The past ten years saw the clash between China’s semi-command saver economy and the market economies of the West. Interaction between supply and demand for goods, services, factors of production, and assets has been polarized on a global scale. Inflation or deflation in the modern world has to be analyzed in the framework of the balance between global demand and supply.
The low-inflation decade that preceded the overheating of 2007 and early 2008 gave central bankers God-like status. But they fell seriously behind the curve by failing to grasp the profound global changes at play and their implications for economic, financial, and price developments. The central bankers’ mistakes could cost the world a dangerous lurch into deflation.
The surge in global consumer price inflation in 2007 and most of 2008 caught many by surprise. The low-inflation decade that preceded this overheating had given central bankers God-like status. But improved monetary policy had at best a supporting role in the global Goldilocks story. The protagonist was the Eurasian savings glut. The setting was the process of globalization. Central bankers across the world fell seriously behind the curve by failing to grasp the profound global changes at play and their implications for economic, financial, and price developments. Their mistakes could cost the world a dangerous lurch into deflation.
The past ten years saw the global clash between China’s semi-command saver economy and the market economies of the West. China’s supersonic expansion turned it into the manufacturing hub of the world. But final demand for manufacturing goods came from the developed borrower countries. China provided the world with an endless supply of low-cost labor and mispriced, cheap capital. Developed countries provided most of the supply of real and financial assets. Interaction between supply and demand for goods, services, factors of production, and assets has been polarized on a global scale. Globalization did not alter the nature of inflation. But inflation in the context of the modern world has to be analyzed in the framework of the balance between global demand and supply.
The Impact of China’s Economic Expansion
China’s reawakening has transformed the global economy. For many centuries it was the world’s greatest. Chinese steel production in 1066, using blast furnaces, exceeded Britain’s in 1866. But China ignored the 18th and 19th century Industrial Revolution. It then failed to tackle its 20th century weakness, culminating in the 30-year economic catastrophe of Mao’s leadership. Since 1978, China has gone down the export-led, catch-up path pioneered by Japan and Korea, with a similar annual growth rate of almost 10%. Growth of GDP per capita at purchasing power parity averaged a huge 12%, meaning the standard of living doubled every six and a bit years. In 2007 China was the second largest manufacturer, after the United States. Much of China’s manufacturing is low value-added assembly, where China now dominates both global output and capacity.
While China was fast becoming the world’s manufacturing powerhouse, the emergence of the Chinese consumer remained a chimera. Final demand for manufacturing goods came from the developed, especially the borrower, economies. The reason is that China saves excessively out of its income, more than a half. This negates the possibility of a mass consumer market. Savings are high for structural reasons. These reasons include the lack of universal social security, pension provision, and poor health care; the one-child policy, which has destroyed family security; migration into cities, which has broken up families; and limited financial products to channel savings between the old and the young, or into the private corporate side of the economy.
Instead, China provided the world not only with what seemed like an endless supply of low-cost labor, but also with mispriced, cheap capital. China’s high savings cannot be invested profitably in the domestic economy. In a command economy they have no need to be. Profitability and return on capital are irrelevant. Instead, command economies are incredibly good at wasting savings through misallocating investment. China can waste its excess savings either domestically or abroad.
In the first half of this decade its excess savings went into a massive domestic investment boom. There was a huge buildup of excess capacity. The mainly state-owned banking system played an instrumental role in this. It has the bulk of the domestic savings, and the bulk of its lending goes to state firms and local governments. It is not done according to market principles and proper credit risk assessment. State banks are unwilling or unable to provide much finance to private firms or households. Access to cheap money gave state firms an unfair competitive advantage over private firms. But for private firms, China’s incorporation into the global economy, especially since its entry in the World Trade Organization (WTO) in 2001, was a boon, providing both the markets and a source of funds. Moreover, Beijing kept its exchange rate fixed to the dollar and the capital account closed.
Unsurprisingly, overinvestment and a pegged currency led to falling global manufacturing goods prices. Meanwhile, energy and commodity prices surged on the world market as China’s production was extremely energy-inefficient. But this was not reflected in the price of manufacturing goods because Beijing does not allow domestic energy prices to be set by the market. Ultimately, China could not escape the business cycle. By mid-2004 it had run into severe energy and transport shortages, which curbed its investment frenzy. Over the next two years domestic demand growth slowed significantly. China was still saving excessively, but now it had to find another channel to waste the savings—this time exporting them to the Americans. The yuan–dollar peg had also forced the Tigers and Japan, which had excess savings for their own reasons, to do the same.
China’s current account surplus surged. Beijing was investing its huge savings in low-risk, low-yield dollar assets, and so did most of the other Asians. Globally this led to a collapse in real yields. But while China was providing the world with the excess savings, developed countries provided most of the supply of real and financial assets. In simplistic terms, when the huge population of China was bolted onto the global economy, the demand for assets shot up. Naturally, the supply of assets shot up in response. The booms in real estate and in mergers and acquisitions in the borrower economies were an expression of that. They were also the source of yet another boom—that of a purely financial type of asset: the asset-backed security and its derivatives.
Bankers Failed to Curb an Overheating Market
Unfortunately, central bankers across the world fell seriously behind the curve by failing to grasp the profound global changes at play. In the developed countries they believed that globalization meant a change in relative prices. Eventually, they started to talk about China “exporting deflation” and then “exporting inflation.” But in terms of their remit, their focus remained firmly at home. They failed to realize how manufacturing prices were set globally; where the “low bond yield conundrum” came from; and why the surge in energy prices did not translate into higher domestic wage inflation. Importantly, they did not pay attention to money and asset price developments.
But the harbingers of the global overheating that began in 2006 came in the form of above-trend broad money growth and asset price inflation. Central banks in the developed economies ignored their message and kept policy rates too low for too long, spawning asset price bubbles and the buildup of excessive debt. The Chinese authorities also made a mistake. They allowed some appreciation of the yuan versus the dollar, but in effective exchange rate terms the yuan was up by a lot less as Beijing was taking advantage of the stronger euro and stronger growth in euroland. Beijing thought the yuan–dollar peg was serving China well. The economy industrialized at breakneck speed, and international influences were kept at bay. The authorities failed to realize that China could no longer be immune to global developments. If Beijing did not allow the exchange rate to appreciate, inflation had to accelerate.
By 2006 most developed and developing economies were overheating. At the start of 2008 the global economy was still operating above its capacity, but the developed and the developing economies had distinctly different cyclical positions. The borrower economies’ ability to take up debt was exhausted. The trigger was the emergence of the US subprime mortgage problems in early 2007. This caused global risk-aversion to surge, leading to a global liquidity crunch, followed by a fundamental failure of the banks’ funding model, and severe de-leveraging. By the middle of 2008 most developed economies were already operating below capacity—the United States, the United Kingdom, and Japan—or close to their capacity in the case of euroland.
However, most developing economies, led by China and India, were still operating above capacity. Their overheating and the oil and commodity bubbles, which were stoked by investment demand and the Fed’s misguided early slashing of policy rates, exacerbated the hit from the credit crunch. Developed economies saw cost-push inflation cutting into real incomes. But spare capacity in their economies suggested that a wage-inflation spiral like the 1970s was unlikely to ensue. For the borrower economies this meant they could not rely on inflating away their excessive household debt. The workout had to involve rising defaults, domestic demand deflation, currency depreciation and falling asset prices. The borrower economies, with the most conspicuous big ones being the United States, the United Kingdom, and Spain are in for a prolonged period of significantly below-trend growth.
About 60% of Western Europe and Japan does not suffer from excess household debt. But these countries have been primarily export-led and are also in for a sharpe cyclical growth correction. Both the developing and the developed countries are likely to see headline inflation start to ease sharply in 2009 as the oil and commodity bubbles burst. While lower headline inflation will not help revive the battered consumer in the excess debt countries, where any increase in real income is likely to be saved rather than spent, it could help kick-start a domestic demand recovery in the countries where excess debt is not a problem. Lower interest rates should also lend support. But in both of the borrower and saver economies, willingness to boost public spending substantially will be needed to pull them out of the doldrums in 2010.
In terms of the overall global story, China is crucial. It seems that slumping external demand has finally pulled the rug from under China’s expansion. The crucial question is how drastic the externally driven slowdown is set to be. Ever since China joined the WTO, external demand has provided the main genuine source of final demand. The share of exports in output was 36% in 2007. But the share of exports tells you about the composition of output, not about the cause of growth. To determine the cause of growth one has to look at the change in the shares of output of the various expenditure components.
Exports were indeed a key growth driver in the early stages of China’s boom. Over the past two years consumer spending has taken over. But the increase in the propensity to consume came on the back of strong export income growth and accelerating wage inflation in the context of overheating. Going forward, with incomes hit and unemployment on the rise, it is difficult to see the Chinese consumer becoming an independent source of final demand. Moreover, the change in investment is determined by the change in the growth of demand, making investment the most volatile component of output. In China the share of investment in output remains ridiculously high at 40%. Consequently, slumping external demand should present a serious hit to China’s economy.
By the middle of 2009 the global economy is likely to be operating significantly below its potential, pointing to severe disinflation—in other words minimal rises in core prices. For the medium term, China’s policy choices will be crucial for the world. China is currently at a major crossroads. The positive path is turning into a fully fledged market economy that allocates its savings efficiently, whether domestically or abroad, and invests its wealth and savings in search of high returns. This involves reforming the banking sector, allowing the yuan to move freely, opening up the capital account, and supporting consumer spending.
The negative path is a return to the bad old ways—state resources thrown into wasteful domestic investment to counteract the global downswing. Public infrastructure spending is the least bad option, but you cannot turn the state spending tap on fast. The worst option will be to force banks to lend support to the struggling manufacturing sector. If Beijing goes for a state-directed investment binge that boosts manufacturing capacity and production when global consumer demand is flagging, there is even the possibility that price deflation—a sustained fall in the price level—could rear its ugly head.