Source: China Financial Markets
Xin Fa'an: A Modest Proposal to Resolve the Coming Earlier this week I had a debate on TV with a local economist on the subject of trade relations. We had the same debate about six and twelve months ago and in each case while I argued that the trade problems were almost intractable and trade relations would inexorably deteriorate, he both times acknowledged that although things may have gotten bad recently, I was being overly pessimistic because the trade disputes had finally bottomed, and conditions would only get better.
Astonishingly enough this was still pretty much the debate we had this week. It is almost impossible to pick up a newspaper today without seeing several articles that directly or indirectly indicate how much worse things must get before we reach bottom, and yet there are still too many people who can’t understand the numbers. I would argue that a lot of people, especially in China, think that it is mainly US pre-election posturing that is driving all of this anger. If that is the case, why are we seeing article like this (“Fears of global currency war rise”) in the Financial Times?
Thailand is introducing a tax on foreign holdings of bonds, the latest in a string of attempts by emerging economies to curb destabilising capital inflows amid fears of a global currency war. The Thai cabinet on Tuesday imposed a 15 per cent withholding tax on capital gains and interest payments for government and state-owned company bonds, a clear signal that it would take tough measures to curb inflows of “hot money”.
Or how about this one?
Japan has called on South Korea and China to “act responsibly” on exchange rates in an unusually strong statement ahead of the G20 summit of leading nations in Seoul, expected to be overshadowed by rising tensions over currencies.
The statement by Naoto Kan, Japan’s prime minister, adds to pressure on Seoul as the host of the meeting in November to broker a discussion on currencies despite some countries, including China, pushing to keep the issue low on the agenda.
In fact it seems that every third article in the front section of the Financial Times indicates one way or another a country that is battening the hatches and preparing for a beggar-thy-neighbor world.
The problem is not pre-election posturing in the US. It is much worse than that. The problems is that the numbers actually do not work. China and Germany need to grow their surpluses to maintain growth. In fact China has to choose between an unhealthy overreliance on the trade surplus and an even unhealthier over-reliance on investment, as I mentioned in a comment in Bloomberg yesterday. Japan cannot allow its trade surplus to decline because with no demand growth this can only come about as a contraction in production.
On the other hand European deficits are collapsing as a consequence of the financial crisis. And the US cannot tolerate a rapid increase in its deficits. How does this math work? Surpluses and deficits, after all, must balance to zero.
Well I guess one way to get this balance (here comes my modest proposal) would be for China to engineer a New Deal in America, which we could call Xin Fa’an (“new deal” in Chinese). As I have discussed many times, most recently in my October 6 entry, my September 29 entry, and my September 11 entry, Beijing needs the US to continue running a rising trade deficit in order to absorb Chinese overcapacity while China slowly rebalances its economy towards domestic demand, which will take many years.
There are two ways that the US can run a rising trade deficit. Remember that a country’s current account deficit is equal to the excess of Investment over savings. If the US runs a rising current account deficit, this just means that the excess of investment over savings has risen.
One way, of course, is for savings to decline. There are two ways that can happen.
- US consumption can grow faster than US income. Since savings is simply income minus consumption, as long as consumption grows faster than income, savings will decline. Of course not only is it unlikely that US consumption will surge, but it would be terrible if it did. The US consumes too much, and needs to bring this number down.
- US unemployment can rise. As US companies fire workers, household income will decline. If consumption declines at the same rate as income, or at a slower rate, gross savings will decline. This, of course, is exactly what the US wants to avoid and why we are on the verge of a trade war.
The other way the US can run a rising trade deficit is for a surge in investment. With a slowing world economy it is unlikely that private investment will rise, but as Joseph Stiglitz pointed out recently in a debate during the IMF/World bank meetings in October last week, the US is paradoxically in a very good position to increase investment because it has very poor infrastructure for its levels of development. The US has tons of room for a major expansion in infrastructure and, unlike in China, almost any infrastructure spending is likely to be value creating.
One way for this to happen is for the US government to fund and engineer the infrastructure spending directly. The resulting increase in the US trade deficit would of course be financed by Chinese lending to the US government as it is forced to accumulate USG bonds. But aside from the fact that there is too much pork-barrel politicking involved in US government spending, it will result in a rapid rise in the US fiscal deficit.
Would that matter? No, because this is exactly the kind of fiscal spending that is sustainable. US wealth creation would exceed the rise in debt and so the US is in the aggregate better off. But of course the politics of a rise in the US fiscal deficit are pretty sticky.
So why not have China do it directly? Let China engage in a massive rebuilding of US infrastructure – it can build airports, highways, damns, and railways – which would raise investment levels enough keep the US trade deficit high in a way that benefits the US and China.
Of course China would also have the right to charge for the use of these projects so that it can earn a positive return on its investment. The return doesn’t even need to be high – just better than the return it gets on its huge expansion in investment in China, which I suspect is negative for the country as a whole.
Even worse, China is lending money to foreign borrowers anyway to boost China’s trade surplus, and I am not sure they can count on a positive return there. Look at the $5 billion loan Premier Wen pledged to Greece to buy Chinese ships. That may look like a clever deal economically, but I think there is a very high probability that within five or six years Greece will be forced to default on its debt and will obtain significant debt forgiveness. In that case China will earn a negative return there too. You can’t get rich giving away ships.
As long as it earns more than it earns on its USG bond holdings, it will be better off economically even without considering the immense advantage of keeping the US trade deficit high for the eight to ten years China is going to need to rebalance its economy away from its toxic over-reliance for growth on the trade surplus and economically non-viable investment.
Talk about win-win. China will get the eight to ten years it desperately needs to engineer what will otherwise be a brutally difficult rebalancing. It will get a much higher return on its investment. And it can avoid the foolish pork-barrel domestic expenditures that have characterized the past several years.
The US can sharply improve its infrastructure in a rational way without a boatload of Congressmen arguing over who gets what. It can raise employment without raising the fiscal deficit. And as icing on the very large cake we can avert the trade war that is an almost inevitable outcome of the current imbalances.
So can we get China to fund the Xin Fa’an in America? Probably not. Muddled Chinese public opinion will be furious that desperately poor China is investing in rich America, even though the overall returns will be better and the cost of China’s adjustment will be much lower. Muddled American opinion will be furious that America is “selling out” to China. Bumptious politicians in both countries will completely fail to get the underlying economics of the trade, and they will never allow it to happen. But it is still a pretty good idea.
