Chimerica Cliff Notes

Sometimes, the best thing a blogger can do is provide a condensed version of another post or article. In this tradition, here is an edited version of Michael Pettis' recent column in the Far Eastern Economic Review. If you want to understand the economic relationship between China and America - the history, the issues, the stakes, and the choices - this is the article to read.

First, we have (yet another) rundown of how Chinese government policy helped create massive American debt:

China runs a massive trade surplus with the U.S. and, in recycling this surplus, [lends a lot of money to America]...It is impossible for either country to adjust [this imbalance] without a major counterbalancing adjustment from the other, but it is far from clear that policy makers on either side, especially in China, have a clear grasp of the issue. The result is likely to be a steep drop in global growth, much of it borne by China, and possibly even a collapse in global trade...

Until recently, excess U.S. demand and excess Chinese supply were in a temporarily stable [equilibrium]. As part of running a trade surplus, China necessarily accumulated dollars, which had to be exported to (invested in) the U.S. This capital export did not occur in the form of private investment—indeed it was exacerbated by Chinese net imports of private capital—but rather as forced accumulation of foreign-currency reserves, which were recycled back to the U.S. largely in the form of purchases of U.S. Treasuries and other dollar assets by China’s central bank, the People’s Bank of China. Since China had effectively pegged its currency to the dollar, the PBoC had no choice but to accumulate reserves in this manner...

In the U.S. the torrent of [cheap money] boosted real-estate and stock-market prices...[U.S. households] became increasingly willing to divert a rising share of their income to consumption...With banks eager to lend, and households eager to [borrow against] their assets in order to fund consumption, it was only a question of time before household borrowing ballooned.

Meanwhile in China, as foreign currency poured into the country via its trade surplus, the [central bank] had to create local money with which to purchase the inflow. In China most new money creation ends up in banks, and banks primarily fund investment rather than consumer spending. With investment surging, industrial production grew faster than consumption...Chinese [productive] overcapacity was matched with American overconsumption, and Chinese official lending was matched with U.S. household borrowing...

[I]t is often the [large and open] U.S. [economy] that absorbs imbalances originating elsewhere.

Pettis fails to mention the role in this of the Republican Party, who forced the government to borrow massive amounts of money in order to fund a bigger military and avoid tax increases. But the story is basically right.

Next, we get a little historical perspective:

For most of last 60 years, with two exceptions, the U.S. current-account surplus or deficit has remained within 1% of GDP. The first exception occurred in the mid-1980s, when the deficit rose to nearly 3.5% of GDP in 1986-87 before declining...The second...took off in 1997-98, after which time it raced forward in a straight line to peak at around 6% of GDP.

If the U.S. trade deficit were driven simply by a U.S. consumption binge, as is often claimed, it is hard to see why it would have followed a pattern of general stability over many decades marked by two surges–a small one from 1984-88 and a very large one after 1997. If it was driven by changes in Asian savings and trade policies, this pattern becomes easier to understand. The 1980s surge was driven largely by domestic Japanese policies and conditions...but it is the post-1997 surge that is much more interesting and relevant to the current crisis...

To protect themselves from a repeat [of the 1997 financial crisis], many Asian governments engineered trade surpluses and began amassing large foreign-currency reserves by managing trade policy and the value of their currencies...

As Asian trade surpluses and net capital exports surged, some other part of the world had to [balance] these adjustments by running large trade deficits...The U.S. did exactly this, and the U.S. trade deficit soared after 1997, while at the same time U.S. household savings collapsed.

Again, Pettis leaves something out - in this case, the fact that China didn't have a financial crisis in 1997-8. Most of the dollar reserves bought by Asian exporters since '97 have gone to China, as Pettis acknowledges. It seems likely that China had some other motive for building up its reserves, but that motive is a story for another day.

Next, we get a picture of where the U.S.-China economic and financial relationship is headed:

Now the party is over. The old balance of payments has broken down, and the world is lurching to find a stable new balance. One necessary consequence of the financial crisis must be an increase in U.S. household-savings rates. Collapsing real estate and stock markets have caused household wealth to decline sharply, and households must save more than ever out of current income to replenish their wealth. But even if consumers wanted to continue spending, American commercial banks–caught in one of the worst credit crunches in recent history–are no longer willing to lend for consumption. The U.S. household savings rate has nowhere to go but up...

Although we can’t say for sure, it is probably safe to argue that U.S. savings rates will climb back at least to earlier average levels, or even temporarily exceed those levels, as American households rebuild their shattered balance sheets. If they return only to 8%, the midpoint of earlier savings rates...household consumption must decline by at least [6% of GDP].

Something must happen to [balance out] this decline in U.S. household consumption. Either consumption in other sectors of the U.S. economy–i.e., the government, since businesses are also contracting–must expand by that amount, or consumption by foreign countries, with China bearing the brunt, must expand by that amount...To the extent that neither happens, global overproduction–which consists mainly of Chinese overproduction–must decline by that amount...

Today China is facing a similar problem [to that of the U.S. in the Depression]. With the collapse of bank[s], U.S. households and businesses are cutting consumption and raising savings. This is a necessary adjustment...If declining U.S. private consumption is met with increasing public consumption [from a huge stimulus], the world will simply continue playing the game that has already led into so much trouble. The only difference would be that instead of having one side of the global imbalance accommodated by private over-consumption and rising debt, it would be accommodated by public overconsumption and rising debt. [Instead,] demand must be created by the trade-surplus countries that have, to date, relied on net exports to protect themselves from their overcapacity. They must force demand up quickly in order to close the gap, and since expecting [Chinese] private consumption to rise quickly enough is unrealistic, it has to be [Chinese government] consumption...

[However,] Beijing already seems to be in the process of defending its ability to export overcapacity. Although there has been an attempt to boost fiscal spending, most analysts argue that this so far has been too feeble to matter much. On the other hand it has tried to protect and strengthen its export sector by lowering export taxes and reducing interest costs, which lower the financing cost for producers and have little impact on consumers.

This cannot work for long...If [China tries] to export their way out of a slowdown, there will almost certainly be [a] trade backlash, in which case [China will experience a severe Depression].

In other words, if China tries to avoid raising consumption, and just tries to boost exports back up by keeping the yuan cheap and subsidizing its exporters, then either A) the imbalances will get worse until we hit a breaking point, or B) the U.S. and Europe will go into Protectionist Mode and throw China into a Depression similar to what Europe threw us into in the 1930s.

We can rail against Western protectionism now, and maybe even halt it. But if China keeps boosting its exports and we keep going into debt, we will reach a point where protectionism becomes too strong to stop. And that will be a worse point than where we are now.

Pettis' solution to the problem is the same as that promoted by Krugman, Yglesias, and Avent: make a deal with China where they spend a bunch to raise consumption. The thing is, what do we have to offer China in such a deal?

As I see it, we have only one thing to offer: NOT to put up trade barriers. Because if we do let slip the dogs of protectionism, China will suffer far worse than we do. So it seems to me that if we really want to make a deal with China to save the world economy, we cannot take the protectionist option, as it were, off the table.