contribute more to world economic growth than developed economies, this means that the success, or otherwise, of China’s economy for the global economy will be pivotal in 2012.

*   *   *

This is an edited version of an article originally published as an opinion piece by China Daily’s website.

China's stronger economic structure than the US and Europe means its fast growth will continue in 2012

The beginning of 2012 is a suitable moment to assess China's economic prospects for the year and coming period. This overall perspective is clear – China will grow strongly, remaining the world's fastest growing major economy, and will continue to substantially outperform Western pessimist predictions. This is the same fundamental analysis maintained by the author over the last two decade period. Factual results during these twenty years have confirmed such projections - as opposed to the opposite perspective. As accurate or inaccurate predictions do not depend on personal characteristics, but on different fundamental analyses, therefore what leads to repeatedly correct and incorrect projections regarding China's economic growth?

The core issue is simple but difficult for the majority of non-Chinese analysts to admit, despite constant confirmation by economic facts and repeated falsification of predictions of China's serious slowdown. This core issue is that statements by Chinese analysts that China has a stronger economic structure than the US and Europe, and that this therefore produces stronger economic performance, is not a boast but actually factually correct. As this stronger character of China's economic structure is not understood by many Western analysts, they therefore systematically, and each year, underestimate China's economic growth potential.

Nevertheless, a genuine difficulty for non-Chinese analysts is that explanations of this economic strength are frequently posed only in terms of specifically 'Chinese characteristics'. It is therefore worth spelling out more generally why China has a stronger economic structure than the US and Europe, and how this relates to global economic issues that will be faced in 2012.

 

 A model performance [By Jiao Haiyang/China.org.cn]

 

China self-definition of its system is a 'socialist market economy'. This denotes it differs fundamentally from the economy, modeled on the former USSR, which existed prior to China's 1978 economic reforms, in that economic policy is not run by administrative but by market means. China has a large and vibrant private sector – indeed the world's most rapidly growing private sector. However China differs from the US or Europe in having a sufficiently large state sector, and a nationalised core banking system, that it can directly set the economy's overall investment level – the state sector is too small in the US or Europe to achieve this. This combination of market system and a state sector sufficiently strong to determine the overall level of investment is what gives China its greater economic strength than the US or Europe - such a structure can be understood either from a Chinese 'socialist' point of view or a Western 'Keynesian' one, and for present purposes it  is unimportant which is chosen. 

To illustrate this, consider a key contemporary economic problem – the current situation in the US. The Financial Times on December 15 accurately described the situation in the US economy. It noted that the share of wages in US GDP had fallen to the lowest level since records began and concluded: 'The decline in the labor share, along with a shift of labor income towards higher earners, may be an important part of why the US economic recovery is so sluggish. Workers on lower wages consume much of their income, while higher wage earners and those with capital income are more likely to save. That will not affect total demand if savers lend to those who want to consume or invest in buildings and start-ups – but investment has been slow to recover in the wake of the recession.'

In short, the US economy is growing slowly not because there is a shortage of funds for investment, on the contrary profits are at a record high, but because investment is very low – indeed the entire decline in US GDP in the current 'Great Recession' is accounted for by the investment fall. The problem is that in the US there is no mechanism which ensures that the huge funds available for investment are actually invested.

In China no such problem exists. If funds are not directly invested by companies, then the state owned banking system and state sector can invest them. Therefore no shortfall of demand occurs of the type analysed by the Financial Times in the US. During the entire international financial crisis China, unlike the US, suffered no investment decline – on the contrary investment increased. The problem of accumulation of unused funds of the US type, that is in Keynesian terms a shortage of effective demand, does not arise in China. Equally if China's economy is booming, and companies are utilizing all funds for investment, the state steps back and cuts its own investment – reducing it to cool overheating. That is why China's macroeconomic policy is stronger than that in the US - the problems of either shortage of or excessive demand, which plague the US and European economies, are smoothed in China.

This evidently does not mean China escapes all macroeconomic issues. No policy maker can judge absolutely accurately how strongly the international economy will grow, what will be all the inflationary or deflationary pressures present, exactly how China's own economy will respond to a given measure etc. Therefore there are always issues of overheating, undershooting, inflation, deflation etc. But these are qualitatively smaller fluctuations than in the US or Europe.

The period since the onset of the international financial crisis showed this strength of China's economic structure clearly. Faced with the international financial crisis in 2008, China was able to launch a massive stimulus package which meant its economy did not suffer a recession at all. The recovery of the world economy in 2010-2011 combined with the aftermath of the stimulus package to create some economic overheating and 2011 was therefore mainly spent damping inflation. In 2012, with negative trends dominating the world economy, China will loosen policy.

The overall result is evident. In the four years to the latest economic data, for the 3rd quarter of 2011, the US grew by 0.5 percent, the EU shrank by 0.3 percent, and China grew by 42.2 percent. China's economy therefore suffered some fluctuations on a strong growth path, whereas the US and Europe suffered overall economic stagnation. The stronger character of China's economic system was shown by these facts – those predicting crisis for China, on the same scale as the US or Europe, made the wrong predictions because they failed to analyze that strength.

It is this superior strength of China's economic structure that also makes it clearly possible to predict for 2012 that China's economy will continue to grow strongly, that it will remain the fastest growing major economy in the world, and that it will outperform on the upside Western pessimists predictions – as in previous years the facts of 2012 will confirm that analysis. Not until they understand the greater structural strength of China's economy will current critics be able to make persistently accurate predictions.

 *   *   *

 A shorter and edited version of this article originally appeared on China.org.cn.

US house price fall a significant negative for global economic prospects

One of the biggest questions for the global economy in 2012 will be whether the US follows Europe into recession – the other is whether the large developing economies will be able to repeat their strong growth performance during the previous wave of the financial crisis in 2008-2010 by ‘decoupling’ from the US and Europe.

A significant negative for US prospects came with the release of the latest S&P Case-Schiller house price index. This showed a larger than expected 3.4 per cent annual fall for the latest period for which data was available – October. But much more significant than one month's figures is the overall trend.

As shown in Figure 1 US house prices reached their post-financial crisis low in May 2009 after falling 31.7 per cent from their peak. Recovery continued until May 2010 after which prices began falling again. By October 2011 US house prices were 33.0 per cent below their all-time peak – the worst level since the international financial crisis began.

As housing is, with shares and bonds, one of the three great US asset classes, a significant fell in this category will have an impact across the whole US economy. In particular:

• it will further negatively impact the balance sheets of US banks;
• it will have a dampening effect on US consumer spending

Figure 1

 

The overall view of this blog remains that the US will continue to have historically slow growth rather than re-entering a recession, and the latest US consumer confidence figures for December were the best for eight months. But the fact that the trend of US house prices has now been down for 17 months is a serious negative.

Whatever their immediate mood US consumers are constrained by objective financial factors. With unemployment not falling significantly and incomes not rising falling house prices will further constrain consumers. The recent increase in consumer purchasing in the US has been financed by a reduction in savings levels – which is unsustainable.

The house price data by itself does not lead to a view the US is entering recession, but it pushes US growth towards the ‘slower’ end of the ‘slow’ spectrum.

Fairy stories about China's 'economic crisis'

The present rapid shifts in the international and Chinese economic situations, resulting from the second wave of the international financial crisis centred on the Eurozone, are a challenge both to policy makers and a major opportunity for those with an accurate analysis of China's economy.

 

China speed [By Jiao Haiyang/China.org.cn]

 

The reasons for this are the same as those when I ran a consulting company and knew inaccurate media analysis was an opportunity to make a profit. Businesses need accurate information to take correct decisions. If a newspaper writes an economy is going to boom when actually it suffers recession, the paper doesn't directly lose anything, but a company acting on the wrong analysis can lose a great deal of money. Economic and business writing therefore operates under an objective discipline which doesn't necessarily exist elsewhere - companies rationally pay a great deal of money for accurate information.

The reason a similar opening exists in China at present is that attempts are being made to convince businesses that China faces an 'economic crisis' on the same scale as that hitting the European Union (EU) and the US. This view is factually nonsense, as any comparison of economic data shows. In the four years to the latest data the US economy grew by 0.5 per cent, the EU's shrank by 0.3 per cent, and China's economy grew by 42.2 per cent. Given such comparisons claims that China is suffering from 'crisis' is rather like saying the US has cholera, the EU has typhoid, and China has a cold and therefore they are basically in the same situation as 'all are ill'. Such claims destroy rational scales of comparison and are therefore wholly misleading in predicting what will happen.

China's economy naturally faces problems - all economies always face problems. It has had excessive house price increases, which are now gradually coming under control, and its consumer price index has been too high - although again it is now falling. Recession in the Eurozone will reduce orders to China's exporters. But China's economic year on year growth rate in the last quarter was 9.1 per cent compared to 1.5 per cent for the US and 1.4 per cent for the EU. If the US and EU were paralleling China's growth far from claiming, this was a 'crisis' they would be calling it an unprecedented boom!

A typical example of such fairy stories regarding China's 'economic crisis' was a recent article in the Wall Street Journal by Nouriel Roubini and Ian Bremmer president of the Eurasia Group - a risk analysis company. This was entitled 'Whose economy has it worst?' and was introduced: 'With Europe, China and the US in crisis, the real question is which of them will stumble first.' The data already given above show such statements are bombast - there is no crisis in China's economy similar to the US or EU.

Why, therefore, are such economic fairy stories published, why are they are publicized, and how to profit, not purely monetarily, from them?

One reason they appear, of course, is simply that people make wrong analyses. But the reason they are publicized is different. Take for example Gordon C Chang. He wrote a book in 2001 entitled 'The Coming Collapse of China'. This argued 'A half-decade ago the leaders of the People's Republic of China had real choices. Today they do not. They have no exit. They have run out of time.'

In the ten years since China's economy more than doubled in size. After such radically wrong predictions you might expect that Chang would find it difficult to obtain coverage for his analysis. But instead he is regularly published by Forbes magazine with articles posing such questions as 'Can Beijing rescue a stumbling economy'. Some 'stumbling' with nine percent GDP growth! Such analyses have nothing to do with reality but fit the politics of Forbes - which specializes in analyzing the ultra-rich in the US and is hostile to China. 

Business people caught up in such political maneuvers can lose huge sums of money. For example, in a case rather similar to the one of China at present, those backing a particular political grouping in Russia in the 1990s persuaded US hedge fund manager George Soros to become involved in a takeover battle around a Russian telecommunications company Svyazinvest. I was retained as a consultant by others involved and concluded Svyazinvest was a terrible investment. Therefore Soros was being pulled in for reasons of political maneuvers and not serious financial analysis. Soros lost approximately a billion dollars.

Companies rightly analyzing that China's economy will continue to grow, GE and Goldman Sachs immediately come to mind, are those most successful in business in China. Equally there are Western analysts who correctly predicted China's growth over the last period - Goldman Sachs Jim O'Neill, who invented the term BRIC, and the specialized consultancy Dragonomics for example.

This gives a major opportunity to those with an accurate analysis of China’s economy. Businesses following the erroneous view that China's economy is going to drastically slow or enter crisis will lose money. Those who rightly predict China's economy will continue to grow rapidly will gain credibility. This requires accurate analysis and reporting - not pretending there are no problems in China's economy but correctly contextualizing that these are far less than in the US and EU. The facts over the next year, as in previous years, will simply show that China’s economy continues to grow strongly, suffering no economic crisis qualitatively equivalent to that in the EU and US at present.

*   *   *

This article originally appeared on China.org.cn. It has been amended to remove references only relevant to readers in China.    

The weakness in world trade - pre-crisis trade levels only regained in Asia and Latin America

Europe’s economy is probably entering a double-dip recession. The indications from world trade, as analysed previously, are so far that the world economy as a whole is facing slowdown but not renewed recession. However a detailed breakdown shows extreme unevenness in the trade recovery - with only Asia and Latin America surpassing pre-financial crisis levels. Regional trends for imports and exports, using a three month moving average to smooth short term fluctuations, are shown in Figures 1 and 2.

Considering trends in detail, pre-crisis world trade peaked in April 2008. In the latest month for which data is available, September 2011, world trade was 2.3 per cent above its pre-crisis maximum on individual month comparisons and 3.6 per cent above on a three monthly moving average.

Table 1 shows a detailed breakdown of trade since the financial crisis by region. This data shows that only in developing Asia and Latin America are both exports and imports clearly above pre-financial crisis levels. Taking three monthly moving averages, imports are up from pre-crisis levels by 16.7 per cent in developing Asia and 9.4 per cent in Latin America, with exports up 17.0 per cent in developing Asia and 6.9 per cent in Latin America. In the US exports are slightly above pre-crisis levels but imports are significantly below. In all other regions – the Euro area, Africa and the Middle East, Central and Eastern Europe, and Japan – both exports and imports remain below pre-crisis levels.

The recovery of world trade to above pre-crisis levels is therefore due to the situation in two developing regions. The weakness of trade in the Euro area is worse than most regions, particularly in terms of imports, but not really exceptional. Trade in most areas of the world economy remains significantly below pre-crisis levels.

Table 1

 

Trade with China

Among the largest economies the chief beneficiary of this pattern of world trade is China - although it is likely the pattern itself is in significant part a result of the dynamics of China's trade.

In the period between China's peak pre-crisis level of exports and imports, in July 2008, and September 2011 China's exports to Asian developing economies rose by 22.9 per cent and its imports from these economies rose 31.4 per cent. China's exports to Latin America rose by 53.0 per cent and its imports by 59.9 per cent. These are clearly exceptional growth rates. China is the main trade partner for most developing Asian economies as well as for a significant number of Latin American economies including Brazil.

The patterns of world trade since the financial crisis therefore indicate the consolidation of a dynamic trading interaction between China, developing Asia and Latin America. China's economy and trade is not yet sufficiently large to offset a global scale recession in the EU and/or US, but there is clear evidence that China's economy is sufficient to produce the most dynamic of post-crisis world trade interactions centred on Asia and Latin America.

Figure 1

Figure 2

During the last four years the EU's economy has grown by -0.3%, the US by 0.6%, and China by 42.2%

The full scale of the difference in economic performance of China compared to the US, Europe and Japan during the international financial crisis is shown in Figure 1. It is summarised in the following figures:

• In the four years to the latest available data, for the 3rd quarter of 2011, China’s GDP expanded by 42.2%
• In the four years to the latest available data, also for the 3rd quarter of 2011, US GDP increased by 0.6%.
• In the four years to the latest available data, for the 2nd quarter of 2011, European Union (EU) GDP shrank by 0.3%.
• In the four years to the latest available data, for the 2nd quarter of 2011, Japan’s GDP contracted by 5.2%.

Figure 1

 

 

These are evidently extraordinary statistics. During this four year period China’s economy expanded 70 times as fast as the US.

Such data also clearly refutes the current attempt to claim that in China there is an economic ‘crisis’ in some sense equivalent to that in the US or Europe. Such arguments are intellectually sloppy (at best) attempts to undermine rational thought by destroying any serious quantitative comparisons.  

To give examples of such claims, a recent article by Nouriel Roubini and Ian Bremmer in the Wall Street Journal is introduced: ‘With Europe, China and the U.S. in crisis, the real question is which of them will stumble first.’ Similarly Will Hutton in the UK’s Observer claims: ‘Nobody would start from here – an ill-designed single currency interacting with an insupportable burden of private debt created by oversized, undercapitalised banks. And it's as much a problem in the US and China as in Europe.’

The data given above shows such claims are false. GDP growth of 42.2% in China, an annualised 9.8%, is not remotely comparable to the US’s annualised 0.2%, or the EU’s annualised minus 0.1%.

Naturally it is impossible to have an annual 9.8% growth rate for almost four years and have no problems at all – in fact no economy ever has no problems! China has had consumer price inflation, primarily due to international commodity price increases, which reached 6.5% before falling and it has had excessively high house price increases – which are also now falling. But none of this constitutes a ‘crisis’ on anything quantitative scale remotely approaching that of the US and Europe.

Nor, to take Hutton’s point, does the EU financial crisis have anything like the same impact in China, or even the US, as in the EU. The effect of the decline in imports from the EU on China’s exports is noticeable but only in the sense that it reduces China’s overall export growth from a very high to a high rate of growth – 15.8% last month, in a factual situation in which none which China’s GDP growth in the last four years has come from net trade. Indeed reduction of China’s trade surplus means that net trade has been a subtraction from China’s GDP growth during that period. The exposure of China’s banks to Europe’s debt crisis is also minimal. While the financial exposure of the US to the Eurozone is certainly higher than China’s there is also no indication that the actual scale of crisis or defaults in Europe is pushing the US into recession – whereas a double dip recession in Europe itself is extremely possible.

Hutton, in short, is engaging in inflated rhetoric to attempt to create a relative equals sign between the situation in China (and the US) and that in Europe when none exists. Inflated rhetoric is merely a form of destroying the quantitative scale of comparison which is a precondition for rational thought.

The GDP data for China, US and Europe GDP data should also end attempts by Kate Mackenzie the Financial Times and Nouriel Roubini to present the US’s Michael Pettis, and similar analysts, as having had a correct analysis of China. Michael Pettis runs an objectively moderated blog on China but his analysis of China has been factually shown to be quite erroneous – claiming that: 'the US would be the first major economy out of the crisis and China one of the last.’ Evidently a situation where China has grown by 42.2% and the US has grown by 0.6% shows the reverse has been the case. Claims that it is too early to judge whether China or the US has been more successful in coming through the financial crisis are just attempts to avoid the test of facts that has taken place. Even if, against the evidence, China’s economy were now to slow significantly the scale of growth it has already achieved demonstrates that has come through the financial crisis far more successfully than the US or Europe.

The basis of any serious analysis or theory is facts. Those who refuse to refer to the data of the relative performance of China, the US or Europe during the last four years do so only because their analyses will not stand the test of examination by these facts.

China in face of the West's 'Great Stagnation'

I have a new article at China.org.cn which analyses the impact of the present 'Great Stagnation' in the developed economies on the prospects for China's economy.

It concludes:'Given extremely slow growth in the developed economies, and that examination of underlying macro-economic factors such as savings and investment indicates no reason to expect a substantial growth acceleration, this places China in a new international economic situation. For almost the entire period since China launched its economic reforms in 1978, it has been growing more rapidly than other economies but in an international context where the developed economies were growing significantly. The only serious previous recession in the advanced economies during China's reform period was right at its beginning, in 1980-81, when China was scarcely integrated in the international economy. The international slowdowns in 1990 and 2000 were brief and mild and while the 1998 South East Asian financial crisis impacted China significantly, it did not originate in the developed economies...

'In economics and business there is no virtue in either optimism or pessimism, there is only a virtue in realism. Given current trends, China has to base itself on a perspective that for several years there will be slow growth of the developed economies and therefore slow growth of their imports. Developing economies, while growing more rapidly than developed ones, will not in the very short term be able to fully compensate China's exports for stagnation in developed economies.

'The international framework for China's economy is therefore clear. It is important to understand that what is faced is a 'Great Stagnation' not a new 'Great Recession' - that is there is no reason to anticipate major international economic downturn of the 2008 type. China therefore does not need a new huge stimulus program of the type it launched in 2008 - which would lead to severe economic overheating. But the international economic situation requires adjustments in emphasis.

'First, even more than previously, China has to rely on developing domestic demand. Greater analytical clarity on this is important as at present domestic demand is frequently confused with domestic consumption - the two are not the same.

'Second, while developing economies will not immediately be able to fully make up for the negative pressure on China's exports from the 'Great Stagnation', they provide an important addition to China's domestic demand - in the last fifteen years the percentage of China's exports going to developing economies have risen from 35 percent to 50 percent. All developing economies face the Great Stagnation, therefore all face constriction on exports to developed countries, while China's imports are continuing to expand. This will produce greater integration of developing economies with China in both exports and imports.

'Within developing economies many of China's top companies, such as Huawei, Haier, and Lenovo already have high brand values and the present situation therefore creates opportunities to further enhance the positions of China's international brands.'

The full article, including a brief comparative analysis of the 3rd quarter US GDP figures with previous US post-war business cycles, may be found here.

Economic downturn even worse in UK than Eurozone - due to government deficit cutting policies

One of the more factually inaccurate pictures being spread by supporters of the policies of the present UK government - with its priority to budget deficit reduction - is that UK economic performance during the financial crisis is superior to that of the evidently crisis hit Eurozone. A typical version of this appears in an article on 3 October in the Daily Telegraph by its international business editor Ambrose Evans-Pritchard.

Evans-Pritchard states: ‘My sympathies go to the hard-working citizens of Germany, Spain, Italy, Portugal, and Ireland for being led into this impasse [the Eurozone] by foolish elites.’ Presumably Evans-Pritchard's sympathy goes to the inhabitants of the Eurozone, rather than his own country the UK, because he believes the UK has been doing better than the Eurozone.

The factual situation is the exact opposite of the impression presented by Evans-Pritchard. Judged by economic performance, the average citizen of the UK far more needs Evans-Pritchard’s sympathy than the average citizen of the Eurozone - i.e. the UK’s economic performance during the financial crisis is much worse than that of the Eurozone. This may be seen in Figure 1 – which shows UK GDP compared to that of the Eurozone since the peak of pre-financial crisis output. Comparison is straightforward as in both the Eurozone and the UK the peak of the previous business cycle was in the 1st quarter of 2008.

Bn the 2nd quarter of 2011, that is 14 quarters after the peak of the previous cycle, Eurozone GDP was 2.0 per cent below its previous peak level whereas UK GDP was 3.9 per cent below its previous peak - i.e. UK economic performance was almost twice as bad as that of the Eurozone.

Figure 1

 

Equally striking is the clear way in which present government’s policies made UK economic performance worse than in the Eurozone. It may be seen from Figure 1 that while the initial decline in UK GDP was greater than in the Eurozone - the greatest decline in UK GDP being 6.4 per cent registered in the 3rd quarter of 2009, compared to a maximum Eurozone drop of 5.5 per cent in the 2nd quarter of 2009 - recovery in the UK was also initially more rapid. This may be clearly seen in Figure 2, which shows year on year GDP changes.

The UK and the Eurozone reached their 1st quarter 2008 peaks with almost exactly the same economic momentum behind them – 1.9 per cent growth in the previous year in the UK and 2.0 per cent in the Eurozone. However by the 3rd quarter of 2010, the one immediately following the departure of the  previous government, UK GDP was rising at 2.5 per cent compared to 2.0 per cent in the Eurozone. Eurozone recovery subsequently slowed somewhat to 1.6 per cent by the 2nd quarter of 2011.

However UK GDP growth under the new government, which gave priority to budget deficit reduction, dropped astonishingly, by more than two thirds, from 2.5 per cent to 0.7%. Under the new government the year on year growth of UK GDP therefore fell from being higher than that of the Eurozone to being less than half that of the Eurozone!

Figure 2

 

The present author is not a supporter of the present constitution of the Euro. On the contrary I predicted the current events unfolding in Greece and other countries in advance due to fundamental weakness in the design of the Euro. Writing in 1996, i.e. fifteen years ago:’ [the Treaty of] Maastricht’s proposals are … disastrous. It proposes to create the most fundamental features of a common state — a single currency and a central bank. But it does not create any state budget which can deal with the huge regional and sectoral implications of this. The process that would unfold with the creation of a single currency by this method may be predicted with certainty. Substantial parts of the EU… will be pushed into severe recession if they join.There will be sharply deepening regional imbalances and inequalities.’There is evidently no reason to revise that analysis.

It is therefore all the more striking that UK economic performance is actually worse than in the Eurozone. And a substantial reason it is worse is clearly due to the policies of the present government with their priority to budget deficit reduction.

In any discussion of the relative economic performance of the Eurozone and the UK two fundamental facts must be held in mind against unsubstantiated myths:

• UK economic performance during the financial crisis is substantially worse, almost twice as bad, as that of the Eurozone.
• And the reason it is that bad is because the present government, through its priority to cutting the budget deficit, reduced the UK’s rate of economic recovery from substantially above that of the Eurozone to less than half that of the Eurozone.

This factual situation evidently has a more general economic significance than merely for the UK and the Eurozone. For reasons dealt with frequently on this blog a policy of simply running budget deficits is inadequate to deal with the consequences of the present financial crisis as it does not tackle its driving force - the decline in investment. But under conditions of private sector weakness any rapid reduction in the budget deficit will lead to rapid economic slowdown or contraction. This is sharply illustrated by the fact that the UK government, by such policies, has reduced the UK's rate of economic recovery to less than half that of the openly crisis struck Eurozone.

Other countries thinking of embarking on immediate deficit reduction policies, such as those advocated by the Republicans in the US, should look at the UK and draw the appropriate negative conclusions. Do not be totally distracted by financial fireworks: the policies of the present UK government are so bad they have produced an economic recovery which is only half that of the Eurozone!

Eurozone rescue packages will continue to fail until they deal with the central issue in Europe's recession

The international financial system is passing through the agony of a new round of the Eurozone debt crisis for the simple reason that European governments, like that in the US, refuse to deal with the core of the economic recession in Europe for reasons of economic dogma.

Anyone who looks at the economic data for the Eurozone without wearing ideological blinkers can see the situation at once – it is charted in Figure 1. The Eurozone recession is due to a collapse in fixed investment. Taking OECD data, at inflation adjusted prices and fixed parity purchasing powers (PPPs), then between the last quarter before the recession, the 1st quarter of 2008, and the 2nd quarter of 2011 Eurozone GDP fell by $204bn. But private consumption declined by only $29bn while the net trade balance increased by $32bn and government consumption rose by $91bn. However fixed investment fell by $290bn – i.e. the recession in the Eurozone was wholly due to the fixed investment decline

Figure 1

 

Equally evidently, due to its scale, until this fall in investment is reversed it will take a prolonged period for the recession to be overcome. Therefore to restore growth, which by now is generally realised is the core to turning round the budget deficit problem, the fixed investment decline must be overcome.

Nor is there anything mysterious about how to do this – the state has entirely adequate means. To take the most decisive international case China made the core of its stimulus package direct state investment particularly aimed at infrastructure and housing – the result being that China’s economy has grown by over thirty per cent in three years.

Europe and the US clearly do not have the scale of state sector, nor the political willingness, to act on the scale China did. But US history shows that even without proceeding to a socialist scale of measures direct state intervention on investment is entirely possible.

Roosevelt expanded US state investment from 3.4% of GDP to 5.0% between 1933 and 1936 (data from US Bureau of Economic Analysis Table 1.5.5). Jason Scott Smith, in his study of New Deal public spending, summarises such investment as including 480 airports, 78,000 bridges, 572,000 miles of highway - which, in addition to its immediate effect in stimulating demand, reinforced the productive position of the US economy. Roosevelt, it is superfluous to point out, was neither a socialist nor a communist (despite claims to the contrary by the US right!).

Quarterly, up to date, data is regrettably not available on what is occurring across the Eurozone for state investment, but it is available for the US and there is no reason to suppose, with  current policies, that the situation in Europe is any better. Between the peak of the previous US business cycle, in the 4th quarter of 2007, and the 2nd quarter of 2011 US private fixed investment fell from 15.8% of GDP to 12.2% - i.e. a decline of 3.6% of GDP. Yet in the same period US state investment did not compensate but also fell marginally – from 3.3% of GDP to 3.2% of GDP. Therefore while Roosevelt expanded the weight of US state investment current US administrations have been letting it fall.

Instead of directly addressing the core issue of the investment fall European administrations are either attempting to stimulate it indirectly – which, as it is ineffective, has led to fiscal/sovereign debt crises, or are acting via expansion of the money supply – which, in a situation whereby companies and households are paying down debt, is merely the famous ‘pushing on a piece of string’. 

The most favourable outcome of such a situation is that eventually the debt will be paid down, but only after several years of stagnation. The less favourable variant, of course, is that the banking system breaks under the strain and renewed recession is further propelled by fiscal cutbacks. All these problems simply arise from the fact that, under the rubric of the dogma ‘private equals good, state equals bad’, European governments refuse to use the state tools available to deal with the investment fall which is at the core of the Eurozone recession.

Some European politicians are now beginning to call for state measures to increase investment, UK Business Secretary Vince Cable being one. But the action they envisage so far is inadequate to deal with the scale of the investment fall.

China's economy, which does not have such ideological inhibitions, will continue to expand while the Eurozone remains relatively stagnant for a significant period - and as long as economic stagnation continues there will be no resolving of the Eurozone debt crisis.

 

Acknowledgement

Some of the data in this article regarding the US was worked up in an exchange with Gavyn Davies on his blog. Readers may therefore want to look at it there, where further points are developed, and some of the issues also become clearer in the context of an exchange with Gavyn Davies own analysis.

A 2nd wave of bank share price Armageddons?

The current falls in the prices of bank shares are widely covered in the financial media. However the overall pattern and scale of the decline in market evaluation of banking shares is still not sufficiently frequently drawn together. The aim of this note is therefore to show this pattern in clear terms. It reveals market estimations of a second wave of major bank share price collapses. This is particularly significant as it follows a lack of recovery of the first wave - i.e. there is a clear pattern of a spreading pool of 'collapsed' share prices of major banks. The cases of Barclays, Bank of America and Société Générale in this wave will be looked at in particular in comparison with the earlier cases of Citigroup, RBS and Lloyd's Banking Group.

The 1^st wave of bank share price collapses

The overall features of the wave of bank collapses in 2008 is too well known to need rehearsing here. Attention is simply drawn to the fact that, in addition to the formal bankruptcy or takeover of investment banks (Lehman Brothers, Bear Stearns, Merrill Lynch), a series of very large retail banks were left in a state which, from the point of view of their share prices, means they may be regarded as ‘collapsed banks’ – ‘collapsed’ for present purposes being defined as having suffered a fall of more than 90% in share price. These share prices may also be regarded as 'collapsed' in the sense that no significant recovery has taken place.

Attention is drawn to these features as there is sometimes an implicit assumption that share prices in these banks may have recovered at least to some degree in line with the overall recovery in share prices. This is clearly not the case.

Figure 1

 

Figure 1 therefore shows the share prices for three of the largest such banks – Citigroup, RBS and Lloyd’s Banking Group. The share prices in all these banks rapidly fell by around 90% during the financial crisis – the falls beginning, as a leading indicator of the coming crisis, in all cases between December 2006 (Citigroup) and February 2007 (RBS and Lloyd’s Banking Group). To make possible international comparisons, as with other banks considered here, share prices have been converted into dollars using daily exchange rates.

Figure 1 shows clearly the 1^st wave of collapses in bank share prices and that no recovery has taken place from it. On 9 September 2011 the shares of Citigroup had fallen by 94.8% from their peak, the shares of Lloyd’s Banking Group had fallen 95.9% and the shares of RBS had fallen 97.6%

The 2nd wave of bank share price collapses

The significance of the new current wave of severe bank share price falls is illustrated in Figure 2. This shows that the share prices of a further series of very large banks – Barclays, Bank of America and Société Générale are analysed – had initially suffered falls in share prices during the financial crisis which were as large as the first group of ‘collapsed’ bank share prices. However unlike the first group this second set of institutions had undergone a genuine recovery in share price. What is now significant, therefore, is that the recent share prices of this second group are now falling sharply downwards towards the level of ‘collapsed’ banks – i.e. a second wave of very large banks are being pulled into a maelstrom of  share price collapses.

Figure 2

 

Specifically, for the banks considered above:

• Barclays share price, after peaking in February 2007, by 23 January 2009 had fallen by 95.5%. By 17 September 2009, however, Barclays share price had recovered to to 59.3% below its peak. By 9 September 2011 Barclays share price had again fallen to 85.3% below its peak level – i.e. a second wave of severe share price falls had set in.
• Bank of America’s share price, having peaked in October 2007, by 6 March 2009 had dropped by 93.4%. It then recovered to 61.1% below its peak by 14 October 2009. By 9 September 2011 however its share price had again fallen to 85.3% below its peak.
• Société Générale’s shares, having peaked in May 2007, by 9 March 2009 had fallen by 88.3%. They then recovered to 58.8% below their peak by 29 September 2009. By 9 September 2011 they had fallen to 87.9% below their peak.

The share price pattern of these banks is therefore common. They reached low points early in 2009 before recovering by autumn 2009. Since then at first a slow, and now rapid, renewed decline in their share price has taken place. In other words the market judgement is that a new wave of severe share drops of major banks – including Barclays, Bank of America and Société Générale – is taking place down towards the level of the 1st wave of ‘collapsed’ (in terms of share prices) banks, that is Citigroup, RBS and Lloyd’s.

In order to show this pattern Figure 3 shows the share prices of both the 1st and 2nd wave of share price falls in the banks considered.

Figure 3

 

Severe price falls, by normal standards, are of course taking place for most other banks – including Goldman Sachs, Deutsche Bank, HSBC etc – but these cannot be said to be approaching the level of near 90% falls for the banks analysed above.

Conclusion

The conclusion of the above trends is evident. Bank share prices show a clear pattern of two waves of ‘collapse’ among large retail, or retail/investment, banks.

• The 1st wave saw falls of 90% plus in the shares of banks such as Citigroup, Lloyd’s and RBS. No significant recovery in their share prices has taken place since – which is why they may, in terms of share prices, be characterised as ‘collapsed’ banks.
• A number of other large banks – of which Barclays, Bank of America and Société Générale may be taken as examples - initially suffered very severe share price falls during the international financial crisis but then saw a significant recovery. Their share prices are, however, now again falling towards the level of the 1st group of banks. It, of course, remains to be seen whether this trend will continue, but a current tendency of a 2nd wave of banks being drawn into crises which essentially destroys share prices is clear.

The market therefore clearly judges that the pool of ‘collapsed’ banks, in terms of share prices, is threating to spread in a second wave.

Negative trends in world trade - further confirmation of economic slowdown

Attempts to assess current prospects for the world economy have primarily focused on deceleration  in US and European GDP growth. But world trade is clearly also indicating negative trends.

Trade is a particularly sensitive indicator as its fluctuations have had a greater magnitude than those for GDP but have moved in the same direction. Trade data is also useful in indicating current economic trends as it is available for recent periods for developing countries many of which do not publish quarterly, and therefore up to date, GDP data.

It is significant for indicating the state of the world economy that the overall volume of world trade is currently at best entirely static and may have turned down. It is important this is affecting both developed and developing economies.

World trade

Analysing first the overall trend in world trade, this is shown in Figure 1 - which charts percentage volume changes in world trade compared to the pre-financial crisis peak in April 2008. The numbers on the horizontal axis indicate the number of months since the peak. A three month moving average is used to remove the effect of purely monthly fluctuations.

World trade reached its post-crisis trough in May 2009 at 20.1 per cent below the previous peak. By March 2011 world trade had recovered to 3.5 per cent above the pre-crisis peak. World trade maintained that level in May 2011 and fell to 1.2 per cent above the pre-crisis peak in June – the latest available data. The June dip is only one month, and it is therefore too early to say a decline is taking place, but world trade growth has clearly stalled since March - i.e. since the end of the 1st quarter of 2011.

Theoretically, world exports and imports should naturally be identical, but due to problems in recording and calculation, there is always some disparity in the data. To avoid the possibility of statistical distortions Figure 2 therefore confirms that the same trend appears whether measures of exports or imports are taken.

Figure 1

Figure 2

 

Developed economy trade

It is significant that the downturn in trade has affected both developed and developing economies - Figure 3 shows the data for developed economies and Figure 4 that for developing ones.

Considering first trade of developed economies, it may be seen from Figure 3 that this has not yet recovered to pre-crisis levels either in exports or imports. Again using a three monthly moving average,  developed economy imports peaked in May at 4.6 per cent below their pre-crisis highest level and exports peaked in the same month at 6.5 per cent below their pre-crisis highest level.

Figure 3 shows that there is now no substantial increase in developed economies exports or imports.

Figure 3

 

Developing economies trade

Figure 4 shows the data for exports and imports for developing economies. Unlike developed economies, both exports and imports of developing economies rose to exceed pre-crisis peaks. Growth momentum in trade was continued for a slightly longer period in developing than in developed economies but has also recently stalled.

Taking a three month moving average, developing economy imports peaked at 11.2 per cent above their pre-crisis highest level in May 2011 before falling back to 8.4 per cent in June. Perhaps more significantly developing economies exports rose to 16.6 per cent above their highest pre-crisis levels in March and by June had slipped to 13.1 per cent above.

It would not be correct to project that trade of developing economies is falling, data over a longer period would be required to establish this, but it is clear that the upward momentum has ended.

Figure 4

 

This trend for developing economies is significant as recovery in their exports and imports was much more rapid and stronger than in developed economies.

China

Not all economies are witnessing trade stagnation. China's latest available data, for July, shows exports at an all time peak of $175 billion, up 20 per cent year on year, while China's imports were also up 23 per cent over the same period. China, however, clearly does not represent the overall trend in developing economies.

As the biggest factor in China's growth is now expansion of domestic demand, followed by exports to developing countries, and then exports to developed economies, there is no reason to revise the analysis made previously that the current world economic slowdown will not lead to substantial deceleration of China's GDP growth. However clearly trends in other developing, as well as developed, economies must be watched carefully for indications of how much they are able to deal with decelerations in export demand.

Conclusion

Overall the trends in world trade strongly confirm a picture of economic slowdown - and the wide spread of this phenomenon. China continues to stand out as the largest exception to the trend - the situation of other developing economies requires more detailed analysis. The present stagnation, at best, of trade in developed economies is evident.

 

China's growth will not be significantly reduced by slowdown in developed economies - how China can use the global economy's 'countryside' to surround its 'cities'

The recently published European Union (EU) GDP figures, following those for the US and Japan, complete the picture of slow growth in the developed economies. Given weak growth, and possible recession, in the developed economies an evidently important question for the global economy is how much this will affect China – now by all measures the world’s second largest economy?

Should the present economic situation be conceptualised as generalised ‘economic slowdown’

A number of commentators suggest that the present international economic situation should be conceptualised as a generalised phenomenon of slow growth. The headline of an article by the Financial Times economics editor Chris Giles succinctly expressed such a perspective, ‘Fears rise as global output stalls’. Having analysed the well-known negative growth trends in developed economies the article continued: ‘similar gloom was evident in all other leading economies. In China, although the July figure beat expectations, the PMI also slipped for the fourth month in a row to fall 0.2 percentage points to 50.7.’ Similarly, the normally highly balanced John Authers, in The Long View in the same paper, analyzed: ‘alarm at the slowing down of the world economy – which includes China, nucleus of all hopes, as well as Europe and the US.’

Such analyses imply that a slowdown will occur in China in some sense equivalent to that in the US and Europe – otherwise it is misleading to place phenomena in the same category.

Such an analysis is erroneous as it is in contradiction with any quantitative comparison. China’s GDP growth, which was 9.5 per cent in the 2^nd quarter of 2011, cannot be meaningfully compared to the present extremely slow growth in the US and Europe. Nor, for reasons analysed below, will China’s growth slow to any level which would place it in the same category as the US and Europe. As the question of China’s dynamic is of considerable importance for trends in the world economy it is useful to summarise current factual data and analyse the impact of trends in the advanced economies on China.

Slow growth not double dip is the key issue for comparison

The majority of media discussion in the US and Europe focuses on whether these economies face a double-dip recession. Whether this occurs naturally has short term implications for China’s economy, particularly in the balance of negative pressures it has to contend with. Slow growth in advanced economies is already helping commodity prices fall – by 19 August the Dow Jones-UBS spot commodity index had declined by 8.5 per cent since its end of April peak. This aids China in its struggle against inflation, which in turn would allow a more expansionary policy to be pursued by its economic decision makers. However recession in developed economies would be negative for China’s exports and increase pressure within the US for a new round of quantitative easing, with negative international financial consequences.

However the most decisive trend is not whether developed economies face a ‘double dip’. The key fact, which is already confirmed by the recent data, is that even without a new recession growth in all major developed economies is very slow. As shown in Figure 1:

• By mid-2011 no region among the developed economies had recovered its peak level of GDP more than three years after the high point of the previous business cycle.
• US GDP is 0.4 per cent below its peak in the 4th quarter of 2007.
• EU GDP is 1.8 per cent below its peak in the 1st quarter of 2008.
• Japan’s GDP is 6.0 per cent below its peak in the 1st quarter of 2008 – this is of course affected by the earthquake and tsunami.

Overall this represents over three years net negative growth in the developed economies.

Figure 1

 

China’s economic performance

For comparison China’s economy has already grown by over 30 per cent in the last three years – Figure 2. If growth continues throughout 2011 at the same rate as in the year so far i.e. assuming there is no recession in the US and Europe, then between 2007 and 2011:

• China’s GDP will have expanded by 44.5 per cent.
• US GDP will have expanded by 0.8 per cent.
• EU GDP will have contracted by 0.4 per cent.

Figure 2

 

Naturally there will be some modification in the final outcome from the figures projected above, depending on developments in the second half of 2011. But the relative orders of magnitude are already clear.

Scale of economic issues in the US, Europe and China

These figures put into their appropriate context current issues in China’s economy. Naturally all economies continually face problems – China’s most serious current one is inflation, followed by the need to control the build-up of local government and other debt. But China’s current issues, in the context of 40% plus growth in four years, are clearly qualitatively smaller than those in the US and EU where growth in the same period will be essentially zero per cent.

This outcome factually settles the debate among economists outside China on whether China, or the US and Europe, would come most successfully through the financial crisis. Some non-Chinese economists accurately predicted that China would grow rapidly, that inevitably in such a context some problems would arise, that these would be overcome by economic fundamentals, and that China would have a ‘soft landing’ - Jim O’Neill, former chief economist of Goldman Sachs, who coined the term BRIC, is probably the best known of these.

But others predicted China’s economy would perform badly. The most extreme, such as US hedge fund manager Jim Chanos, advised short selling China in expectation of economic catastrophe. Others projected that the US would recover from the financial crisis more rapidly than China. For example US financial analyst Michael Pettis claimed that: 'the US would be the first major economy out of the crisis and China one of the last.' With China’s economy expanding by 40% while the US has not grown at all, even if China’s growth were to slow it is already clear it has come through the financial crisis much more successfully than the US.

China and developing economies

A clear implication for China’s economy of the slow growth in developed economies is that it will have rely even more on a combination of expansion of its domestic demand and growth in developing economies.

The latter, however, have not slowed during the financial crisis in the same way as developed economies. In 2010, measured in dollar terms and not only percentages, seven out of ten of the world’s most rapidly growing economies were developing ones – China, Brazil, India, Russia, South Korea, Indonesia and Mexico. (Figure 3) Current dollar prices are used in this chart for all economies as this best indicates the growth of markets for China’s exports – which are analysed below.

Figure 3

 

Particularly striking is growth in economies classified by the World Bank as ‘middle income’ – all of which are developing, such as Brazil, India, Mexico etc. In 2010 GDP growth in the developed economies was $1.6 trillion, whereas in middle income ones it was $3.3 trillion – twice as much. (Figure 4)

Figure 4

 

Nor is this a short term trend. If a five year period is taken, starting before the financial crisis, average annual growth in developed economies was $1.4 trillion while in middle income economies it was $2.0 trillion. (Figure 5)

The world economy has therefore moved into a period in which, not only in percentage but in absolute dollar terms, growth in developing economies, particularly middle income ones, is either essentially equivalent to or is greater than in developed ones.

Figure 5

 

This trend gives China considerable advantages. China’s companies face tough competition in advanced markets where, in terms of brands, they are up against firms such as Apple. But in developing economies China’s companies such as Haier and Huawei are already building up strong brand positions. Rapid expansion by such companies in developing economies, in turn, gives them rapidly increasing revenue to plough back into R&D which strengthens their challenge in the developed markets.

Some analysts have correctly noted this. In an excellent recent report ‘Heavy Duty, China’s next wave of exports’ (currently available as a free download, which those following China’s economy should take advantage of) the Economist Intelligence Unit accurately notes: ‘In 2012 it is likely that non-OECD will take over as the primary export market for China. If Turkey, Chile and Mexico are excluded from the OECD group, the transition will take place in the second half of 2011. However defined, developing countries – especially emerging markets such as India and Brazil – will be the dominant driving force between China’s export growth in the coming decade.’

The overall trend regarding China’s overall exports is shown in Figure 6. The rapid rise of China's exports to developing economies, to the point where they will overtake those to developed economies, is clear.

Figure 6

 

China uses the countryside of the world economy to surround the cities

A graphic, accurate, and very Chinese way to conceptualise the above trends was succinctly expressed by an exam student at Antai College of Economics and Management in Shanghai - where I lecture. Having had the statistical trends in world trade outlined in an economist's usual prosaic fashion, i.e. more rapid growth in the developing economies and in China’s trade with them, the student remarked that this was a well known strategy: ‘the countryside will surround the cities’.

For those not familiar with China’s history the significance of this phrase is that leading to the creation of the People’s Republic of China, in 1949, Mao Zedong famously remarked that the correct strategy was that ‘the countryside will surround the cities’.

While the vocabulory of economic statistics is more mundane than the student’s graphic characterisation, nevertheless in essence their statement was both vivid and correct. Slow growth in the advanced economies, combined with rapid growth in developing ones, is creating a situation where China’s companies are building up very strong positions in the ‘countryside’ of the world economy from which to launch a challenge in its ‘cities’.

The growth trends in developing economies, underpinning their rapidly expanding position in China’s exports, combines with rapid expansion of its domestic demand to show why China’s economy will not significantly decelerate under the impact of slowdown in the US and Europe.

The overall international economic situation should therefore not be conceptualised as one of ‘generalised economic slowdown’. It should be conceptualised as one of significant slowdown in the US and Europe combined with continued rapid growth in China.

*   *   *

A shortened edited version of this article appeared in China Daily.

More than three years without full economic recovery in the developed economies – the latest GDP figures in context

The publication of the European Union (EU) and German 2nd quarter GDP figures, following those for the US and Japan, completes the data regarding the state of the business recovery in the main developed economies. The picture is completely clear – Figure 1:

• By the 2nd quarter of 2011 none of the major regions among the developed economies has recovered their peak level of GDP more than three years after the high point of the previous business cycle.
• US GDP is 0.4% below its peak level in the 4th quarter of 2007.
• EU GDP is 1.8% below its peak level in the 1st quarter of 2008.
• Japan’s GDP is 6.0% below its peak level in the 1st quarter of 2008 – Japan’s data is of course affected by the earthquake and tsunami.

Overall, taking the period as a whole, this represents over three years of net negative growth in the developed economies. The key economic issue is not the possibility of a double dip recession, which the media is speculating on, but this extremely low growth rate even without one.

For comparison it may be noted that China’s economy has grown by over 30% in this same three year period.

Figure 1

What lies behind the renewed international economic crisis - and what policies are required to deal with it?

Given the onset of a renewed round of the international financial crisis it is useful to draw together its various elements in an analysis of its overall determinants, its course, and the policies necessary to deal with it. This is the aim of this article.

* * *

For the second time in three years almost all parts of the world economy are being shaken by a renewed financial and economic crisis. The most important immediate drivers of this are not Standard and Poor's downgrading the US's credit rating, or political struggles between President Obama and Republicans in Congress, but weak US economic recovery, Europe's widening debt crises, the consequent $8 trillion loses on international share markets by 9 August with knock on effects on balance sheets and spending, the continuing decline of US house prices and a new developing crisis of the banking system.

Reasons for the open reappearance of crisis

The reason severe crisis has reappeared, and what determines its dynamic, is the failure of US and European government policies to resolve the issues which created 2008's financial collapse. The policies pursued since then, which were adapted to deal with much more minor economic events than the ones which occurred, postponed the unwinding of the crisis without removing its underlying causes. As a result the focus of the crisis changed but it was not resolved.

The immediate cause of the financial crash of 2008 was an unsustainable build-up of US private sector debt – this debt being accumulated due to the attempt to maintain the growth of the US economy and to ensure political stability by sustaining US living standards. By the 4th quarter of 2007, the peak of US economic expansion, total US household, private non-financial company, and government debt was 218 per cent of US GDP – Figure 1. That the fundamental debt build up was private, and not government, is shown by the fact that household and non-financial company debt was equivalent to 168 per cent of GDP compared to 51 per cent of GDP for government debt - i.e. private debt was more than three times as large as government debt.

Figure 1

 

Interest rate increases introduced leading to 2008, in order to deal with inflation, resulted in the inability of the US private sector to finance this debt burden. The US sub-prime mortgage crisis was simply the weakest link in the overall excessive US private debt.

In 2008 the inability of the US private sector to meet its debt obligations, with consequent falls in asset values, initially in housing and then in shares and other financial instruments, destroyed US financial institutions’ balance sheets. The US financial sector overall became insolvent. Therefore a stronger and more centralized financial instrument, the US state, had to step in to rescue the private financial system - with a similar process occurring in other countries. The new crisis has broken out because of the risk that the tools available to the US and European states themselves will be insufficient to restore stability.

Transfer of private sector debt into the public sector

The debt data clearly show the process of transfer of the original excessive US private debt into the public sector – the changes in US debt since the peak of the previous business cycle are shown in Figure 2.

Following the onset of the US economic downturn in 2008, the overall US debt burden rose, reaching 247 per cent of GDP in the 3rd quarter of 2009 – these changes reflecting the decline in US GDP as well as increasing debt. Since then up to the 1^st quarter of 2011, the latest available data, US debt fell only marginally to 243 per cent of US GDP - still 26 percentage points above pre-recession levels.

However the internal structure of US debt shifted. US private sector debt peaked at 180 per cent of GDP in the 2nd quarter of 2009. It then fell to 163 per cent of GDP – still 5 percentage points above its pre-recession level. But any recent decline in private sector debt has been almost entirely offset by increases in government debt created by budget deficits exceeding 10 per cent of GDP.

Figure 2

 

The US therefore simply ‘nationalized’ its debt problem – replacing private with public debt. The mechanisms by which this occurred were the indirect consequences of the financial crisis, with recession increasing welfare payments and reducing tax receipts, as well as transfer of funds to the private sector in bank bailouts and similar measures.

John Mauldin and Jonathan Tepper therefore put it correctly in their book Endgame: ‘Debt is moving from consumer and household balance sheets to the government. While the debt supercycle was about the unsustainable rise of debt in the private sector, endgame is the crisis we will see in the public sector debt.’ (p25)

In short, although the US crisis may currently appear in the form of a government deficit and debt issue, the origins of the problem lay in the private sector and the government debt issue is the consequence of nationalization of private sector debt.

The European debt crisis

Europe followed a similar path to the US but with some countries, e.g. Greece and Italy, building up large public sector debts alongside the private ones in Spain and other states. Europe’s situation is structurally more potentially threatening than the US as the Federal Reserve has greater resources than the European Central Bank and the US state is able to react in a more centralized way than the decentred structure created by the different states of the European Union.

The European Central Bank simply does not have sufficient resources to be able to deal with a spread of the debt crisis into the larger EU economies such as Spain and Italy. Given the exposure of European banks to national state debt the spreading of the European sovereign state crisis to major economies therefore has the potential to bring down the European banking system. For this reason there have been rising European interbank lending rates, reflecting banks decreasing willingness to lend to each other, extremely high rates for bank insurance in a number of countries, and sharply falling bank share prices in both Europe and the US.

Kenneth Rogoff, author of the notable quantitative study of debt crises This Time is Different, and former chief economist of the IMF, accurately summarized the situation in the financial sector as follows:

‘Securitization, structured finance, and other innovations have so interwoven the financial system’s various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed… the financial system remains on government respirators… in the US, UK, the euro zone, and many other countries today. 

‘Most of the world’s largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. Many banks have already acknowledged their open-ended losses in residential mortgages. As the recession deepens, however, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity, and hedge funds. As governments try to avoid outright nationalization of banks, they will find themselves being forced to carry out second and third recapitalizations.

‘Even the extravagant bailout of financial giant Citigroup, in which the US government has poured in $45 billion of capital and backstopped losses on over $300 billion in bad loans, may ultimately prove inadequate.’ 

Political struggles are the symptom of the renewed crisis and not its cause

Given the scale of the debt situation none of the means used for tackling the debt problem in the US and Europe can avoid severe economic pain. The political fighting which has broken out is simply over how this pain should be shared. The political struggles which have occurred, for example between President Obama and Republicans in Congress, or between Germany’s government and other European states, are therefore not the cause of the renewed economic crisis but its result. Analysing the different responses however leads directly to the issue of the necessary policies to deal with the financial and economic crisis.

The necessity to run budget deficits

The most ideologically right wing forces - the US Tea Party and those in Europe sharing the views of the British Conservatives - advocate limiting the public debt build up by radically reducing government spending. This is linked to a theory that the state is ‘crowding out’ the private sector. This entire analysis is false. Because of its ideological blinkers it fails to see that the origin of the crisis lay in the private sector debt. It is also extremely dangerous in terms of economic policy.

The main transmission belt from excessive debt into recession is the fall in private investment. As may be seen in Figure 3 the entire decline in GDP in the G7 economies between the 1^st quarter of 2008, the peak of the previous business cycle, and the 1^st quarter of 2011, the latest available data, was accounted for by the decline in fixed investment. In fixed price parity purchasing powers (PPPs) the decline in G7 GDP was $381 billion and the decline in fixed investment was $591 billion – the decline in fixed investment can be greater than the decline in GDP as it is offset by increases in household and government consumption.

Figure 3

 

The theory of ‘crowding out’ argues that resources used to finance the budget deficit would be used to generate economic expansion if released to the private sector – for example US financial analyst John Mauldin argues ‘increasing government debt crowds out the necessary savings for private investment, which is the real factor in increasing productivity.’ (Endgame p59)

But reducing budget deficits by cutting public spending cannot create an economic way out in present conditions. Reducing budget deficits cuts demand. But resources released to the private sector are used to pay down debt, so private spending will not increase sufficiently to compensate for the fall in public spending. Total demand will fall, increasing recessionary pressure.

In short, it is vital in the short term to maintain budget deficit spending, including by targeting maintaining or expanding consumption – state spending on investment is analysed below. Attempts to immediately reduce budget deficits must be strongly resisted. Countries facing an economic slowdown should run, or increase, budget deficits to compensate for the shortfall of private sector demand.

Richard Koo, in his important books Balance Sheet Recession and The Holy Grail of Macroeconomics, has dealt with this correctly in analysing the experience of the decades long fight against the consequences of over-indebtedness in Japan. As Koo noted:

‘What sets Japan’s Great Recession apart from the U.S. Great Depression is that Japanese GDP stayed above bubble peak levels in both nominal and real terms despite the loss of corporate demand worth 20 per cent of GDP and national wealth worth ¥1,500 trillion… The financial deficit of the government sector mounted sharply, leaving in its wake the national debt we face today. But it was precisely because of these expenditures that Japan was able to sustain GDP at above peak-bubble losses despite the drastic shifts in corporate behavior and a loss of national wealth equivalent to three years of GDP. Government spending played a critical role in supporting the economy…

‘Japan was left with a large national debt. But if the government had not responded with this kind of stimulus, GDP would have fallen to between one-half and one-third of its peak – and that is an optimistic scenario. U.S. GNP shrank by 46 per cent after falling asset prices destroyed wealth worth a year’s worth of 1929 GNP during the Great Depression, and the situation in Japan could easily have been much worse. This outcome was avoided only because the government decided early on to administer fiscal stimulus and continue it over many years…

‘In summary, the private sector felt obliged… to pay down debt… Disastrous consequences were avoided only because the government took the opposite course of action. By administering fiscal stimulus, which was also the right thing to do, the government succeeded in preventing a catastrophic decline in the nation’s standard of living despite the economic crisis.’ (The Holy Grail of Macroeconomics p22-25)

Naturally the form the budget deficit takes is itself extremely important. Government spending on those on average and low incomes, and on investment, is not only socially more just but is far more effective as a stimulus than tax cuts for the best-off – who save, rather than spend, a higher proportion of their income. Equally spending on investment is far more effective in expanding the economy that military spending – which does not add to productive capacity. But overall it is necessary to fight moves by fiscal conservatives to reduce the budget deficit in the short term. As an immediate response to the financial crisis countries facing the threat of economic downturn should run or maintain stimulus packages funded, if necessary, by budget deficits.

Budget deficit and the medium term

While budget deficits with a large component targeted at maintaining consumption are immediately vital to prevent short term economic decline they are not sufficient, faced with deep economic problems, to relaunch substantial growth because they do not deal with the most fundamental issue driving the downturn – the investment fall. This is in addition to the fact that few countries have Japan’s financial strength, which enabled it to sustain a very large budget deficit over a long period. For most countries large budget deficits can be run in the short term but are financially unsustainable in the medium term.

A policy of running large budget deficits is often inaccurately described as a 'Keynesian' one  - inaccurately as Keynes own central concern was factors affecting investment and not budget deficits.¹ Paul Krugman in the New York Times, for example, regularly but wrongly argues that the budget deficit is both the most central issue in economic policy and the core of Keynes views. US economist Paul Davidson similarly claims in The Keynes Solution: ‘Anything that increases spending on goods and services increases the profitability of business firms and the hiring of workers.’ (p54) But this is false - for example, an increase in spending on goods and services accompanied by cost increases may lead profits to fall.

However, even if profit did increase due to increases in demand, companies may not reverse the cuts in investment that are the core of the recession. Keynes pointed out that to generate investment a price must be paid to overcome ‘liquidity preference’ - the advantages of holding assets in cash and other liquid forms. In circumstances of high uncertainty, such as at present, the cost of overcoming liquidity preference may be prohibitive and therefore it will prevent investment taking place even if such investment would yield a positive profit.

Low interest rates necessary but not sufficient

Even more fundamental than liquidity preference in the present situation is that, given excessive indebtedness, companies use resources to repay debt, that is to build up their balance sheets, and not to invest even if demand increases. Therefore stimulating demand by budget deficits may prevent worse declines in production but does not produce significant output increases.

In such conditions low interest rates are also insufficient as an economic policy to provide a way out. Low interest rates are necessary to prevent interest payments becoming unsupportable and to remove a block to borrowing for investment. But they do not lead to investment under conditions where companies are intent on paying down debt and have no intention of borrowing for investment.

International redistribution of debt

As any solution to the present situation must involve medium term debt reduction a number of states are seeking to achieve this at the expense of other countries even without formal defaults on debt payments. In particular the US, via falls in the exchange rate of the dollar, reduces the real value of its debt at the expense of countries which hold dollar assets. Such policies however clearly only aid one country at the expense of others, effectively redistributing the debt without reducing the overall debt burden.

Inflation is not a relatively harmless solution

It is important to remove an illusion currently being suggested that inflation would be a relatively painless and non-harmful way to reduce debt. The idea behind this is that while the monetary volume of debt, its nominal value, would remain the same its real size would be reduced. Kenneth Rogoff, for example, has argued this:

‘It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass…. Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective. ‘

Similarly the British economist Will Hutton has argued:

‘As the IMF's chief economist, Olivier Blanchard, has suggested, if the options are public and private default, continuing bank weakness, economic stagnation (perhaps depression), or inflation, then the least bad option is to accept inflation, but to manage it within bounds.

‘Since inflation will happen anyway as governments seek the least bad way out, the choice in reality is whether to accept and manage it or not. Once debt is at a sustainable level and growth has resumed, then the world's financial system can be redesigned to avoid a repeat, and price stability restored.

‘This is the truth that cannot speak its name: as a senior financial policy official told me, even to raise it at home or abroad merely as an issue for debate is to invite universal disapproval. But truth must be faced. Britain should provide a lead – both for its own economic fortunes and to set the new international standard. As a minimum it should announce a new programme of quantitative easing, in effect printing money; insist the Bank of England uses the money it prints to buy the broadest range of private debt; and immediately replace the 2% inflation target with a target for the growth of money GDP – so getting Britain off the hook of its unpayable private debts.’²

However someone will have to suffer the loss in real resources created by the inflation. Usually this is the majority of the population as the rate of increase of incomes fall behind the rate of inflation. Politically a policy of lowering debt by inflation is therefore likely to be drastically unpopular for whoever implements it.

Furthermore economically inflation, striking at the majority of the population by reducing living standards, will actually cut consumption – which strengthens recessionary tendencies. Inflation also does not deal with the issue of increasing investment – the fall in which drove the recession. In short inflation is not a solution either politically or economically to a crisis of the depth which currently exists.

Indirect means of stimulating investment

If the way out is turned to, the necessary policies cannot be separated from the analysis of the depth of the crisis.

If the current economic crisis were of small or moderate dimensions then it could indeed be tackled by increases in budget deficits which primarily raised or maintained consumption. Such deficits would increase demand while liquidity preference, lack of profitability and debt levels would be insufficient to prevent companies responding to the increase in demand by raising investment - therefore substantial economic recovery would occur. This, however, has clearly not occurred in the crisis since 2008 despite large budget deficits being run.

Given budget deficits have been insufficient, attempts are also made to raise investment by extremely low interest rates and by seeking to reduce liquidity preference – the latter being a key goal of the talk regarding the need to ‘restore confidence’. These measures have also clearly not succeeded.

Confronted with this impasse more logical economic commentators are therefore beginning to address the need to raise investment. Such discussion currently primarily centres on advocating indirect means such as tax breaks. For example Joseph Stiglitz recently argued:

‘those worried about the shortage of policy instruments are partially correct. Bad monetary policy got us into this mess but it cannot get us out. Even if the inflation hawks at the Federal Reserve can be subdued, a third bout of quantitative easing will be even less effective than QE2. Even that probably did more to contribute to bubbles in emerging markets, while not leading to much additional lending or investment at home.

‘The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy’s plight. But, even if it succeeds in stopping, at least temporarily, the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down. Corporations are awash with cash, but the banks have not been lending to the small and medium-sized firms… The Fed and Treasury have failed miserably in getting this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015.

‘But the real answer, at least for countries such as the US that can borrow at low rates, is simple: use the money to make high-return investments. This will both promote growth and generate tax revenues, lowering debt to gross domestic product ratios in the medium term and increasing debt sustainability. Even given the same budget situation, restructuring spending and taxes towards growth – by lowering payroll taxes, increasing taxes on the rich, as well as lowering taxes for corporations that invest and raising them on those that do not – can improve debt sustainability. ‘

By identifying raising investment as the key target Stiglitz does address the central dynamic of the recession. But the issue is once again quantitative and related to the depth of the crisis. Will measures such as tax breaks be sufficient to raise investment if they are added to other policies such as running budget deficits and low interest rates? If the economic crisis is not deep they will suffice. If the economic crisis, and the necessity to pay down debt, is stronger then indirect measures to target investment, such as tax breaks, will not be sufficient.

The current indications, given the scale of the economic problems and debt burden, is that indirect means to stimulate investment by policies such as tax breaks will be insufficient to relaunch substantial economic growth.

Direct means of raising investment

The most decisive way to overcome the current situation flows from the above trends. Its practical effectiveness was shown by its use by China in its successful 2008 stimulus package, which was followed by over 30 per cent GDP growth in three years. Keynes also analysed and advised it. This is that the state must overcome the reality or threat of a fall in investment by itself undertaking and organizing investment. Keynes noted this in The General Theory of Employment, Interest and Money: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.’ (p378)

Such an analysis flowed from Keynes practical experience regarding the relation between the depth of economic crisis and lack of sufficient efficacy of other economic instruments: 'Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.' (p164) Therefore: ‘‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes naturally did not advocate an administered economy. But he therefore explicitly argued in the General Theory that the state should have the ability to intervene sufficiently to determine overall investment levels.

Keynes also noted that this 'somewhat comprehensive socialisation of investment' and 'the duty of ordering the current volume of investment' did not mean the elimination of the private sector, but socialised investment operating together with a private sector: 'This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.' (p378)

The country which most approximates to this economic system is China. China, of course, describes its economy in a different way and using Marxist terminology. China defines itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However it is not the important question whether China’s definition of its own system should be accepted, or whether its economy should instead be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how such an economic system works and to note that China has been able to run the world’s largest stimulus package without an unsustainable budget deficit, and why its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe – and why China’s economic system has generated, during the last thirty years, the most rapid economic growth of any major economy in the world.

China’s economy

The difference between China and the US and Europe, of course, lies in economic structure. After its 1978 economic reforms China abandoned an administered economy. But it did not abandon the ability of the state to set the overall level of investment, and it maintains a state owned banking system which is  stronger in a crisis than the ones in the US and Europe and which can be instructed to expand lending in order to sustain stimulus packages. China therefore actually implements Keynes point that ‘the duty of ordering the current volume of investment cannot safely be left in private hands.’ That is, a ‘somewhat comprehensive socialization of investment’ does exist in China, not in the sense that the private sector is eliminated, on the contrary China’s private sector is large and dynamic, but in the sense that the state has sufficient levers to determine the overall level of investment. In contrast in the US and Europe the conditions outlined by Keynes do not exist, and the state sector is insufficiently large to deliver an investment-led stimulus.

As a conseuence of these differences China has come through the financial crisis far more successfully than the US or Europe

Implication of the differences

Once again the interaction of these different factors cannot be separated from analysis of the scale of economic crisis itself. China’s economic structure clearly gives it a superiority which has allowed it to avert serious downturns, as shown both in the 1997 Asian debt crisis and in the international financial crisis since 2008, and to maintain very long term rapid economic growth. But how serious the lag in the US and Europe compared to China is depends on how serious the economic crisis is.

If the economic crisis is not deep then gradually time, and greater application of the measures which are available to the US and European economies – budget deficits, low interest rates, tax breaks for investment – will overcome the investment decline. China will still grow more rapidly, but the US and Europe will also resume growth. If the crisis is deep then only adoption of full scale Chinese methods of direct state action to implement ‘the duty of ordering the current volume of investment’ would suffice. That, however, would require a huge extension of the state sector of the economy, and therefore greater application of the indirect methods available in the US and Europe will be tried first.

One clear implication, of course, is that in all these different circumstances China continue to will grow much more rapidly than the US and Europe even if the latter escape a 'double dip' recession.

Conclusion

The realistic conclusions which follow from the present renewal of the international financial crisis, in terms of both analysis and the required policy response, are therefore clear:

• The International financial crisis has recurred because the economic policies to deal with the 2008 crash in the US and Europe did not remove its underlying cause - excessive debt build up in an attempt to sustain US economic growth and living standards. The post-2008 policies failed because they were designed to deal with much less serious economic events than the ones which unfolded.
• The effect of the policies pursued after 2008 has been to nationalize large part of the debt that originated in the private sector. Therefore, in most cases, and in particular in the US, even if the crisis reappears around state finances the actual origins of the problem lay in the private sector debt.
• The strategic failure to overcome the debt crisis creates strong pressure to a renewed crisis of the banking system.
• The debt crisis transmits itself into the real economy above all though a collapse in investment – taking the G7, the entire decline in GDP is due to the fall in fixed investment.
• In the short term it is necessary to deal with the crisis by continuing to run budget deficits, and countries that have not done so may well need to introduce budget deficit spending. China is an exception because its economic structure allows it to run large stimulus packages without budget deficits due to its ability to directly stimulate investment. Only a handful of other countries, however, have a state sector large enough to fund and run such investment programmes and therefore other economies will have to run budget deficits in the short/medium term. However while budget deficits are necessary to avoid sharp economic decline the experience of the last three years has shown that the economic crisis is too deep for budget deficits by themselves to stimulate significant growth because they do target the core of the recession, the investment decline.
• Very low interest rates must be maintained in order to lighten the burden of interest payments on the overextended debt, and to remove an obstacle to investment. However, once again the experience of the last three years has shown that the economic crisis is too deep for low interest rates themselves to relaunch investment and substantial economic growth.
• China possesses the advantage that it can directly stimulate investment. In other countries there is also a growing realisation that the core transmission of the economic problem lies in investment falls. But without a sufficiently large state sector most other countries do not have the means to directly launch investment. Therefore indirect methods such as tax incentives for investment and similar measures are being proposed. It remains to be seen in practice, if these are introduced, whether they are effective. Given the depth of the crisis the probability is that even if such measures are introduced they will not be enough to sufficiently overcome the low investment level. Consequently growth will continue to be very slow in the US and Europe even if a new recession can be avoided.
• The world economy will therefore see a further period in which China’s economy will grow rapidly while the US and Europe remain at best relatively stagnant.

 

Notes

1. See Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

2. The British newspaper The Observer made the same call:

‘The only alternative to default is inflation – governments printing money to get out of the corner they, their banks and their citizens are in. The question facing policymakers in the years ahead will be which of the unpalatable options they confront – economic stagnation, public and private default together with endemic bank weakness, or uncontrolled or managed inflation – they are going to choose…

‘The British government's policies are locked in the same impotent stasis as the rest of the world's – battening down the hatches, cutting public spending and borrowing, and refusing to accept realities. The government should declare independence. It should abandon the suffocating 2% inflation target and replace it with a target for the total volume of spending in the economy. It should prepare to stimulate the economy with more quantitative easing – in effect printing money – using the proceeds to lend directly to public agencies and departments prepared to lift capital spending.’

The financial crash and macro-economic policy - why the US and Europe have budget crises and China does not

The events precipitating the renewed financial crash were the combination of debt crises and confirmation of slow US economic growth. Regarding the former countries were either trying to cut deficits (the US, Greece, Italy, the UK) or feared they will have to bail out those running unsustainable ones (Germany, France). But these large deficits were not accompanied by strong economic growth – although it can be cogently argued that they were necessary to stave off sharp economic downturn.¹

Japan is currently preoccupied with overcoming the consequences of the tsunami and earthquake, but it also will soon have to face the reality that, due to decades of budget deficits, it has the largest government debt as a percentage of GDP of any country – twice that of the US.

In contrast China in 2008 launched the world's largest state stimulus package to counter the international financial crisis. But it is not running any substantial budget deficit - this year it will only be around two per cent of GDP. But China has enjoyed rapid economic growth.

It has been claimed that China is applying ‘Keynesianism’, but if budget deficits were the key issue defining such policies then China is clearly not pursuing ‘Keynesianism’ at all.

Actually, the core of Keynes’ analysis did not lie in advocating budget deficits, and in some ways China has a policy which more corresponds to his views than that pursued in the US and Europe. This is is briefly outlined below. But before dealing with this it is illuminating to contrast the nature of the economic policies pursued by the US and Europe in the last three years on the one hand, and by China on the other, and to analyse why the latter was able to launch such a large stimulus package without a significant budget deficit.

The actual core of the Great Recession

The core of the difference between the policies pursued in the US and Europe on the one hand, and that followed in China on the other, requires understanding what actually occurred during the 'Great Recession' after 2008. A more extensive analysis has been given elsewhere but to summarise in the US and Europe the Great Recession was dominated by an investment collapse. To take the largest example, in the 2nd quarter of 2011 US GDP was still $56 billion below its 4th quarter of 2007 peak. However all major components of US GDP except fixed investment were already above their previous peak levels – inventories were $37 billion above, government consumption $51 billion above, personal consumption $66 billion above, and net exports $159 billion above. But US private fixed investment was $388 billion below its 4th quarter 2007 level. The entire decline in US GDP was therefore due to the fixed investment fall.  These changes are shown in Figure 1. A similar pattern exists in almost every major developed country.

Figure 1

 

This investment fall, by driving and maintaining the downturn, produced a decline in personal and company income and therefore a fall in tax revenue – the latter being the primary reason for budget deficits. The crucial issue, both for economic development and to close the budget deficit, is therefore how to relaunch growth.

China's situation was different and explains why it ran no significant budget deficit. China abandoned administrative running of its economy with the economic reforms beginning in 1978, but it still has a sufficiently large state sector that this could be, and was, instructed to increase investment. As the key banks are state owned they could be instructed to increase lending to companies – in the US the opposite occurred and lending to companies fell sharply. The rapid economic growth initially generated by China's state companies in turn stimulated the private sector.

The result, during the crucial period 2008-2009, is shown in Figure 2. Instead of China's investment falling it rose by $420bn. Consequently there was no recession. Under the impact of the increase in jobs and incomes created by the stimulus package, China's household expenditure also rose by $160bn. Therefore despite the combined effect of a fall in net exports and inventories of $160bn China's GDP in 2009 rose by $440bn.

As there was no recession there was no fall in tax revenue and no major budget deficit. As this process continued, by 2011 China's GDP had increased by over 30 per cent, $2.3bn in current price terms, compared to pre-crisis level. In contrast by the 2nd quarter of 2011 US GDP was still 0.4 per cent below its 2007 peak level.

Figure 2

 

In the US and Europe the budget deficits were increased by government attempts to restart growth. China could instruct its state companies to invest and its state banks to lend, but the state sector in the US and Europe is too small for this to be effective. Only indirect means, such as quantitative easing (printing money) and budget deficits were available as policy tools. Both proved ineffective in restarting rapid growth. But the latter policy worsened the deficits. China, due to the rapid growth resulting from the investment stimulus, had no significant budget deficit.

Relative scale of economic problems in the US, Europe and China

Naturally the above does not mean China escaped all economic problems - particularly food price inflation, but these are not on the same scale as the budget deficit crises gripping the US and Europe.

Nor do such developments mean China does not face economic policy choices. It is impossible to judge the size of a stimulus package perfectly in advance. The crucial thing in 2008, confronted with the worst economic crisis for eighty years, was to act rapidly and forcefully to head off downturn. This was achieved.

Indeed, so successful was the stimulus that by the 2nd quarter of 2010 China's GDP growth was 11.9 per cent – well above the average 9.9 per cent since its economic reforms began and unsustainably high. Also, despite the government's efforts, it is always impossible to prevent some part of a stimulus spilling into unintended areas  - creating a too high rate of increase in China's house prices.

In summer 2010 world food price inflation also began. China suffered from this less than other comparable BRIC countries – Brazil, India and Russia. But countering these price rises required monetary tightening and slowing the economy

Finally, a medium term problem must be tackled. It is impossible to implement a huge lending increase, under conditions of international economic downturn, without some increase in bad loans. When China's government launched the 2008 stimulus package it anticipated this by making banks increase provisions for bad loans and stating they would have to raise extra capital. The government's calculation was simply that large scale economic growth resulting from its policies would generate more than sufficient resources to deal with any bad loans problem of the type now appearing in municipal debt – i.e. far more would be gained than lost. With more than 30 per cent growth in three years China's economy has easily enough resources to deal with bad loans.

In short China's economic structure does not produce perfection – which only exists in heaven. But the problems it faces are far smaller than the budget deficit and debt crises in Europe and the US.

China's economy grew by more than 30 per cent in three years while Europe and the US remain below their peak levels of output. It is therefore easy to see which policy has been more successful.

Keynes and Chinese descriptions of China’s economic system

How is such an economic system as that operating in China to be described? China itself, of course, uses Marxist terminology – it describes itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However there is another, more familiar in the West, way of looking at it.²

Keynes in the General Theory of Interest, Employment and Money evidently did not advocate an administered economy.³ But he did explicitly argue that the state would have to intervene sufficiently to determine the overall level of investment: ‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes, as is well known, attached great weight to changes in the rate of interest in affecting the investment level. But he did not believe these would be sufficient by themselves: 'Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.' (p164)

This led Keynes to the conclusion: 'It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.' (p378)

Keynes noted that 'somewhat comprehensive socialisation of investment' and 'the duty of ordering the current volume of investment' did not mean the elimination of the private sector, but socialised investment operating together with a private sector: 'This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.' (p378)

It does not seem the most interesting question is whether we should accept China’s definition of its own system, or whether its economy instead should be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how China’s economy actually works, why it has been able to run the world’s largest stimulus package without a budget deficit, and why therefore its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe.

Notes

1. For an analysis of this see Richard Koo’s The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.

2. A more detailed discussion of these issues can be found in Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

3. All page references are to the 1983 Macmillan edition of the The General Theory of Employment, Interest and Money.

Since the financial crisis began China's economy has expanded by almost 40% and the US and Europe not at all

The publication of GDP data for the first half of 2011 for the world’s two largest economies, the US and China, provides a suitable moment to assess trends in economic growth since the international financial crisis commenced. Publication of 2nd quarter GDP data for the European Union (EU) and Eurozone later this month will alter details but is highly unlikely to alter the overall picture.

Ideally quarter by quarter GDP growth data would be available for all countries but unfortunately, until the beginning of 2011, China only produced figures for quarterly GDP calculated on a year on year basis compared to the same quarter for the previous year. Fortunately for clear analysis, the differences in growth rates between the main economies are sufficiently large that utilising annual data leaves no doubt as to fundamental trends.

The peak of pre-crisis US GDP was in the 4th quarter of 2007 - the peak for the EU and Japan was only one quarter later in the 1st quarter of 2008. Therefore the appropriate starting point for comparison, using annual data, is with the final pre-crisis year of 2007.

Data for GDP growth using a base year of 2007 is therefore shown in Figure 1. As 2011 is not yet over the working assumption has been made that the growth for this entire year is the same as the year on year change in the latest available quarter – the 2nd quarter 2011 for the US and China and 1st quarter 2011 for the EU. These projections will be modified as subsequent data is published.

Both the US and China are slowing – see Figure 2. Therefore, projecting for the whole of 2011 the latest available quarterly year on year change may therefore somewhat exaggerate growth for the year as a whole. However the difference between China on the one hand, and the US and the US and Eurozone on the other, is so large that no significant change in relative positions will result if the eventual 2011 growth rate for all three is altered by any reasonable margin.

Japan’s data will, of course, be highly depressed by the aftermath of the earthquake and tsunami. Therefore, apart from noting that the fall in Japan’s GDP during the financial crisis was greater not only than for China but also for the US and Eurozone, emphasis is not given here to quantitative comparisons for Japan.

Taking the above assumptions, then taking the entire period between 2007 and 2011:

• China’s GDP will have expanded by 44.5%.
• US GDP will have expanded by 0.8%.
• Eurozone GDP will have expanded by 0.4%.

Assuming some deceleration during the second half of 2011, the essential qualitative parameters of economic performance during the four years since the beginning of international financial crisis will therefore be that China’s economy has expanded by somewhat over 40% while the US and Eurozone economies have approximately not grown at all.

Such facts evidently have major implications both at the level of the objective development of the world economy and of analysis.

• In terms of development of the world economy, a 40%+ expansion of China’s economy during a four year period, simultaneously with essentially zero growth in the US and Eurozone, is sufficient to significantly alter the balance between the world’s major economies. To take an example of implications, in assessing when China’s GDP will overtake the US to become the largest in the world, the types of assumptions typically employed have been that the US economy will expand at around 2.5% a year and China’s at around 8.0% a year. However at present China is somewhat outperforming this figure, with an annual average growth rate of 9.6% in the last four years, while the US is substantially underperforming. Evidently, projecting US growth continuing at only an annualised 0.2%, as would be the case during the last four years from the data above, would be entirely unreasonable. But any lowering of the US annual growth rate below 2.5%, which appears a clear possibility, would bring forward the data when China’s GDP will overtake the US at market exchange rates from the 8-10 year period which is generally calculated to a 5-7 year period.
• The growth of China’s GDP by around forty per cent in the last four years, while the US has not grown at all, is already sufficient to show as incorrect those analyses, publicised in the Financial Times and elsewhere, which projected that  the US would recover from the financial crisis more rapidly than China. For example Michael Pettis of Beijing University analysed that: ''the US would be the first major economy out of the crisis and China one of the last.' Attempts have been made to defend this and similar analyses by stating that the crisis is not yet over, therefore it is too early to pass judgement. In reality, with China’s economy expanding by 40% while the US has not grown at all, even if China’s growth were to slow it is already clear it has come through the financial crisis far more successfully than the US. Michael Pettis and those with similar views should therefore note that they were wrong, that those such such as this blog and others who analysed the opposite were correct, and begin to examine what errors in economic theory and analysis led to these wrong conclusions.

Growth of 40% in China over a four year period, compared to zero per cent in the US and Eurozone, is a quite sufficient test by facts to establish which analysis was right and which was wrong regarding the relative trajectories of China’s and the US economies during the international financial crisis.

Figure 1

Figure 2