Regular Insights blogger Brian Keeley is in Beijing, from where he sends this post.
You can sum up the hottest question on China’s economic future in just four words: Hard or soft landing.
At the moment, most people seem to think China’s economy isn’t about to hit a brick wall. Yes, the phenomenal growth rate since the 1990s is slowing, but it’s still at a level most mature economies would envy. After a decade in which GDP rose by at least 9% a year, it slipped back to “only” a bit above 8% by the end of last year, according to the OECD. For the next decade, the OECD forecasts annual growth will hover at around 7%.
To some extent, such a slowdown is inevitable as any economy matures – after all, you can only build so many roads, bridges and airports. But some fear it could be a sign of worse things to come – in other words, the much-feared hard landing. As China is now in many ways the engine of the world economy, that would be bad news not just for Beijing but for the rest of us too.
These questions on the mind of speakers at last weekend’s China Development Forum in Beijing, not least that of Dr. Nouriel Roubini – the economist whose all-too accurate forecasts in the run up to the financial crisis earned him the nickname “Dr. Doom”. Given his track record, it probably wasn’t surprising that he saw a hard landing as “possible” but, he insisted, “not inevitable”. To guard against it, he argued, China must undertake economic reforms, most notably to encourage Chinese to spend more and save less.
Dr. Roubini pointed out that China was the only major exporter to avoid a recession in the wake of the financial crisis. That was due in large part to massive programme of investment in things like infrastructure and property development. But, he warned, that’s not sustainable. Indeed, to some extent, the chickens from this spending are already coming home to roost, most notably in falling property prices and signs of a credit crunch as a result of loose lending.
Combine this with weaker demand in China’s export markets, most notably in Europe, said Dr. Roubini, and it’s inevitable that “the model of growth has to change”. That makes reforms essential, he stated, and those reforms must aim to turn the Chinese consumer into a much more powerful driver of the country’s economy.
So, why do Chinese prefer to save rather than spend? There are many reasons, but one of the most important is the lack of an adequate social security net. Fall ill or lose your job in China, and you quickly realize the benefits of having a few yuan under the mattress. There’s a similar problem when it comes to pensions, a major concern for China’s ageing population; the one-child policy means many elderly parents and grandparents will have to rely on just one or two breadwinners for support.
Another factor is China’s currency, which is widely perceived as undervalued, although there’s debate over the scale of this. A relatively weak currency is good for China’s exports, but it makes imports more expensive than they should be, further weakening Chinese consumers’ spending power.
The valuation of the yuan is controversial, but in many respects much of what else Dr. Roubini had to say is not. Just last week, China’s outgoing Premier, Wen Jiabao, said the need for reforms was urgent, while China’s most recent five-year plan focuses a lot of attention on expanding the social security net and on reducing inequality.
Such concerns have been widely echoed in OECD work and were repeated again at the weekend in Beijing. Speaking at the forum, OECD chief Angel Gurría called for a bigger share of profits from state enterprises to go on social spending, and for more resources to go on education and training. Such measures would deliver both short and long-term benefits for workers and the economy, not least in the form of a more highly skilled workforce.
Encouragingly, there may already be some signs that China is beginning to rebalance its economy towards a greater dependency on domestic demand. An OECD report released at the forum pointed out that real household incomes rose by 10% in 2011 (and by more in the countryside), while the share of overall consumption in GDP increased for the first time in a decade, albeit only slightly. Nevertheless, there’s no question that the task ahead will be challenging. As Yang Weimin, a vice-minister for economic policymaking, stated at the forum, “these things cannot be achieved overnight”.
The OECD’s Chinese-language site – 网站 (中文)
In your baseline scenario, GDP growth across the OECD countries is projected to slow from 1.9% this year to 1.6% in 2012, before recovering to 2.3% in 2013. In some economies, especially the euro area, a mild recession is projected in the near term. Why are you so pessimistic?
The global economy has deteriorated significantly since our previous Economic Outlook. Advanced economies are slowing and the euro area appears to be in a mild recession. Concerns about sovereign debt sustainability in the European monetary union are becoming increasingly widespread. Recent contagion to countries thought to have relatively solid public finances could massively escalate economic disruption if not addressed. Unemployment remains very high in many OECD economies and, ominously, long-term unemployment is becoming increasingly common.
Emerging economies are still growing at a healthy pace, but their growth rates are also moderating. In these countries falls in commodity prices and slower global growth have started to mitigate inflationary pressures. More recently, international trade growth has weakened significantly. Contrary to what was expected earlier this year, the global economy is not out of the woods.
What factors underpin this assessment?
Deleveraging in the financial and government sectors remain with us. Likewise, imbalances within the euro area, which reflect deep-seated fiscal, financial and structural problems, have not been adequately resolved. Above all, confidence has dropped sharply as scepticism has grown that euro area policy makers can deal effectively with the key challenges they face. Serious downside risks remain in the euro area, linked to the possibility of a sovereign default and its cross-border effects on creditors, and loss of confidence in sovereign debt markets and the monetary union itself.
Another serious downside risk is that no action will be agreed upon to counter the pre-programmed fiscal tightening in the United States, which could tip the economy into a recession that monetary policy can do little to counter.
If this is the “baseline” scenario, are the others?
Alternative scenarios are possible, and may be even more likely than the baseline. A downside scenario would be characterised by materialisation of negative risks and the absence of adequate policy action to deal with them. An upside scenario could arise if policy action were successful in boosting confidence and no significant negative events occurred.
In the downside scenario, the implications of a major negative event in the euro area depend on the channels at work and their virulence. The results could range from relatively benign to highly devastating outcomes. A large negative event would, however, most likely send the OECD area as a whole into recession, with marked declines in activity in the United States and Japan, and prolong and deepen the recession in the euro area.
Unemployment would rise still further. The emerging market economies would not be immune, with global trade volumes falling strongly, and the value of their international asset holdings being hit by weaker financial asset prices.
What would be required for an upside scenario to materialise?
A credible commitment by euro area governments that contagion would be blocked, backed by clearly adequate resources. To eliminate contagion risks, banks will have to be well capitalised. Decisive policies and the appropriate institutional responses will have to be put in place to ensure smooth financing at reasonable interest rates for sovereigns. This calls for rapid, credible and substantial increases in the capacity of the European Financial Stability Facility together with, or including, greater use of the European Central Bank’s balance sheet. Such forceful policy action, complemented by appropriate governance reform to offset moral hazard, could result in a significant boost to growth in the euro area and the global economy.
An upside scenario also requires substantial and credible commitment at the country level, in both advanced and emerging market economies, to pursue a sustainable structural adjustment to raise long-term growth rates and promote global rebalancing. In Europe, such policies are also needed to make progress in resolving the underlying structural imbalances that lie at the heart of the euro area crisis.
Deep structural reforms will be instrumental in strengthening the adjustment mechanisms in labour and product markets that, together with a robust repair of the financial system, are essential for the good functioning of the monetary union. By raising confidence, lowering uncertainty and removing impediments to economic activity, rapid implementation of such reforms could raise consumption, investment and employment.
If combined, stronger macroeconomic and structural policies might raise OECD output growth by as early as 2013. The largest benefits would be felt in the euro area, though these could take some time to emerge. Stronger activity and trade, and the consequent rise in asset values in the OECD economies, should boost activity in the emerging market economies as well.
What is your advice to policy makers?
In view of the great uncertainty policy makers now confront, they must be prepared to face the worst. The OECD Strategic Response identifies country-specific policy actions that need to be implemented if the downside scenario materialises. The financial sector must be stabilised and the social safety net protected; further monetary policy easing should be undertaken; and fiscal support should be provided where this is practical. At the same time, stronger fiscal frameworks should be adopted to reassure markets that the public finances can be brought under control.
The difference between the upside and the downside scenarios reflects the impact of credible, confidence building policy action. Such action, as we have seen, requires measures to be implemented at the euro area level as well as at the country level throughout the OECD, especially in the structural policy domain. In the case of a downside scenario, policy action would clearly be needed to avoid the worst outcomes. But then the question arises of why policy efforts are not taken to deliver the upside scenario even if the worst case does not materialise. Why, in other words, should we settle for less?
The mathematician Stanislaw Ulam did not have a high opinion of the social sciences. He once challenged Paul Samuelson, Nobel laureate in economics, to name one social science proposition that was both true and non-trivial. Samuelson nominated comparative advantage: “That this idea is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.”
Samuelson was right. The absolute advantage Adam Smith talks about is simple and intuitive: it makes obvious sense for France to export wine to Scotland and import Scotch whisky. Comparative advantage is much more complicated. Ricardo introduced the notion in his 1817 book On the Principles of Political Economy and Taxation, using the example of England and Portugal and the production of cloth and wine. Portugal is more productive than England in both. Intuitively, you’d say that it makes sense for Portugal to export both, and that English industry would have little to gain from trade.
However, no country can develop a comparative advantage in everything because comparative advantage is a concept of the relative costs of doing things, so some things have to be comparatively more or less advantageous. Moreover all countries must have a comparative advantage in something. (You can find a good explanation of why this is the case here).
Ricardo demonstrated numerically that in fact if England specialised in one of the goods and Portugal in the other, total output of both goods would rise, allowing both countries to gain from trade.
Two centuries after Ricardo, can comparative advantage still provide useful guidance to policy makers? A new working paper from OECD’s Przemyslaw Kowalski argues that it can. Kowalski looks at what determines comparative advantage today, as part of the OECD project on The Effects of Globalisation: Openness and Changing patterns of Comparative Advantage. Kowalski analyses the bilateral trade of 55 OECD and selected emerging market economies and 44 manufacturing sectors covering the entirety of merchandise trade He examines physical capital, human capital, financial development, energy supply, business climate, and labour market institutions as well as import tariff policy.
Comparative advantage is still an important determinant of trade, but the OECD countries’ economies are more similar than they used to be, so the possibilities of trade driven by comparative advantage differences within the OECD grouping aren’t as great as they once were. However there are still marked differences between OECD and non-OECD countries, while the differences among non-OECD countries don’t seem to be diminishing much. That means that comparative advantage is more important for North-South and South-South trade than for North-North trade.
If you look at OECD and non-OECD countries as a whole, it’s interesting to see where differences have been decreasing and increasing. these differences decreased (although there are still big variations) as regards physical capital, average years of schooling, tertiary education, primary energy supply, and availability of credit. On the other hand, cross-country variation increases for regulatory quality, rule of law, control of corruption as well as import tariffs.
Most of these factors can be influenced significantly by policy. The trick is to make sure that trade and other policies don’t cancel each other out, but with so many factors interacting it’s not easy. Luckily for government policy makers, help is at hand from this year’s Nobel laureates in economics, Thomas J. Sargent and Christopher Sims.
Working separately, but in a complementary fashion, they’ ve developed methods for analysing causal relationships between economic policy and what happens in the economy. Sargent has mainly studied the effects of systematic policy shifts – such as attempts to reduce fiscal deficits – while Sims looks at how shocks spread through the economy.
Even if you’re one of those important and intelligent men who can’t grasp comparative advantage, you can probably see why the Sveriges Riksbank gave Sargent and Sims the prize this year.
Globalisation, Comparative Advantage and the Changing Dynamics of Trade collects OECD work that builds on recent contributions to the theory and empirics of comparative advantage, emphasising the role of policy in shaping trade. Click on the image to find out more and browse the book.
Last week, we reported on the latest OECD Economic Outlook. Writing in the New York Times, Paul Krugman was highly critical of the Organisation’s analyses and policy recommendations. Here we summarise Krugman’s argument and the reply by OECD Deputy Secretary-General and Chief Economist Pier-Carlo Padoan.
Krugman argues that the most ominous threat to the still-fragile economic recovery is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.
He contrasts this with actions taken when the financial crisis first struck, and most of the world’s policy makers responded by cutting interest rates and allowing deficits to rise.
He goes on to say that “The extent to which inflicting economic pain has become the accepted thing was driven home to me by the latest report on the economic outlook from the Organization for Economic Cooperation and Development… what [the OECD] says at any given time virtually defines that moment’s conventional wisdom. And what the OECD is saying right now is that policy makers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.
What’s particularly remarkable about this recommendation is that it seems disconnected not only from the real needs of the world economy, but from the organization’s own economic projections.”
His demonstration is as follows. The OECD declares that interest rates should rise sharply over the next year and a half to head off inflation, but inflation is low and declining, and OECD forecasts show no hint of an inflationary threat.
The reason the OECD wants to raise rates is in case markets start expecting inflation, even though they shouldn’t and currently don’t.
Likewise, although the OECD predicts that high unemployment will persist for years, it asks that governments cancel any further plans for economic stimulus and that they begin fiscal consolidation next year.
Krugman insists that both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because a weaker economy depresses tax receipts, wiping out any gains from governments spending less.
Moreover, the reasons for doing this don’t hold. Investors aren’t worried about the solvency of the US government and interest rates on federal bonds are near historic lows. And “even if markets were worried about U.S. fiscal prospects, spending cuts in the face of a depressed economy would do little to improve those prospects”.
This contrasts with the OECD’s calls for cuts because inadequate consolidation efforts “would risk adverse reactions in financial markets.”
Krugman is worried that this view is spreading, citing the case of “conservative members of the House, invoking the new deficit fears, [who] scaled back a bill extending aid to the long-term unemployed… many American families are about to lose unemployment benefits, health insurance, or both — and as these families are forced to slash spending, they will endanger the jobs of many more.
He concludes by stating that “more and more, conventional wisdom says that the responsible thing is to make the unemployed suffer. And while the benefits from inflicting pain are an illusion, the pain itself will be all too real.”
In reply, Padoan starts by saying that they differ on the strength of the recovery, with the OECD more optimistic than critics of the Outlook. Unemployment will take time to fall to acceptable levels, but this will be underway by 2011. A double-dip recession cannot be ruled out, but is not very likely. The risks of running big fiscal deficits and a zero interest rate monetary policy are rising.
Recent events in Europe are a warning sign and even though the US has the world’s biggest capital market, the risks are shifting. In this unsettled financial environment, governments need to get out ahead of markets, because otherwise they will be hostage to them.
On inflation, he argues that it is not a risk today, but could be in two-years’ time. Monetary policy needs to be forward looking and this means easing up on monetary stimulus in anticipation.
“To be clear, we are not arguing for contractionary policy, but for progressively less stimulus. In fact, stimulus should not be withdrawn completely until the economy returns to full employment. But the process should be started fairly soon, to take into account the well known long and variable monetary policy lags.”
How quickly interest rates should rise depends on many things, especially inflation, inflation expectations and the pace of growth. It also depends on fiscal policy, which influences growth.
“All else equal, if fiscal policy turns out to be tighter than in our projection, then monetary policy should be looser to compensate.”