Saturday, July 20, 2013

Krugman Warns of China's Unstable Economy. Will Ottawa Listen?

Maybe Steve Harper picked a bad moment to bind Canada's economic future to China's.   The way Paul Krugman sees it, China has a structural time bomb within its economy and it's ready to blow:

China  ...seems to invest only to expand its future ability to invest even more. America, admittedly on the high side, devotes 70 percent of its gross domestic product to consumption; for China, the number is only half that high, while almost half of G.D.P. is invested.

How is that even possible? What keeps consumption so low, and how have the Chinese been able to invest so much without (until now) running into sharply diminishing returns? The answers are the subject of intense controversy. The story that makes the most sense to me, however, rests on an old insight by the economist W. Arthur Lewis, who argued that countries in the early stages of economic development typically have a small modern sector alongside a large traditional sector containing huge amounts of “surplus labor” — underemployed peasants making at best a marginal contribution to overall economic output.

The existence of this surplus labor, in turn, has two effects. First, for a while such countries can invest heavily in new factories, construction, and so on without running into diminishing returns, because they can keep drawing in new labor from the countryside. Second, competition from this reserve army of surplus labor keeps wages low even as the economy grows richer. Indeed, the main thing holding down Chinese consumption seems to be that Chinese families never see much of the income being generated by the country’s economic growth. Some of that income flows to a politically connected elite; but much of it simply stays bottled up in businesses, many of them state-owned enterprises.

It’s all very peculiar by our standards, but it worked for several decades. Now, however, China has hit the “Lewis point” — to put it crudely, it’s running out of surplus peasants.

That should be a good thing. Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic “rebalancing” — the jargon phrase of the moment. Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place. The question is whether this can happen fast enough to avoid a nasty slump.

And the answer, increasingly, seems to be no. The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes, instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. (Since someone is going to raise this issue: no, this bears very little resemblance to the Federal Reserve’s policies here.) These measures postponed the day of reckoning, but also ensured that this day would be even harder when it finally came. And now it has arrived.
How big a deal is this for the rest of us? At market values — which is what matters for the global outlook — China’s economy is still only modestly bigger than Japan’s; it’s around half the size of either the U.S. or the European Union. So it’s big but not huge, and, in ordinary times, the world could probably take China’s troubles in stride.

Unfortunately, these aren’t ordinary times: China is hitting its Lewis point at the same time that Western economies are going through their “Minsky moment,” the point when overextended private borrowers all try to pull back at the same time, and in so doing provoke a general slump. China’s new woes are the last thing the rest of us needed.

No doubt many readers are feeling some intellectual whiplash. Just the other day we were afraid of the Chinese. Now we’re afraid for them. But our situation has not improved.


Anonymous said...

Excellent topic that interests me greatly Mound. As does the Middle East and Africa, given we're all so closely connected these days. Just one point, as it's late here.

" instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. "

My understanding is the Chinese have injected a great deal of credit into their economy, but it's not like here and it wasn't all that cheap in comparison to the absurdly low rates in the West. What I've read says the State controlled Banking institutions kept prime rate at about 6%, but they don't just lend to anyone, They only lend to very large Banks, who in turn lend to large volume middle men lenders, who in turn lend to other middle men and so on. Every time the funds move from one lender to another however, the interest rate climbs substantially.

This continues until much of the money is in the hands of people who are in the business of high risk, high interest loans. Here is where the catch comes in, a lot of defaults and high delinquency rates, and that is pyramiding up, back to source.

Most recent reading suggests the Chinese gov. is about to embark on another round of more of the same, stimulus, more spending on infrastructure and more credit, same as they have done for the last while. Likely to produce the same effect as well. They do have a fair bit stuffed in the mattress though.

As for Harper and followers, well Steve is a real economist after all, not just some old Trotskyite (Krugman) as one of Harper's seals recently called CBC's Terry Milewski.

Well, maybe more than one point.

The Mound of Sound said...

It's hard to get inside the mind of China's rulers. Some months ago, in one of China's "official" online sites, I read an op-ed written by one of the country's top economists.

This fellow's premise was that we would need another five to seven Earth's worth of resources to float a Western affluence in India and China so that had to be ruled out except for his equivalent of what we would consider the "1%." He argued that, to avoid social upheaval, it was necessary to sequester the wealthy, buffer them with a layer of relatively prosperous in whose interests it would be to secure the masses and then have what he described as "islands" of the wealthy floating atop the plebs.

Oddly enough, from a purely pragmatic position, it all seemed quite logical. This fellow was quite convinced it was China's only hope of descending into revolution.

Purple library guy said...

The Chinese definitely have some trouble coming down the pike. But I wouldn't count it certain that they won't be able to pull through. While I wouldn't consider their policies optimal, most of their leadership have a couple of key attributes in China's favour.
1. Unlike ours, they are basically nationalists. Near as I can figure it, class interests, while certainly there, are ultimately secondary to national interests for the leadership of China.
2. They seem smarter than most of our bunch. Doesn't take much.

They do have the basic problem that they need to make that shift from low-income exporters to high-income country with greater emphasis on its internal economy and local consumption. And it's easy to get caught there--don't want to boost the wages and lose the exports before local consumption can take up the slack. Also, as the US, Canada and others have shown, you need some protectionism if you want to keep your local production after the wages go up. Putting up the right protectionism at the right time without your export markets putting up barriers of their own before you're ready to reduce exports . . . balancing acts, for sure.

On basic stimulus, though, they've still got stuff they can spend money on. For instance, they could plow a ton of cash into renewable energy in hopes that someday Beijingites will be able to breathe air. There's some indication that they do want to do that.

Anyong said...

Purple library guy: Having lived and worked in China, you are very close to the truth. On ABC radio the other evening, Australia reported China has decreased it purchase of coal enough to raise concern with the government. China is working very diligently with a nation wide tree planting sceme begun in 2007 while living there. It also is producing solar and wind systems all over the country and manufacturing is installing polution systems on their factories. They have already begun to plow money into cleaning up their polution.

Income Insurance said...

China should stop it's aggression against smaller countries. Otherwise, it's economy will be at stake.