Rogoff: Rebalancing the US-China Economic Relationship

Kenneth Rogoff is worried that we’ll rebuild the same economy we had before the crisis and risk another financial meltdown:

Rebalancing the US-China Economic Relationship, by Kenneth Rogoff, Commentary, Project Syndicate: As the global economy stabilizes, there is a growing danger that the United States and China will slip back into their pre-crisis economic patterns, placing themselves and the rest of the world at risk. … Short-run stability certainly seems attractive right now. But if the US-China trade and debt relationship merely picks up where it left off, what will prevent recurrence of the same unsustainable dynamic that we just witnessed? After all, huge US foreign borrowing was clearly a key factor in creating the recent financial mess, while China’s excessive reliance on export-driven growth has made it extraordinarily vulnerable to a sudden drop in global demand.

A giant fiscal stimulus in both countries has helped prevent further damage temporarily, but where is the needed change? Wouldn’t it be better to accept more adjustment now in the form of slower post-crisis growth than to set ourselves up for an even bigger crash?

True, both the US administration and China’s leadership have made some sensible proposals for change. But is their heart in it? US Treasury Secretary Timothy Geithner has floated a far-reaching overhaul of the financial system, and China’s leaders are starting to take steps towards improving the country’s social safety net.

Both of these measures should help… Nevertheless, there is cause for concern. As the world seems to emerge from its horrific financial crisis, it is human nature for complacency to set in, and the domestic politics of the US-China trade and financial relationship is deeply rooted. …

Another reason to worry is that the global recovery is still fragile. US and Chinese leaders have fought the crisis with not only massive fiscal stimulus, but also deep intervention into credit markets. Such extraordinary fiscal largesse, all at taxpayers’ expense, cannot continue indefinitely.

World Bank President Robert Zoellick has rightly warned that all this massive temporary fiscal stimulus is a “sugar high” that will ultimately pass without deeper reforms. As I have argued before, the endgame to the financial bailouts and fiscal expansion will almost certainly mean higher interest rates, higher taxes, and, quite possibly, inflation.

For better or for worse, it may not be possible to turn back the clock. The US consumer, whose gluttony helped fuel growth throughout the world for more than a decade, seems finally set to go on a diet. …

Frankly, higher US personal saving rates would not be a bad thing. It would almost certainly help reduce the risk of an early repeat of the financial crisis. The obvious candidates to replace them are Chinese and other Asian consumers…? Outside Japan, Asia policymakers certainly don’t seem amenable to exchange-rate appreciation

Since the beginning of this decade, at least a few economists (including me) have warned that the global trade and current-account imbalances needed to be reined in to reduce the chance of a severe financial crisis. The US and China are not solely responsible for these imbalances, but their relationship is certainly at the center of it.

Prior to the crisis, there was plenty of talk, including high-level meetings brokered by the International Monetary Fund, but only minimal action. Now, the risks have spilled out to the entire world. Let’s hope that this time there is more than talk.  If US and Chinese policymakers instead surrender to the temptation of slipping back to the pre-crisis imbalances, the roots of the next crisis will grow like bamboo.  And that would not be good news for the US and China, or anyone else.

I think he gives himself a bit too much credit for foreseeing the crisis, the type of financial meltdown he and others predicted – a sudden unwinding of international imbalances – didn’t occur.

But the question is how much risk there is of a big international meltdown in the future, and this is what Rogoff is worried about. On that score:

Where’s the money coming from?, by Paul Krugman: The huge borrowing by major governments, the U.S. government in particular, has confused many people — and not just Niall Ferguson. What I hear again and again is either the assertion that all this borrowing must drive up interest rates, or worries that the Chinese won’t be willing to lend us the money.

We know as a matter of principle that these concerns are misplaced: if there were a shortage of savings, the economy wouldn’t be depressed. Indeed, one way to think about our current problem is that the world as a whole wants to save more than it’s willing to invest.

But it’s always nice to have some real-world data illustrating a principle. From Brad Setser, private and public borrowing in America, as a percentage of GDP:

setser.png

We’re actually borrowing less from foreigners than we were before.

Rogoff asks “where is the needed change?” We are already undergoing structural change, we have a smaller financial sector, a smaller housing sector, a smaller domestic automobile sector, and an increase in household saving. And though the actual degree of change that we will see in things like household saving is unknown, we will see permanent change. Thus, the type of structural reforms Rogoff would like to see are, in fact, underway already and they will continue. But because so much has to change – minor tweaks to the economy won’t be enough – it will delay the recovery relative to the more usual case when the economy is able to return to what it was doing before.

As the financial, housing, and domestic automobile industries shrink, resources and labor are freed up and become unemployed. They must, somehow, find their way into other sectors. Some have to move geographically, and that process can be lengthy. Building new industries that can absorb the idle resources takes time, rebuilding the financial sector, household deleveraging, one of this will happen overnight. (And it doesn’t help that, on top of all this, housing markets are notoriously slow to adjust so that the needed shrinkage and adjustment driving the structural change is itself a slow process.)

So the process will be slow. Does deficit spending to combat the recession slow this adjustment process down even further? Is Rogoff right that we’d be better off just letting things crash and burn so that the new and improved version can be rebuilt faster?

The economy is already changing as described above, and in other ways too, and it is doing so about as fast as it can. Any faster than this, which would involve even more unemployment and more stagnation of resources and the economy, more ensuing foreclosures, etc., and we’d risk undermining the very foundation we want to rebuild upon. Structural change and social programs to help people who are struggling due to poor economic conditions are not at odds with each other, and infrastructure spending supports rather than hinders future growth and change.

We will get the change we need, it’s underway already, and that change does not require the government to sit by idly while people struggle with the poor economic conditions. Worries about inflation and high interest rates, and about the negative effects of higher taxes on those who can more than afford them are overblown. Those worries should not stand in the way of extending a compassionate hand to the struggling, or to spending money to stimulate the economy and build the social and physical infrastructure we need to support robust economic growth in the future.


Originally published at Economist’s View and reproduced here with the author’s permission.

One Response to "Rogoff: Rebalancing the US-China Economic Relationship"

  1. nfrazier   June 15, 2009 at 9:43 am

    The classic policy biases for managing an investment bust might be classified as permanent conservative austerity and permanent liberal stimulus. It is not clear that either extreme optimizes the long term growth of a post investment boom economy. Obviously, these two policy extremes throw out a large number of policy pathways in between.Consider the following pathway for example. At the beginning of a crisis, the discontinuous fall in private investment is offset with a discontinuous rise in public investment. This prevents the shedding of excess capacity from overshooting (and thus having to rebuild some of it later) and provides resources to those that are proactively restructuring (and thereby facilitates their doing so).It might be optimal to subsequently and gradually taper the stimulus and eventually even allow the economy to adjust to a small primary fiscal surplus. This would provide incentives for continued restructuring, force any residual stubborn excess capacity out of the system, and allow asset prices to settle to their longer term equilibrium values sooner. The absence of excess capacity and propped up asset prices would then free the economy from its extreme vulnerability to further economic contractions. The absence of this fiscally draining excess capacity would also enable the economy to return to fiscal sustainability as well. Increasing the retirement age, shortening the work-week, and job-sharing could lessen the subjective pain of the adjustment and improve political stability during the transition.There is of course the risk that this will create a positive feedback loop of falling prices and hoarding of cash at some point. It may become necessary therefore to give the economy one final jolt of fiscal stimulus to break the liquidity trap at the end of its period of restructuring.Unlike so many historical approaches to severe recessions, this approach suggests a less dogmatic adherence to policy extremes that ultimately lead to the further imbalances and crises that seem to tragically prolong and deepen such adjustments. Instead, the above policy provides for one deep U-shaped recovery in which it asymptotically approaches equilibrium relatively quickly*, regains robust fiscal health, and break frees of any temporary liquidity traps.** If the global economy’s heroine is US debt, then Keynesian stimulus is its temporary methadone treatment – nothing more.While there almost certainly is a glut of savings relative to risk-free investment opportunities today (a likely side effect of excessive performing debt and broken growth speed limits…), one might still argue that this will not always be the case. Researchers, entrepreneurs, and managers could continue to innovate. Developing nations could continue to reform their political systems, legal infrastructure, and macroeconomic policies. Populations could continue to grow. The buying power of today’s savings might thus be retained for investment in such opportunities when they materialize in the future. This would seem to be the best policy for long-term growth. (As a technical issue, the post-tax hurdle rate of return on CAPEX may need to be raised in some older economies and the subsequent revenue reinvested in R&D if the pre-tax long-term real cost of capital is to remain above levels that lead to liquidity traps…)So much for theory. The longer term real world issue may be China’s centrally planned and non-democratic political economy – one that will soon become the world’s largest. This has contributed to trade imbalances today. In the future, it could create excess industrial capacity and an insolvent rural migrant consumer. This in turn could lead to a political upheaval. Ultimately, China may learn to become more democratic and decentralized. But how shall the world prepare itself for the resulting economic dislocations that occur along the way over the next 30 to 60 years?Since the rest of the world has little control over China’s political, legal, and fiscal practices (other than pointing out that systemic health is in everyone’s best long-term interest), this suggests that the rest of the world should retain even further savings for future downturns (e.g. via pursuit of fiscal sustainability after the current adjustment). If trade imbalances continue to exist even after attainment of fiscal sustainability in the US, the US, EU, and Japan might consider a coordinated and gradual revaluation of the yuan afterword (depending upon China’s interest rates, rate of industrialization, domestic wage inflation, tax bracket compression, fiscal balance, reduction in structural impediments to imports, improvement in patent law protection, current account balance, etc, etc).*compared to the great depression or Japan’s lost decade**It may be an open question as to whether or not static inflation targeting paradoxically steers some economies near a liquidity trap and then “holds them there” until the inflation target is allowed to temporarily adjust downwards for a finite period.