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

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

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

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

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

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

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

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

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

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

Figure 1

Figure 2

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

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

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

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

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

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

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

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

Inconsistency of the theory

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

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

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

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

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

The rise in US consumption

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

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

Figure 1

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

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

The decline in US investment and saving

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

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

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

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

Figure 2

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

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

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

Figure 3

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

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

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

China’s rising investment and declining trade surplus

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

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

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

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

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

Figure 4

Figure 5

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

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

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

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

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

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

The errors of the ‘global imbalances hypothesis’

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

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

Notes

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

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

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

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

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

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

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

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

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

All highly recommended reading.

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

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

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

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

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

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

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

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

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

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

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

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

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

Figure 1

Figure 2

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

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

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

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

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

Figure 1 shows the percentage change in domestic components of
US GDP since the onset of the recession, following the second quarter of
2008, up to the first quarter of 2009.

US GDP in this period declined by 3.1%. Personal consumption, however, fell by only
1.7% while government expenditure rose by 0.9%. In contrast private fixed
investment dropped by 20.7%.

Figure 1

The
trend may be equally clearly seen in Figure 2 which shows the change
over the same period in the constituents of US GDP in constant price dollar terms -
all figures using dollar prices of 2000.

Figure 2

Two components of US GDP have actually grown, or improved, since the
downturn commenced following the second quarter of 2008. Due to US imports falling more rapidly than
exports US net trade has improved by $84.5 billion. Simultaneously
government expenditure has risen by $19.5 billion.

The decline in US GDP is accounted for by a decline
in inventories, personal consumer expenditure and private investment. Taking these in terms of their quantitative impact,
inventories have declined by $53.1 billion, personal consumption
expenditure by $143.3 billion and private fixed investment by $352.8
billion.
The decline in US private fixed investment is therefore almost seven times
the size
of the decline in inventories and almost two and half times the scale
of the fall in
private consumption.

Analyses of the US economic downturn which focus on the decline
in inventories or personal consumption therefore miss the main
constituent of the recession.

Nor, contrary to statements by Paul Krugman and others,
is the fall in US investment only accounted for by the decline in
residential investment. From the second quarter of 2008 to the first
quarter of 2009 the decline in US residential investment was $75.4
billion and the decline in US non-residential investment was $241.2
billion – i.e. the fall in non-residential investment accounted for
more than three times as much of the declines in US GDP as the fall in
residential investment.

These final US GDP figures therefore leave no ambiguity. The US
economic downturn is being driven by a huge fall in investment.

This
fall
in investment will have clear short term and long term
consequences. In the short term, in terms of the business cycle, as the
investment decline is driving the recession, unless this is reversed it
will be very hard for the US to escape from economic recession or
stagnation.

Regarding the longer run modern econometric research clearly confirms that it is investment which has been the main
driver of US economic growth – i.e. the old claim, associated with
Solow and Kuznets, that it was productivity and technology, and not
capital and labour growth, which drove economic growth has been shown
to be factually false.

As Dale Jorgenson, former President of the
American Economic Association and the foremost econometrician studying
US economic growth, put it in a survey of the latest evidence
in 2009: ''the growth of productivity was far less important than the
contribution of capital and labour inputs to US economic growth.'  More
specifically he notes the evidence leaves no doubt 'investment is the predominant source of U.S. economic
growth' [1].  The very sharp current decline in investment, in addition to its short term
cyclical effects, therefore also undermines the main source of US
economic growth – making it hard for the US to resume rapid economic development.

The
investment driven character of the US downturn therefore has
major short term and long term consequences for both the US and world
economies.

Notes

[1] Dale W. Jorgenson, Productivity Volume 1: Postwar U.S. Economic Growth, The MIT Press, Cambridge Massachusets 1995 pxv.

What are the great economic challenges facing Europe? Almost a century ago Europe was overtaken by the US as the latter created the world's first continental sized economy. Europe is now being overtaken by the 'second continental economy' – China. Rapidly developing is the 'third continental economy' – India.

The major challenges for Europe's faced with such a development are clear. To raise its rate of investment to match the new high growth continental sized economies of China and India. To link itself to these rapidly growing new Asian economies. To integrate Europe's economy in order to help achieve the same all round rate of productivity as the US – European manufacturing matches US productivity but its service sector lags behind.

Instead what issues increasingly dominated these elections? Increasingly the alleged 'threat' from immigrants and narrow national particularism.

Italy's economy, for example, is in decline because its investment rate, which during the post-World War II period used to be one of the highest in Europe, which in turn fuelled major economic growth, has declined. Italy's economy has become progressively less competitive. But, to judge by the rhetoric of the Italian election campaign, the real problem facing the country is Romanians and other foreigners – who hold absolutely no power. According to prime minister Berlusconi 'Kicking back clandestines to their countries is working'  – as if that would solve any major problem facing Italy even if true.When visiting Prato Berlusconi loudly declared 'there are too many Chinese here'.

Britain, which in London has one of the world's most important international financial centres, desperately needs to strengthen its links with China and India. It has already hampered itself by refusing to join the common European Schengen visa system which allows entry to 25 other countries. The result is, for example, that more than 400,000 Chinese tourists visit France and only just over 100,000 visit Britain. New proposals being loudly promoted in the media in Britain, for example, are that as it is legally impossible to stop immigration from within the European Union all non-EU immigrants should be banned – a measure which will, again, sabotage Britain's relations with India and China.

A smaller, symptomatic, example of such idiocy is the activity of the new Mayor of London, Boris Johnson, Johnson has scrapped 'for financial reasons' such events as the annual Chinese lanterns in London's Oxford Circus to mark the Chinese New Year, which used to generate widespread publicity for London in China, and the 'Russian Winter Festival' in London's Trafalgar Square. Instead he has  launched a cultural programme with a centre piece of the celebration of the coronation of Henry VIII (which occurred in 1509 for those unfamiliar with the finer points of English history). Doubtless Indian software companies, or Chinese banks, assessing whether to develop their activity in London will be greatly inspired by this new evaluation of England's Tudor monarch.

Generously, regarding Europe at present, one is rather reminded in all this irrelevance by the accounts of the Roman aristocrats who, as the Roman Empire collapsed around them, didn't bother to address contemporary reality but spent their time writing tracts evaluating the rhetoric and etiquette of the Roman Republic and its early Empire. Or, to take another analogy of the same historical epoch, Europe is simply fiddling as Rome burns.

There is a more precise parallel from within the continent's history itself of the pre-occupations of much of Europe revealed at these elections. Countries which rose to peaks of power within Europe were then typically bypassed by others and fell into long periods, typically centuries, of decline.

Northern Italian cities such as Venice, which had powered the early period of Europe's modern economic development, were from the 16th century onwards marginalised and Italy itself remained disunited until 1861. Spain, the 16th century's greatest European power, passed into three centuries of economic marginality. Holland declined from its domination of the early 17th century. Britain, the greatest European power of the 19th century, was overtaken economically not only by the United States but then by France and Germany,

That peaks of power are followed by decline and decay is a common pattern in history. It is therefore scarcely surprising if the entire continent of Europe, which from the 15th to the 19th centuries was the most powerful in the world, passed into decline and increasing marginality. Not only is its current widespread mood of racism and xenophobia distasteful and damaging in itself but If Europe continues with the trend and pre-occupations shown at these election, an obsession with immigrants and narrow national concerns, its decline as a continent is inevitable.

Consider first China’s domestic situation. China requires a high savings rate in order to finance its high level of investment. As the evidence shows that the most important determinant of the rate of economic growth is the rate of increase of investment and labour, if China were to cut its rate of investment its economy would grow less rapidly. Furthermore, China’s growth is responsible for the majority of the reduction of the number of people living in poverty in the world. Reduction of China’s rate of investment, which in turn requires a high savings rate, would therefore result in China’s economy growing less rapidly, the world economy growing less rapidly, and world poverty shrinking less rapidly – clearly nothing positive lies down that road either for China or for anyone else. On the contrary, as the Indian Prime Minister has stressed countries such as India and China require high savings rates.

Internationally what is normally argued by the ‘China is saving too much’ view is that the key issue is to reduce China’s balance of payments surplus – the latter being statistically necessarily equal to China’s surplus of domestic savings over domestic investment. A case can be certainly be made that China should utilise a higher proportion of its savings domestically. Investment in the domestic Chinese economy would almost certainly earn a better rate of return than the present situation of large scale purchases of US Treasury Bonds. It might also lead to more rapid economic growth by China. The latter however depends on other factors as well – for example, prior to the financial crisis last year China’s economy was in danger of overheating and encouraging a higher level of investment would have exacerbated this. But a high investment level is certainly a means by which China's balance of payment surplus could be reduced.

But what would be the consequence of China reducing its balance of payments surplus in the present circumstances – whatever the means chosen? China recirculates its surplus in large part through purchase of US Treasury Bonds – that is, China adds to international savings. Reduction in China’s balance of payments surplus, unless compensated for by an increase in savings elsewhere, would inevitably lead to a rise in interest rates as the international supply of savings shrank – a likely form being a very direct increase in the interest paid on US Treasury Bonds. Such a rise in interest rates, under conditions of a world economic downturn, would be highly undesirable as so far there is no indication at all of an increase in the overall US savings rate that would compensate for a decrease in international saving by China. Such an increase in international interest rates would be economically contractionary when the opposite is what is required.

More fundamentally what choice did the increase in international savings by China offer to the US – and other economies? In essence it simply meant the US economy was able to borrow money at extremely low interest rates. That finance could have been used to rebuild the productive base of the US economy – that is, it could have been invested. That such finance available at low interest rates was not invested but was instead wasted in a consumer splurge was the result of economic policies  pursued by successive US government not others. Others could have used such low interest rate finance for productive purposes.

An article in China Daily on 29 May by Lau Nai-keung put the issue in rather popular and polemical style with a distinct Asian emphasis – but he actually stated the question very accurately as regards economic fundamentals (incidentally rightly linking it to the need to raise investment for environmental reasons). Lau Nai-kueng is from Hong Kong.

’The [Chinese] government has decided to make domestic consumption the engine of sustained growth. But many people tend to confuse it with personal consumption…

‘Hong Kong’s experience of the 1990s, when it saw more than six years of deflation, tells us that an economy doesn’t need excessive subprime loans to create a big enough bubble in the property market that would hurt everybody once it bursts.

‘The experience taught us that a high rate of savings should be viewed as a virtue, not as a vice. It’s the inappropriate use of savings that is to blame for the economic ills of today. The Chinese mainland’s rapid growth is attributed to massive infrastructure building financed by a high savings rate. The yield from investment into infrastructure is long-term.

’Putting more resources into education, healthcare and the environment is also investment. And such an investment has for long been overdue on the mainland…After that, we can increase the spending on social security and housing for low-income groups, which are not investment but nevertheless are very important components of social security because they enhance general welfare, social stability and harmony.

‘On completing these tasks, the government can consider a free or highly subsidized transport system. Beijing’s example of subsidized subway transport is a good example of minimizing the risk of abuse in public service. Once a smooth and efficient public transport, which is free or subsidized, is in place, owning a car would only be a status symbol. The government can then think of scrapping hire purchase for cars so that fewer vehicles are on the streets. That will not only ensure a freer flow for public transport vehicles, but also mean reduced greenhouse gas emission…

’Before the [1997] Asian financial crisis, credit cards were not very common in South Korea. But after that, credit cards were dished out on the pretext of boosting consumption, and transformed almost the entire country into a group of ruthless spenders. The savings rate of South Koreans has dropped drastically, and as a result the country is now finding it difficult to weather the global economic storm.

‘In the US, most people are… spending money they have not earned. Ironically the economic crisis has forced people to rely even more on credit cards to maintain their lifestyle… Outstanding payment for credit cards worldwide is estimated to be more than $1 trillion and rising. Like subprime loans, card payments are also packaged in different kinds of derivatives, and when bad loans pile up, as is inevitable, another wave of financial tsunami will lash the global economy.

‘We have to learn to make good use of our high savings rate, instead of encouraging the middle class to buy more houses and cars, and spend like there is no tomorrow. Most of the suggested measures does not require a lot of resources to implement and, in fact, will reduce pollution. On the contrary, they will help create quality employment and generate solid GDP growth.

‘When welfare schemes make people feel more secure, they would be more willing to spend. The social and economic infrastructure will also ensure sustained economic growth. Proper channelling of savings into investment and social spending will enhance real private consumption in the long run. Higher savings will then imply higher investment and, in turn, higher GDP and a more robust growth. Without proper savings, a high private consumption rate will lead to disaster, as has been the case in many Western countries.

‘If a high savings rate is as bad as many Western economics would like us to believe, then how come we have succeeded and they have failed to weather the economic storm?’

The last sentence would seem to hit the nail rather accurately on the head.

In policy making all theoretical and other arguments have to be aligned and concentrated around one settling one decisive issue – ‘what should be done’. That is, what is involved is a synthetic decision – assembling issues, and giving them their specific weights, around one point. In academic discussion exploration of distinctions and points can be pursued without settling the decisive practical question of what difference it makes to what should be done.

This particular reflection was reinforced by re-reading, to prepare the debate, Paul Krugman’s well known 1995 paper, ‘The Myth of Asia’s Miracle’. This analysis, arguments from which are still frequently used today, drew heavily on two quantitative papers by Alwyn Young on growth in the four Asian Tigers/Newly Industrialised Economies (NICs) of South Korea, Singapore, Taiwan and Hong Kong.[1]

In analysing the Asian Tiger economies Young/Krugman were attempting to deal with a theoretical/analytical issue. Was the rapid rate of growth of the South East Asian Tigers based on, or substantially contributed to, by a particularly high rate of growth of productivity – whether of labour, capital, or total factor productivity? Or to what degree was it based on quantitative growth of factors of production – i.e. accumulation of labour and capital?

It should be noted that the quantitative results of Young’s work has come under criticism – notably from Chang-Tai Hsieh. However, for the moment, leave statistical criticism aside and assume, for the sake of argument, that Young’s quantitative conclusions were correct – although, to be clear, this is done as a hypothesis and is not an acceptance of Young’s calculations per se. Then what follows?

Writing in 1995 Young noted that for the period 1960-85 the four Asian Tigers constituted four out of the five countries with the fastest growth of GDP per capita in the world – the fifth, Botswana, was an economy sufficiently small that no general conclusions would be drawn from it. However, after subtracting growth due to the increase in labour input (including increased participation in the workforce, higher educational achievement etc) and the rate of additions and improvements to capital, Young concluded that the growth of total factor productivity in the Asian Tiger economies was not remarkable. Summarising his article, Young wrote that he:

‘presents estimates of “total factor productivity” in the sample economies… the ranks of Taiwan and South Korea [among economies placed in descending order of growth of total factor productivity] are now reduced to 21st and 24th, respectively. While this remains a strong performance, it is no longer dramatically differentiated from that of the rest of the world economy. Fully 81 of the 118 sample economies lie within one standard deviation… of Taiwan and South Korea. Surprisingly, economies such as Bangladesh, Uganda, Iceland and Norway are now seen to have outperformed Korea and Taiwan, whose productivity growth is only 0.5% greater than that of a renowned laggard, the United Kingdom. Singapore, where participation and investment rates have risen faster than any of the NICs, is reduced to a rank of 63rd in the world economy.’

So, therefore, Young finds the growth of productivity in the NICs was average or slightly above average and their rapid growth was not primarily due to extraordinary growth in total factor productivity but was due to large scale quantitative inputs of capital and labour. To which the appropriate answer, from the point of view of economic growth, is: ‘yes, that is quite adequate, even very encouraging. For it shows that if it is possible to combine average productivity growth with very large quantitative inputs, then the economy’s rate of growth will be far higher than the average and very rapid in absolute terms – enough to industrialise a country in a single generation (which is what the NICs achieved).’

The point is a simple arithmetic one. The effectiveness of the contribution of investment, for example, to economic growth depends on the combination of its quantity and how efficiently the economy utilises it. This blog has noted on numerous occasions that there is a fundamental logical error in judging an economy’s growth potential by economic approaches which concentrate only on the efficiency of the use of investment rather than also analysing the quantity of investment. The quantitative relation of the relative scale of investment and the relative efficiency of investment is the critical one. If, for example, economy A utilises investment 20% more efficiently from the point of view of generating growth than economy B, but nevertheless economy B invests 50% more as a proportion of GDP, then economy B will grow more rapidly than A despite the fact that economy A uses its investment more efficiently.[2]

Young/Krugman demonstrate that the rate of productivity growth of the Asian Tiger economies is not below average, but only average, as a result of which these economies quantitative advantage in growth of inputs of investment and labour ensures much more rapid growth that economies with higher rates of total factor productivity growth but much lower rates of input growth.

This is why, for example, criticisms that countries such as South Korea, during their phases of rapid growth, allegedly allocated capital inefficiently compared to more ‘liberal’ economies such as Britain or the United States entirely miss the point. An economy such as South Korea invested so much more as a proportion of GDP, almost double the rate of the US, that unless, from the point of view of growth, its' efficiency of investment was only half that of the US the South Korean economy would still have grown more rapidly than the US.

Put in properly formulated economic terms the quantitative level of macro-economic allocation of resources to investment may be more important from the point of view of economic growth than the marginal efficiency of investment. Put crudely, when it comes to investment and growth, 'quantity' may simply be more important than 'quality'. That, for example, would by itself be enough to vindicate the present very high rates of investment in India and China.

Whether it has proved in practice a more viable growth strategy to have an average rate of growth of productivity, combined with very high quantitative inputs of investment and labour, or whether it is more effective to aim at the highest rate of growth of total factor productivity, with much smaller quantitative inputs of investment and labour, may be illustrated rather graphically by showing the rank order of countries produced by Young’s calculation.

Young found that the top five countries in terms of growth of total factor productivity, after he has carried out his adjustments, were as set out in Table 1. 

Table 1

In short, if highest possible growth in total factor productivity is the variable that should be targeted, then Egypt, Pakistan, Congo and Malta, together with Botswana, should be taken as the most successful economies in the world – the economic models to be emulated.

If, however, the key criteria of success is increase in GDP per capita, achieved, according to Young’s calculation, by the Asian Tiger economies combining average rate of growth in total factor productivity with massive quantitative inputs of investment and labour, then in contrast Table 2 shows the world ranking of economies.

Table 2

Which economic variable is in practice decisive in determining real economic outcomes may be shown graphically by taking the case of by far the worst performing case of total factor productivity according to Young/Krugman’s account – Singapore.

Singapore, poorly performing in terms of total factor productivity, has today, in Parity Purchasing Power terms, the 5th highest GDP per capita in the world – a level 9% higher than the United States. Egypt, which is better performing in terms of growth of total factor productivity, ranks 101st in the world with a GDP per capita only 13% that of the United States. While the second ranking, from the point of view of total factor productivity growth, Pakistan ranks 130th in the world with a GDP per capital 6% that of the US.

In short, taking for arguments sake Young and Krugman's calculations as entirely correct, then the route to actual economic success, in terms of economic growth and a high living standard, lay in the average rate of increase of total factor productivity, combined with massive quantitative inputs of capital and labour, of Singapore rather than in the high total factor productivity, combined with far lower quantitative growth of inputs, of Egypt, Congo and Pakistan. Or, put in deliberately shocking terms, 'quantity' (growth of factor inputs) was much more successful in determining growth in GDP per capita than 'quality' (growth in total factor productivity)!

It is, of course, possible to have a rate of growth of total factor productivity that is so low (potentially a negative number) that even the greatest increases in quantitative inputs cannot produce viable growth – the USSR in its final period represents such a case. But the case of the Asian Tiger economies showed that provided close to average increases in total factor productivity can be achieved then quantitative increases were the decisive ones. Put formally, the evidence is that provided an average, or near to
average, rate of total factor productivity growth can be achieved then
ensuring very large quantitative inputs proved a more viable growth
strategy than aiming to maximise efficiency – i.e. total factor
productivity growth.This is simply the arithmetical outcome of multiplying the rate of growth of factor productivity by the rate of growth of inputs. The criteria which must decide the strategy chosen is therefore that which maximises the rate of growth of GDP per capita, not the abstract theoretical one of maximising rate of growth of factor productivity.

Turning to India and China this has an immediate practical consequence. It means that even if it were to be assumed, for the sake of argument, that the efficiency of their use of investment were average, or even somewhat below average, then they might well be right to concentrate on massive inputs – to take the Singapore route. That, in turn, evidently raises the question of whether investment in India and China actually is inefficient – which goes beyond the scope of the present article, but will be returned to in a future article. But it should be noted from the above that even if, for the sake of argument, it were assumed that Krugman and Young’s quantitative premises are correct then this does not constitute a valid argument, from the point of view of the key variable of maximising the rate of growth of per capita GDP, against the effectiveness of the growth model followed by either the South East Asian Tiger economies or current policies pursued by India or China.

As stated at the beginning of this article, in economics quantity in some cases may simply be more important than quality.

Notes

[1] The argument of all three papers by young and Krugman was that the rapid growth of the NICs was based on quantitative accumulation of inputs of labour and capital and not on any productivity growth that was remarkable by international standards. The same analysis was then applied to China in Young’s 2003 paper ‘Gold into Base Metals: Productivity Growth in the People’ Republic of China during the Reform Period’.

[2] Ideally, of course, a combination of the maximum level of efficiency of investment from the point of view of economic growth and the maximum level of inputs would be achieved. However, while this is optimal in a purely abstract theoretical model in practice it may be necessary to chose between the two. An evident case of this is heavily state influenced financial systems aimed to maximise savings, as for example existed in Japan and South Korea during periods of rapid growth, versus those which are aimed to maximise the efficiency of use of savings. General discussion of this point, however, goes beyond the scope of this article.

Krugman’s sincerity, good intentions, and factual knowledge were beyond dispute. He bluntly contrasted the new situation for rational discussion under the Obama administrations, in comparison to George W. Bush's, as the ‘difference between light and darkness’. Krugman’s overall economic perspective, with a major exception discussed below, was rather realistic – the format of a nearly one hour talk, followed by two hours of panel discussion and audience questions, giving considerably greater opportunity for detailed clarification than newspaper columns.

Krugman outlined his view that ‘probably’ the world economy would escape a 1930s type depression – noting that the fact he had to use the word ‘probably’ showed how serious the situation was. What he however considered possible, and feared, was a prolonged economic stagnation, or anaemic recovery, similar to the 1990s ‘lost decade’ in Japan. In such a perspective there would not be a 1929 type collapse in production but only a weak and protracted US recovery – i.e. a prolonged period of US economic stagnation. According to the latest survey by the Wall Street Journal such a perspective has now become the dominant view among US economists of diverse theoretical outlooks.

Krugman’s own argumentation for such a perspective was Keynesian – he restated Keynes was his ’god’. The present blog, in contrast, would not agree with such a line of reasoning – and would stress supply side factors rather than those rooted in demand stressed by Keynes. The reasons for this are that additions to effective demand are ineffectual rather than raising output, or merely produce inflation, if the appropriate conditions for increasing production do not exist on the supply side of the economy. This is not merely the case under the well known condition that spare capacity does not exist in the economy, in which case evidently increased demand cannot translate into increased output, but, in a private sector dominated economy, under conditions in which profitable increases in output cannot be undertaken. Nevertheless, analysing the supply side, then provided rational economic policies are adopted a 1929 style collapse, if not a significant period of relative economic stagnation in the US and Europe, should be avoidable.

The reason for this lies in the different state of the world economy today compared to 1929. In 1929 the US was not only the world’s largest economy but also its most dynamic. When the US financial system imploded in that year there was therefore no backstop to prevent the whole world economy being dragged downwards.

Today the world’s most rapidly growing economies are in Asia not in the US. India has the second most rapidly expanding economy in the world and is coming through the international financial crisis with a slow down in the rate of growth in GDP but no contraction of the type seen in the US and Europe. China’s savings, i.e. its finance available for investment, are as large as those of the US in absolute terms. Some other South East Asian states are continuing to grow – although a number, such as Singapore and Hong Kong, have suffered severely from the financial crisis. In short there is today an economic and financial backstop to the US, unlike in 1929.

These economically more dynamic Asian states are not large enough by themselves to propel strong overall world economic growth. China, India and the economies of the other South East Asian states taken together are still somewhat smaller than the US economy. But they are large enough, provided rational economic policies are pursued elsewhere, to prevent an international 1929 type collapse. Relative stagnation in the US and Europe, accompanied by growth in major parts of Asia, is therefore a realistic perspective for the world economy – even if the present author would arrive at that conclusion via a rather different perspective than Paul Krugman – Krugman did not outline his specific perspective for Asia. The proviso, however, is provided ‘rational’ policies are pursued and this is where the differences with Krugman developed in the debate.

Relative economic stagnation in the US and Europe, accompanied by still relatively strong economic growth in China and India, necessarily means a further shift in the economic relation of forces in favour of the latter two countries. From the point of view of the world economy and its recovery, or of increasing the standard of living of the two and a half billion people in these countries, of course, this is no problem. But it is for those who approach the financial crisis not via the angle of what is good for the world economy but from that of how to maintain the dominance of the US in the world. It is this which produces the danger of policies being pursued that are not economically rational.

The underlying problem in the world economy at present is that at its current rate of investment in GDP the US cannot compete, at anything like its present exchange rate, with the rising Asian economies. This is the cause of the well known US balance of payments deficit. US consumption has therefore been kept higher than its production via a massive borrowing from abroad that is ultimately unsustainable. The only way stabilisation can be achieved is therefore through a reduction in US consumption. This, in turn, can only take place through means that are either extremely painful for the US population in terms of reduced living standards (a reduction in the share of household consumption in GDP) or by means which probably involve reductions in US military spending (that is if a reduction in government consumption is not to take place in the fields of health and education). In short, to adapt the old phrase, the US can afford butter or guns but it can no longer afford both.

The attempts by the Obama administration to avoid this choice between butter and guns, that is to maintain both the high level of household consumption in US GDP, together with spending on health and education, while simultaneously refusing to cut the military budget has only been achieved through a radical reduction in US investment. But such a strategy is not viable in anything other than the short run as it undermines further the competivity of the US economy – the original cause of the crisis. The inescapable choice between butter and guns therefore still lies ahead for the US.

Paul Krugman, when questioned, however would not accept the importance of the low US investment rate. He also argued that in any case he could see no policy which could reverse this. He also stated the further decline in US investment was only due to the fall in residential investment under the impact of the sub-prime mortgage crisis.

First these statements are factually incorrect. While the decline in US investment certainly started in the residential sector, under the impact of the sub-prime mortgage crisis, the largest fall in US investment since the financial crisis started in September 2008 has been in non-residential investment. Between the third quarter of 2008 and the first quarter of 2009 US residential investment fell by 0.6% of GDP but non-residential investment fell by 1.6% of GDP i.e since the beginning of the international financial crisis 72% of the decline in the proportion of US GDP devoted to investment has been caused by a decline in non-residential investment and only 28% is due to a decline in residential investment.

These trends are shown in Figure 1, which graphs the decline in the components of US GDP as a percentage of total GDP since the third quarter of 2008, and in Figure 2 – which shows the decline in residential and non-residential US investment as a percentage of GDP over the same period. These trends make it clear that since the financial crisis broke out it is the decline in non-residential US investment, not in residential investment, that has been the driving force of the economic downturn.

Figure 1

Figure 2

Second, however, a decline in residential investment is by itself destabilising. It both reduces overall demand in the US economy and will be a contributory factor to macro-economic destabilisation created by future house price bubbles – such bubbles are due not only to excessive demand, due to excessively lax monetary policy, but to shortages in supply due to lack of investment in housing stock. This is clear from the experience of countries such as the UK, where house price bubbles have been worsened by shortage of supply, particularly in specific areas of the country such as London.

Third, contrary to Paul Krugman’s reply, it is evident that there are policies which could raise US investment. Shortage in US savings, accompanied by a balance of payments deficit, is simply another way of saying that the US is consuming more than it produces. Increased investment, financed from within the US, requires that the share of consumption in US GDP must be cut. As noted above that can either be done by reducing living standards, that is reducing household consumption, which presumably Paul Krugman would not want, or by reducing government consumption. Releasing resources in these ways would stimulate investment both via indirect means, ending the excessive calls on available resources leading to a reduction in interest rates, or via direct ones, the government for example increasing tax breaks for investment, or both. Therefore it is simply not true that there are no policies which would increase US investment.

What is true, however, is that such policies would require a change in the shape of the US economy. However that is precisely what is required – as it is the present unsustainable excess of US consumption over US production that led to the financial crisis. Maintenance of the present structure of the US economy merely means that the crisis will reappear even if the most immediate wounds are bandaged up through the financial stabilisation packages.

In short, the error of Paul Krugman’s perspective was that it underestimates the reshaping of the US economy that is required. This error is in line with the present policies of the Obama administration which, as discussed on previous posts on this blog, are also essentially maintaining the existing pre-crisis structure of the US economy. Whether or not the immediate US government packages stabilise financial markets, which remains to be decided, the fact that the underlying distortions of the US economy have not been resolved means that in the medium term, and possibly in the short term, various symptoms of the crisis will reappear.

The discussion with Paul Krugman in Shanghai was therefore enlightening not only from the point of view of its discussion of China but from the point of view of analysis of the US economy. It revealed Paul Krugman, together with the Obama administration, underestimates the scale of transformation which is required in the US economy.This misunderstanding by the Obama administration will doubtless have significant consequences in the months to come. Altogether a clarificatory event.