Tuesday, September 21, 2004

The Politics of Globalization

I've been trying to boil my ideas down to a grand strategy with a prime directive that is important and pertinent to the moment and dialogical to everyone. I've settled on "Truly Balanced Values" and "It's The Exchange Rates, Stupid." Now, I'm going to leave the exchange rates for the moment and discuss the dialogical problem...I've discovered by working in groups like this, that there is a giant linguistics mountain to hurdle, so we may communicate successfully with each other...

Should we continue playing bankruptcy capitalism? The system is broke financially and politically, yet, the solution is simple - the understanding and implementation is near impossible - our insecurities, fears and misinterpretations are blocking solutions and implementations. On the one hand, we have extreme under-funded wanton democracy and on the other, we have extreme over-funded speculative capitalism or extreme un-funded democracy verses extreme printed capitalism, yet we need a new Keynesian funded and balanced democracy.

The extreme capitalists see the problem as internal to the person, while they amass great concentrations of wealth. The extreme democrats see the problem as external to the person, while yearning for great dispersions of wealth. The three super-concentrations of wealth are tax havens - the oil rich nations and the 3rd world's super-rich. Is extreme democracy's grand strategy no more than desire? Do they see poverty is simply an illusion or reality of our stupidity? Has anyone glimpsed the great balancers of history? - the founding fathers -Washington, Marshall, Madison, and Hamilton or the great middle period balancer - Lincoln, or more recent balancers - Roosevelt and Truman's Keynesian truly funded and balanced ideas and policies? After studying these great men who knew what to do with the closed wallet of concentrated wealth verses the open wallet of dispersed wealth, I easily came to the conclusion, we needed a new global financial democracy, re-founded on the best ideas of these great men's minds.

The entire world's core values are the problem and solution. We need the best balanced autonomous solution - an authentic grand strategy. The prime directive should be based on growth and balance - a truly new and full balance, from the bottom of our values systems to the top and most hierarchical law structures. The middle path is the road of true balance, yet, we must recognize the limits of capitalism and her sovereignty. We must rebalance social democracy verses market concentrations. Growth of the public good supports social democracy, historically, yet, we must ask - "has globalization gone too far?" While answering, we shouldn't seek perfect government, we should seek perfect competitions, because the imbalances inherent in extreme capitalism are defeating its purpose - hands down!

The intuitive universal truths of common sense show us the modern world is adrift on a sea of unknowing, yet, must we endure a visionless world? Using vision logic, can we glimpse truth as a balance of money and values? or has reason gone mad, trapping us in the horrendous global imbalances? I think not. If we use a major global strategy of thinking locally and acting globally, through policy reform proposals geared to spiritualism's balance of ideas - the world perfect ideas or a perfect competition balance of as many truths as possible, we can surmount a grand strategy to rebalance most of America's values through a true new balance - the center of a new democracy.

I'll say it again, we need a grand strategy - a balanced strategy, and the American mind is wide open to change. At present, the system is so imbalanced, it's robbing itself, yet, in the absolute, there are no problems - it's all a matter of perception. There's answers and solutions to all problems - we just can't talk truth - yet! As ol' man Bechtel used to say, "Problems are just opportunities in work-clothes." Yes, it is true, we have a long way to go, but if we concentrate on the real political problems of globalization's two major causes of technological and state action, and globalization's two major aspects of free trade and free capital, we may start to understand the three stages of mythic, real and integral capitalism. We may further be able to work toward a supra-rational omega structure - a global democracy of money invested in perfect competition, instead of our blindness to possibilities. We must curtail the demonizing of truth and wisdom and seek real and balanced solutions!

Here's a compliment to my post - Thaksinomics - A New New Deal
A globalization article by George Monbiot - "The Age of Consent" - "Without global democracy, national democracy is impossible."
A new Stephen Roach post on Globalization - China/Europe/America
A new post by Martin Hutchinson - Economics & Globalization of Russia
A new post - Speculation in Derivatives, etc.
Bluster and Debt Fill the Sails of the USS Macroeconomy
Andy Xie on China and America, Debt Troubles

Tuesday, September 14, 2004

The Risks Ahead For The World Economy

The Economist

Fred Bergsten explains why policymakers need to act now in order to avert the danger of serious damage to the world economy

FIVE major risks threaten the world economy. Three centre on the United States: renewed sharp increases in the current-account deficit leading to a crash of the dollar; a budget profile that is out of control; and an outbreak of trade protectionism. A fourth relates to China, which faces a possible hard landing from its recent overheating. The fifth is that oil prices could rise to $60-70 per barrel even without a major political or terrorist disruption, and much higher with one.

Most of these risks reinforce each other. A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates. A sharp dollar decline would increase the likelihood of further oil price rises. Larger budget deficits will produce larger American trade deficits, and thus more protectionism and dollar vulnerability. Realisation of any one of the five risks could substantially reduce world growth. If two or three, let alone all five, were to occur in combination then they would radically reverse the global outlook.

There is still time to head off each of these risks. Decisions made in America immediately after this year's elections will be pivotal. China, the new growth locomotive, is key to resolving the global trade imbalances and must play a central role in future. Action by a number of other countries will be essential to maintain global growth and to avoid deeper oil shocks and new trade restrictions.

The most alarming new prospect is another sharp deterioration in America's current-account deficit. It has already reached an annual rate of $600 billion, well above 5% of the economy. New projections by my colleague Catherine Mann (see chart 1) suggest it will now be rising again by a full percentage point of GDP per year, as actually occurred in 1997-2000. On such a trajectory, the deficit would exceed $1 trillion per year by 2010.

There are three reasons for this dismal prospect. First, American merchandise imports are now almost twice as large as exports; hence exports would have to grow twice as fast as imports merely to halt the deterioration. (In the past, such a relationship occurred only after the massive fall experienced by the dollar in 1985-87.) Second, economic growth is likely to remain faster in America than in its major markets and higher incomes there increase demand for imports much faster than income growth elsewhere increases demand for American exports. Third, America's large debtor position (it currently is in the red by more than $2.5 trillion) means that its net investment income payments to foreigners will escalate steadily, especially as interest rates rise.

Of course, it is virtually inconceivable that the markets will permit such deficits to eventuate. The only issue is how they are to be averted. An immediate resumption of the gradual decline of the dollar, as in the period 2002-03, cumulating in a fall of at least another 20%, is needed to reduce the deficits to sustainable levels.
If delayed much longer, the dollar's inevitable fall is likely to be much larger and much faster. Moreover, much of the slack in America's product and labour markets will probably have disappeared in a year or so. Sharp dollar depreciation at that stage would push up inflation and macroeconomic models suggest that American interest rates could even hit double digits.

The situation would be still worse if future increases in energy prices and the budget deficit compound such developments, as they surely could. The negative impact would also be much greater in other countries because of their need to generate larger and faster domestic demand increases in order to offset declining trade surpluses.

Fears of a hard landing for the dollar and the world economy are of course not new. The situation is much more ominous today, however, because of the record current-account deficits and international debt, and the high probability of further rapid increases in both. The potential escalation of oil prices suggests a parallel with the dollar declines of the 1970s, which were associated with stagflation, rather than the 1980s when a sharp fall in energy costs and inflation cushioned dollar depreciation (but still produced higher interest rates and Black Monday for the stockmarket). Paul Volcker, former chairman of the Federal Reserve, predicts with 75% probability a sharp fall in the dollar within five years.

The prospects for the budget deficit and trade protectionism further darken the picture. Official projections score the fiscal imbalance at a cumulative $5 trillion over the next decade, but exclude probable increases in overseas military and homeland-security expenditures, extension of the recent tax cuts and new entitlement increases proposed by both presidential candidates. This deficit could also approach $1 trillion per year (see chart 2), yet there is no serious discussion of how to restore fiscal responsibility, let alone an agreed strategy for reining in runaway entitlement programmes (especially Medicare).

Different deficits
The budget and current-account deficits are not “twin”. The budget in fact moved from large deficit in the early 1990s into surplus in 1999-2001, while the external imbalance soared anew. But increased fiscal shortfalls, especially with the economy nearing full employment, will intensify the need for foreign capital. The external deficit would almost certainly rise further as a result.

Robert Rubin, former secretary of the Treasury, also stresses the psychological importance for financial markets of expectations concerning the American budget position. If that deficit is viewed as likely to rise substantially, without any correction in sight, confidence in America's financial instruments and currency could crack. The dollar could fall sharply as it did in 1971-73, 1978-79, 1985-87 and 1994-95. Market interest rates would rise substantially and the Federal Reserve would probably have to push them still higher to limit the acceleration of inflation.

These risks could be intensified by the change in leadership that will presumably take place at the Federal Reserve Board in less than two years, inevitably creating new uncertainties after 25 years of superb stewardship by Mr Volcker and Alan Greenspan. A very hard landing is not inevitable but neither is it unlikely.

The third component of the “America problem” is trade protectionism. The leading indicator of American protection is not the unemployment rate, but rather overvaluation of the dollar and its attendant external deficits, which sharply alter the politics of trade policy. It was domestic political, rather than international financial, pressure that forced previous administrations (Nixon in 1971, Reagan in 1985) aggressively to seek dollar depreciation. The hubbub over outsourcing and the launching of a spate of trade actions against China are the latest cases in point. The current-account, and related budget, imbalances may not be sustainable for much longer, even if foreign investors and central banks prove willing to continue funding them for a while.
The fourth big risk centres on China, which has accounted for over 20% of world trade growth for the past three years. Fuelled by runaway credit expansion and unsustainable levels of investment, which recently approached half of GDP, Chinese growth must slow. The leadership that took office in early 2003 ignored the problem for a year. It has finally adopted a peculiar mix of market-related policies, such as higher reserve requirements for the banks, and traditional command-and-control directives, such as cessation of lending to certain sectors. The ultimate success of these measures is highly uncertain.

Under the best of circumstances, China's expansion will decelerate gradually but substantially from its recent 9-10% pace. When the country cooled its last excessive boom after 1992, growth declined for seven straight years. A truly hard landing could be much more abrupt and severe. Either outcome will, to a degree, counter the inflationary and interest-rate consequences of the other global risks. But a slowdown, and especially a hard landing, in China would sharply reinforce their dampening effects on world growth.

The fifth threat is energy prices. In the short run, the rapid growth of world demand, low private inventories, shortages of refining and other infrastructure (particularly in America), continued American purchases for its strategic reserve and fears of supply disruptions have outstripped the possibilities for increased production. Hence prices have recently hit record highs in nominal terms. The impact is extremely significant since every sustained rise of $10 per barrel in the world price takes $250 billion-300 billion (equivalent to about half a percentage point) off annual global growth for several years. Mr Greenspan frequently notes that all three major post-war recessions have been triggered by sharp increases in the price of oil.

My colleague Philip Verleger concludes that this lethal combination could push the price to $60-70 per barrel over the next year or two, perhaps exceeding the record high of 1980 in real terms. Gasoline prices per gallon in America would rise from under $2 now to $2.60 in 2006. Prices would climb even more if political or terrorist events were further to unsettle production in the Middle East, the former Soviet Union or elsewhere.

Curtail the cartel
The more fundamental energy problem is the oligopolistic nature of the market. The OPEC cartel in general, and dominant supplier Saudi Arabia in particular, restrict supply in the short run and output capacity in the long run to maintain prices far above what a competitive market would generate. They do not always succeed and indeed have suffered several sharp price falls over the past three decades. They are often unable to counter excessive price escalation when they want to, as at present.

Primarily due to the cartel, however, the world price has averaged about twice the cost of production over the past three decades. The recent price above $40 per barrel compares with production charges of $15-20 per barrel in the highest-cost locales and much lower marginal costs in many OPEC countries. This underlying problem also looks likely to get worse, as the Saudis have talked openly about increasing their target range from the traditional $22-28 per barrel to $30-40.

There is a high probability that one or more of these risks to global prosperity and stability will eventuate. The consequences for the world economy of several of them reinforcing each other are potentially disastrous. All five risks can be avoided, however, or their adverse effects at least substantially dampened, by timely policy actions. The most important single step is for the president of the United States to present and aggressively pursue a credible programme to cut the federal budget deficit at least in half over the coming four years and to sustain the improvement thereafter. This will require a combination of spending cuts, revenue increases and procedural changes (including the restoration of “PAYGO” rules in Congress), as well as rapid economic growth.

Such a programme would maximise the prospects for maintaining solid growth in America and the world by avoiding the crowding out of private-sector investment and by reducing the likelihood of higher interest rates. It would represent the best insurance against a hard landing via the dollar, by buttressing global confidence in the American economy. It should be feasible, having been more than accomplished during the 1990s. Its absence would virtually assure realisation of at least some of the inter-related global risks within the next presidential term.

An energy stability pact
America and its allies must also move decisively on energy. Sales from their strategic reserves, which total about 1.3 billion barrels (including 700m in the United States), would reverse the recent price increases for at least a while and demonstrate a willingness to counter OPEC. For the longer run, America must expand production (including in Alaska) and increase conservation (especially for motor vehicles). Democrats and Republicans must together take the political heat of establishing a gasoline, carbon or energy tax that will limit consumption, help protect the environment and reduce the need for future military interventions abroad.

All three major post-war recessions have been triggered by sharp increases in the price of oil
The most effective “jobs programme” for any American administration and the world as a whole, however, would be an initiative to align the global oil price with levels that would result from market forces. America should therefore seek agreement among importing countries (including China, India and other large developing importers as well as industrialised members of the International Energy Agency) to offer the producers an agreement to stabilise prices within a fairly wide range centred at about $20 per barrel.

Consumers would buy for their reserves to avoid declines below the floor of the range and sell from those reserves to preserve its ceiling. A sustained cut of $20 per barrel in the world price could add a full percentage point to annual global growth for at least several years. The resultant stabilisation of price swings would avoid the periodic spikes (in both directions) that tend to trigger huge economic disruption. Producers would benefit from these global economic gains, from their new protection against sharp price falls and from trade concessions that could be included in the compact to help them diversify their economies.

China must also play a central role in protecting the global outlook. Fortunately, it can resolve its internal overheating problem and contribute substantially to the needed global rebalancing through the single step of revaluing the renminbi by 20-25%. Such a currency adjustment would simultaneously address all of China's domestic troubles: dampening demand (for its exports) by enough to cut economic growth to the official target of 7%; countering inflation (now approaching double digits for inter-company transactions) directly by cutting prices of imports; and checking the inflow of speculative capital that fuels monetary expansion.

A sizeable renminbi revaluation is also crucial for global adjustment because much of the further fall of the dollar needs to take place against the East Asian currencies. These have risen little if at all, although their countries run the bulk of the world's trade surpluses. China has greatly intensified the problem by maintaining its dollar peg and riding the dollar down against most other currencies, further improving its competitiveness. Other Asian countries, from Japan through India, have thus intervened massively to keep their currencies from appreciating against the dollar (and, with it, against the renminbi). This has severely limited correction of the American deficit and thrown the corresponding surplus reduction on to Europe and a few others with freely flexible exchange rates. China should reject the US/G-7/IMF advice to float its currency, which is far too risky in light of its weak banking system and could even produce a weaker renminbi, and opt instead for a substantial one-shot revaluation. It should in fact take the lead in working out an “Asian Plaza Agreement” to ensure that all the major Asian countries make their necessary contributions to global adjustment.

Countries that undergo currency appreciation, and thus face reductions in their trade surpluses, will need to expand domestic demand to sustain global growth. China need not do so now because it must cool its overheated economy. But the other surplus countries, including Japan and the euro area, will have to implement structural reforms and new macroeconomic policies to pick up the slack. America and the surplus countries should also work together to forge a successful Doha round, renewing the momentum of trade liberalisation and reducing the risks of protectionist backsliding.

Risk in our times
The global economy faces a number of major risks that, especially in combination, could throw it back into rapid inflation, high interest rates, much slower growth or even recession, rising unemployment, currency conflict and protectionism. Even worse contingencies could of course be envisaged: a terrorist attack with far larger economic repercussions than September 11th or a sharp slowdown in American productivity growth, as occurred after the oil shocks of the 1970s, that would further undermine the outlook for both economic expansion and the dollar.

Fortunately, policy initiatives are available that would avoid or minimise the costs of the most evident risks. America will be central to achieving such an outcome and the president and Congress will have to decide in early 2005 whether to address these problems aggressively or simply avert their eyes and hope for the best, taking major risks with their own political futures as well as with the world economy. China will have to play a new and decisive leadership role. The major oil producers and the other large economies must do their part. The outlook for the global economy for at least the next few years hangs in the balance. ...Link

Fred Bergsten is director of the Institute for International Economics in Washington, DC. His book, “The United States and the World Economy: Foreign Economic Policy for the Next Administration” is forthcoming.

Thursday, September 09, 2004

China 's Great Depression

With a grain of salt.

Dr. Krassimir Petrov is a disciple of the Austrian School of Economics and spent this summer at the Mises Institute of Austrian Economics at Auburn , Alabama.

Having recently completed Rothbard's “America's Great Depression”, I couldn't help draw the parallels between America's roaring 20's and China's roaring economy today, and I couldn't help conclude that China will inevitably fall in a depression just like America did during the 1930s. The objective of this article is to present an Austrian argument as to why this must happen; to substantiate my arguments, I will be quoting Rothbard's Fifth Edition where relevant.

Before proceeding any further, I would urge all readers who haven't read Rothbard's “ America 's Great Depression”, to pick up a copy and read it. First, it is a real pleasant read, and Rothbard's witty style of writing makes reading it fun. Second, the first part of the book develops the Austrian Business Cycle Theory, which is indispensable for understanding credit booms and their inevitable busts. Finally, the second part of the book elaborates the development and the causes of the Inflationary Boom of the 1920s and provides a basis for comparison with the economic policies of modern-day China .

In order to establish our parallel, we need some historical perspective of the relationship between a world superpower and a rising economic giant. In the 1920s, Great Britain was the superpower of the world, and the United States was the rising giant. As such, Great Britain ran its economic policies independently, and the U.S. adapted its own policies in a somewhat subordinated manner. Today, The United States is the hegemonic superpower of the world, and China is the rising economic giant. Not surprisingly, the U.S. runs its policy independently, while China adjusts its own accordingly.

Continuing our parallel analysis, during the 1920s the British Empire was already in decline, was militarily overextended, and in order to pay for its imperial adventures, resorted to debasing its own currency and running continuous foreign trade and budget deficits. In other words, Britain was savings-short, a net-debtor nation, and the rest of the world was financing her. Meanwhile, America was running trade surpluses and was a net creditor nation. Importantly from a historical point of view, the British Empire collapsed when the rest of the world pulled the plug on their credit and began capital repatriation. Today, the American Empire is in decline, is militarily overextended, and is financing her overextended empire with the “tried-and-true” methods of currency debasement and never-ending foreign trade and budget deficits. In other words, America is savings-starved, a net-debtor nation, and the rest of the world is financing her. At the same time, today China runs trade surpluses and is a net-creditor nation. When the rest of the world finally pulls the plug on American credit, will the American Empire also collapse?

The cause of the Depression, as Rothbard explains, was a credit expansion that fuelled the boom. According to Rothbard, “[o]ver the entire period of the boom, we find that the money supply increased by $28.0 billion, a 61.8 percent increase over the eight year period [of 1921-1929]. This was an average annual increase of 7.7 percent, a very sizable degree of inflation (p.93)…The entire monetary expansion took place in money substitutes, which are products of credit creation… The prime factor in generating the inflation of the 1920s was the increase in total bank reserves” (p.102). In other words, during the 1920s, the United States experienced an inflationary credit boom. This was most evident in the booming stock and the booming real estate markets. Furthermore, there was a “spectacular boom in foreign bonds… It was a direct reflection of American credit expansion, and particularly of the low interest rates generated by that expansion” (p.130). To stem the boom, the Fed attempted in vain to use moral suasion on the markets and restrain credit expansion only for “legitimate business. Importantly, consumer “prices generally remained stable and even fell slightly over the period” (p. 86). No doubt the stable consumer prices contributed to the overall sense of economic stability, and the majority of professional economists then did not realize that the economy was not fundamentally sound. To them the bust came as a surprise.

Today, in a similar fashion, the seeds of Depression are sown in China . Economists hail the growth of China , many not realizing that China is undergoing an inflationary credit boom that dwarfs that American one during the roaring ‘20s. According to official government statistics, 2002 Chinese GDP growth was 8%, and 2003 growth was 8.5%, and some analysts believe these numbers to be conservative. According to the People's Bank of China own web site (http://www.pbc.gov.cn/english/baogaoyutongjishuju), “Money & Quasi Money Supply” for 2001/01 was 11.89 trillion, for 2002/01 was 15.96 trillion, for 2003/01 was 19.05 trillion, and for 2004/01 was 22.51 trillion yuan. In other words, money supply for 2001, 2002, and 2003 grew respectively 34.2%, 19.3%, and 18.1%. Thus, during the last three years, money supply in China grew approximately three times faster than money supply in the U.S. during the 1920s.

No wonder the Chinese stock market has been booming and the Chinese real estate market is on fire. Just like the U.S. in the 20s, China finances today foreign countries, mostly the U.S. , by buying U.S. government bonds with their trade surplus dollars. Just like the Fed's failed attempts of moral suasion during the 20s, the Chinese government today similarly attempts in vain to curtail growth of credit by providing it only to those industries that need it, that is, only to industries that the government endorses for usually political reasons. Also, for most of the current boom, Chinese consumer prices have been mostly tame and even falling, while prices for raw commodities have been skyrocketing, which perfectly fits the Austrian view that prices of higher-order goods, such as raw materials, should rise relative to prices of lower-order goods, such as consumer goods. This indeed confirms that credit expansion has already been in progress for a considerable time, and that inflation now is in an advanced stage, although it has not yet reached a runaway mode. Thus, economic conditions in China today are strikingly similar to those in America during the 1920s, and the multi-year credit expansion implies that a bust is inevitable.

There are also important parallels regarding currency and export policy. During the 1920s, the British Pound was overvalued and was used by smaller countries as a reserve currency. While Britain ran its inflationary policies during the 1920's, it was losing gold to other countries, mainly the United States . Therefore, “if the United States government were to inflate American money, Great Britain would no longer lose gold to the United States” (p. 143). Exacerbating the problem further, the Americans artificially stimulated foreign lending, which further strengthened American farm exports, aggravated the net-export problem, and accelerated the gold flow imbalances. “It [foreign lending] also established American trade, not on a solid foundation of reciprocal and productive exchange, but on a feverish promotion of loans later revealed to be unsound” (p. 139). “[President] Hoover was so enthusiastic about subsidizing foreign loans that he commented later that even bad loans helped American exports and thus provided a cheap form of relief and employment—a cheap form that later brought expensive defaults and financial distress” (p.141) Thus, the preceding discussion makes it clear, that the fundamental reasons behind the American inflationary policy were (1) to check Great Britain's drains of gold to the United States, (2) to stimulate foreign lending, and (3) to stimulate agricultural exports.

Similarly, today the dollar is overvalued and used as the reserve currency of the world. The U.S. runs its inflationary policy and is losing dollars to the rest of the world, mainly China (and Japan ). Today, the currency and export policy of China is anchored around its peg to the dollar. The main reason for this is that by artificially undervaluing its own currency, and therefore overvaluing the dollar, China artificially stimulates its manufacturing exports. The second reason is that by buying the excess U.S. dollars and reinvesting them in U.S. government bonds, it acts as a foreign lender to the United States . The third reason is that this foreign lending stimulates American demand for Chinese manufacturing exports and allows the Chinese government to relieve its current unemployment problems. In other words, the motives behind the Chinese currency and export policy today are identical to the American ones during the 1920s: (1) to support the overvalued U.S. dollar, (2) to stimulate foreign lending, and (3) to stimulate its manufacturing exports. Just like America in the 1920s, China establishes its trade today not on the solid foundation of reciprocal and productive exchange, but on the basis of foreign loans. No doubt, most of these loans will turn out to be very expensive because they will be repaid with greatly depreciated dollars, which in turn will exacerbate down the road the growing financial distress of the banking sector in China .

Therefore, it is clear that China travels today the road to Depression. How severe this depression will be, will critically depend on two developments. First, how much longer the Chinese government will pursue the inflationary policy, and second how doggedly it will fight the bust. The longer it expands and the more its fights the bust, the more likely it is that the Chinese Depression will turn into a Great Depression. Also, it is important to realize that just like America 's Great Depression in the 1930s triggered a worldwide Depression, similarly a Chinese Depression will trigger a bust in the U.S. , and therefore a recession in the rest of the world.
Unless there is an unforeseen banking, currency, or a derivative crisis spreading throughout the world, it is my belief that the Chinese bust will occur sometime in 2008-2009, since the Chinese government will surely pursue expansionary policies until the 2008 Summer Olympic Games in China. By then, inflation will be most likely out of control, probably already in runaway mode, and the government will have no choice but to slam the brakes and induce contraction. In 1929 the expansion stopped in July, the stock market broke in October, and the economy collapsed in early 1930. Thus, providing for a latency period of approximately half a year between credit contraction and economic collapse, based on my Olympic Games timing, I would pinpoint the bust for 2009. Admittedly, this is a pure speculation on my part; naturally, the bust could occur sooner or later.

While I base my timing of bust on the 2008 Olympic Games, Marc Faber, however, believes the bust will occur sooner. According to him, the U.S. is due for a meaningful recession relatively soon, which in turn will exacerbate already existing manufacturing overcapacities in China . This, coupled with growing credit problems, makes him believe that China will tip into recession sooner than the Olympic Games. In other words, Dr. Faber believes that a U.S. recession will trigger the Depression in China . Indeed, that very well may be the trigger, but if so, it still remains to be seen whether the Chinese government will let the bust run its course or choose the route of a “crack-up” boom, come hell or high water.

We should also consider another possible trigger for a bust, namely trade surpluses turning into trade deficits due to the accelerated rise of prices for resources, such as commodities, which China must import. Faced with trade deficits, China may decide to dishoard surpluses by selling U.S. government bonds, or it may decide to abandon its peg to the dollar. In either case, this will exacerbate the problems of the ailing U.S. economy, which in turn will boomerang back to China .

Finally, the bust may be triggered by a worldwide crisis in crude oil supplies. Peak oil supply is around the corner, if not already behind us, and Middle East or Caspian instability could sharply cut oil supplies. Historically, oil shortages and their concomitant rise of oil prices have always induced a recession. China 's growing dependence on oil ensures that should an oil crisis occur, it will slip into recession.
To summarize, the likely candidates for a trigger to the Chinese depression are (1) a worldwide currency, banking, or derivatives crisis, (2) a U.S. recession, (3) the containment of runaway inflation, (4) the disappearance of Chinese trade surpluses, and (5) an oil supply crisis.

Whatever the trigger of the bust in China , there is little doubt that this will provide the onset of a worldwide depression. Just like the U.S. emerged from the Great Depression as the unrivalled superpower of the world, so it is likely that China will emerge as the next. With a grain of salt.

Wednesday, September 08, 2004

Roach: Rebalancing or Relapse?

Keeping an eye on China.

An unbalanced world economy needs a new recipe for sustainable growth. A two-engine global growth dynamic has been pushed to excess. The over-extended American consumer can no longer carry the demand side of the equation. And an over-heated Chinese economy can no longer power the supply side. Nor can the world, as a whole, sustain the massive imbalances -- financial and trade -- that have arisen from this lopsided growth paradigm. But risks are building that a rebalancing may not go smoothly. As China and the US now slow, new growth engines must fill the void. Absent that important shift in the mix of global growth, the imperatives of rebalancing could well give way to a global relapse.

There can be no mistaking the disproportionate impetus that the US and China have provided to world economic growth in recent years. Over the 1996 to 2003 period, our estimates suggest that these two economies directly accounted for 49% of world GDP growth -- well in excess of their combined 33% PPP-based share in the global economy. Adding in the indirect effects due to trade linkages, and the total contribution could easily be in the 60-70% range. The US contribution shows up mainly on the aggregate demand front. Over the past eight years, growth in US personal consumption expenditures averaged 3.9% in real terms. That’s about one percentage point faster than trend growth over the prior 15 years and about 75% faster than the 2.2% gains elsewhere in the developed world. It is hardly an exaggeration to conclude that the American consumer has been the principal engine on the demand side of the global growth equation since 1995.

China has played an equally important role in driving growth on the supply side. Chinese real GDP growth averaged 8.2% over the 1996 to 2003 period -- more than three times average gains of 2.7% in the advanced nations and more than double average gains of 3.5% elsewhere in the emerging market and developing economies of the world. Yet the contribution of the Chinese producer is probably much greater than the GDP statisticians imply. Industrial output growth in China has averaged about 12% since 1995 -- fully 50% faster than gains in the official GDP growth metric. With a relatively undeveloped services sector -- less than 35% of Chinese GDP in 2003 -- and a relatively small consumption share -- 54% of Chinese GDP in 2003 -- surging industrial activity accounted for 54% of the cumulative increase in Chinese GDP since 1990. The impacts of this industrial-production-led strain of growth are global in scope. China now consumes a highly disproportionate share of worldwide demand for industrial commodities -- having accounted for 25-30% market shares in global consumption of aluminum, steel, iron, and coal in 2003. Moreover, China’s investment-led impetus resulted in a 40% surge in imports in 2003 -- underscoring its emerging role as a growth engine for externally-dependent economies such as Japan, Korea, Taiwan, and Germany. At the margin, there can be little doubt of China’s increasingly dominant role in driving the global production dynamic.

Both of these engines have now shifted to lower gears. Growth in US consumer demand moderated to a 1.6% increase in 2Q04, well below the 4.2% pace of the prior four quarters and the weakest quarterly performance in over three years. Largely reflecting this moderation, the consumption share of US GDP has receded from a record high of 71% in mid-2003 down to about 70%. While this is progress, it is only very limited, at best, in restoring some sense of balance to the US economy. From 1980 through 2000, the consumption share of US GDP averaged about 67%; by reversing only one percentage point of the recent four point overshoot, the American consumer has completed only about 25% of the journey on the road to normalization. A similar result is evident for the Chinese producer: Growth in China’s industrial output slowed to 15.5% in July -- a four percentage point reduction from peak growth rates of around 19.5% earlier this year. In my view, China needs to bring its production comparisons down into the 8-10% range in order to achieve a soft landing. The recent slowing of Chinese industrial output growth has achieved about 40% of the ten percentage point deceleration that a soft landing would require.

Downshifts in the US and China are now setting in motion the first phase of global rebalancing. Yet on both counts, as noted above, progress has been only limited -- the bulk of the slowing still lies in the future. Moreover, for both economies, the moderation of growth is largely a reflection of the internal dynamics of the business cycle. In the case of China, the downward impetus has come from a conscious shift to policy restraint in an effort to slow an overheated Chinese economy; this is critical to temper emerging imbalances that, if left unattended, could prove increasingly destabilizing in the future. Signs of such imbalances have been especially evident in the property markets of coastal China. They are also increasingly evident in the auto sector, where trade reports now suggest that inventories of unsold vehicles are piling up much more rapidly than the official figures suggest. With the Chinese slowdown having only just begun, senior Chinese officials have stressed recently that their commitment to a slowdown has now reached a “critical stage.” As policy restraint remains in place, China’s domestic investment should slow, tempering its supply-led impetus to global growth. A secular increase in Chinese export penetration is likely to be a partial offset.

For the American consumer, the recent moderation is less of an immediate response to policy restraint and more a by-product of the tough internal dynamics of an over-extended household sector. Nowhere does this show up more vividly than in the renewed sharp decline in the personal saving rate, which plunged to just 0.6% in July -- well below the already depressed post-1995 average of 2.7%. Lacking in job and wage income growth, consumers have drawn the bulk of their support from tax cuts and equity extraction from asset markets. However, with future tax cuts and sharp house-price appreciation unlikely, US consumers are likely to be increasingly mindful of depleted income-based saving rates. Add in a likely back-up in interest rates that should boost the carrying costs of record debt loads, together with sharply higher energy costs, and the squeeze on discretionary purchasing power could become all the more acute. While it’s always tough to bet against the American consumer, the noose finally appears to be tightening. I continue to believe that a US consumption adjustment will end up being the single most important source of moderation on the demand side of the US and global economy over the next couple of years.

Global rebalancing is not a one-way street -- it entails far more than just slowdowns in the US and China. Equally critical, in my view, is the renewal of growth elsewhere in the world -- namely, autonomous support from domestic demand, especially private consumption. On that count, the global economy remains woefully deficient. The Asian consumer is effectively missing in action. Thailand is perhaps the only exception, as consumption dynamics remain disappointing in most of the region -- especially in Japan, China, and Korea. For a while, there was hope that the Japanese consumer was about to awake from a decade-long slumber; however, with Japanese consumption now down for three months in a row in the period ending July 2004, those hopes have been all but dashed. Similarly, a likely popping of the Chinese property bubble spells new pressures on consumption trends in coastal China. And the Korean consumer is still reeling from the impacts of the bursting of credit and property bubbles in 2003. Nor is there much of an offset evident in Europe, where domestic demand continues to eke out relatively anemic gains. While that’s especially true in Germany, which makes up fully 30% of Euroland GDP, gains elsewhere in the region can hardly be described as vigorous. Europe is, at best, a 2% growth story over the next couple of years, according to the latest forecasts of our European economic team. If the US and China now slow, as I suspect, Europe is hardly capable of filling the void that could be left by the American consumer and/or the Chinese producer.

Partial rebalancing is a distinct negative for the global growth outlook. Our current baseline forecast calls for 4.7% growth in world GDP in 2004 -- the first year of above-trend growth in four years. However, we continue to expect that resurgence to be short-lived. Our 2005 forecast calls for global growth to decelerate to 3.8% --a slowing of nearly one percentage point from this year’s estimated gains and only fractionally above the longer-term 3.7% trend. Key to our slowdown call is likely deceleration in both the US and China. China and the US combined account for about 34% of total world GDP as measured on a purchasing power parity basis. US economic growth is expected to decelerate by 0.6 percentage point in 2005 (from 4.4% in 2004 to 3.8% in 2005) and Chinese economic growth is expected to slow by 1.5 percentage points (from 9.0% in 2004 to 7.5% in 2005). Collectively, projected downshifts in these two economies knock about 0.5% off world GDP growth in 2005 -- a direct effect of 0.35 percentage point and an indirect effect on other economies of about 0.15 percentage point. Consequently, if downshifts in the US and China are not countered by improved growth prospects elsewhere in the world, there is a distinct possibility of a major shortfall in global activity.

That takes us to the biggest risk of all: Any unexpected growth shortfalls could easily push growth in a still fragile world economy back into the 2.5% to 3.5% zone in 2005. Growth in that range would then leave the world dangerously near its stall speed and, therefore, highly susceptible to a shock. Recent developments on the energy front are especially worrisome in that regard (see my 20 August dispatch, “Oil-Shock Assessment”). With oil prices closing on $50, the risks of global recession were mounting. At $40, those risks would obviously be a good deal lower. The current price point of around $44 sits precariously between these two extremes. But whether it’s an oil shock or some other unexpected blow, the verdict is the same: With China and the US slowing and the rest of the world unwilling or unable to pick up the slack, a partial rebalancing could well heighten the possibility of a global relapse in 2005.

Keeping an eye on China.