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This is an excellent article. My conclusion is that we are likely to be heading for a trade war which may eventually morph into another major war. I know that Marc Faber thinks that the world may have another major conflict.
Excerpt – Far Eastern Economic Review, by Michael Pettis, Jan/Feb 2009
It’s 1929 Again
Although there are great differences between 1929 and 2008, the global payments imbalances that led up to the current crisis were nonetheless similar in many ways to the imbalances of the 1920s. A few countries, dominated by one very large one, ran massive current-account surpluses and in the process rapidly accumulated reserves. In the 1920s it was the U.S. that played the role that China is playing today. The U.S. economy was plagued in the 1920s with overcapacity caused by substantial increases in U.S. labor productivity. This in turn was a consequence of significant investment in the agricultural and industrial sectors and mass migration from the countryside to the cities.
Although U.S. capacity surged in the 1920s, domestic demand did not rise nearly as quickly. As a consequence, the U.S. ran large annual trade surpluses ranging from 1% to 3% of GDP during the 1920s, or 0.4% of global GDP (China, although only 6% of world GDP, has run trade surpluses of roughly the same magnitude). U.S. overcapacity didn’t matter when there was sufficient foreign demand. It could be exported, mostly to Europe, while foreign bond issues floated by foreign countries in New York permitted deficit countries to finance their net purchases.
But as the U.S. continued investing in and increasing capacity, without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process. When bond markets collapsed as part of the crash, bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for most foreign borrowers to continue raising money, and by effectively cutting off funding for the trade-deficit countries, it eliminated their ability to absorb excess U.S. capacity.
The drop in foreign demand required a countervailing U.S. adjustment. Either the U.S. had to increase domestic consumption, or it had to cut back domestic production, but there was unfortunately more to the crisis than simply the drop in foreign demand. With the collapse of parts of the domestic U.S. banking system, domestic private consumption also fell. The slack in demand should have been taken up by U.S. fiscal expansion, but instead of expanding aggressively, as John Maynard Keynes advised, President Roosevelt expanded cautiously. When the credit crunch came and the world was awash in American-made goods that no one was willing or able to buy, it was unreasonable, as Keynes argued bitterly, to expect the rest of the world to continue purchasing U.S. goods, especially since the financing of their consumption had been interrupted.
Since U.S. production exceeded consumption, the need for demand creation, according to Keynes, most logically resided in the U.S. But Washington had other ideas. In 1927 and 1928 there were already unemployment pressures, and the 1929 collapse in demand exacerbated those pressures. This prompted U.S. senators to respond in 1930 with the notorious Smoot-Hawley Tariff Act aimed at boosting demand for domestic production. They attempted to divert demand for foreign goods to U.S. goods–basically to export their overcapacity–and in so doing force the brunt of the adjustment onto their trading partners. Their trading partners, not surprisingly, retaliated by closing their own borders to trade, causing international trade to decline by nearly 70% in three years, thereby shifting the brunt of the adjustment back onto the U.S.
The trade tariff made things worse not just because impediments to trade are costly to the global economy, but rather because it set off a trade war in which other countries forced the U.S. broadly into balance. In two years, U.S. merchandise exports declined 53%, while the trade surplus declined by 63%. Excess production over consumption had to be resolved largely within the U.S., and since much domestic investment had been aimed at the export sector, the collapse in exports brought a concomitant decline in domestic investment. The U.S. either had to engineer a substantial increase in domestic demand by fiscal means, as Keynes demanded, or adjust via a drop in production and employment. It did the latter.
Today China is facing a similar problem. With the collapse of bank intermediation, U.S. households and businesses are cutting consumption and raising savings. This is a necessary adjustment. Most analysts, perhaps thinking they are echoing Keynes’s analysis of the problem in the 1930s, call on the U.S. government to engage in massive fiscal expansion to replace lost private demand. But this is not what Keynes would have recommended. If declining U.S. private consumption is met with increasing public consumption, 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. 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 private consumption to rise quickly enough is unrealistic, it has to be public consumption–a large fiscal deficit.
Might China and smaller Asian countries repeat the U.S. mistake of the 1930s? Perhaps. 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. The proper place for new demand to originate is, as in the 1930s, in trade-surplus countries. They should be engaged in expanding demand, not expanding supply. If they try to export their way out of a slowdown, there will almost certainly be another trade backlash, in which case the full force of the adjustment will be borne by the trade-surplus countries, again as in the 1930s—with the proviso that although China’s trade surplus as a share of global GDP is comparable to the U.S. trade surplus in the 1920s, China is a much smaller economy, and so its trade surplus represents a much higher share of its GDP.
In order to make the transition workable and avoid trade friction, the world’s major economies must engineer a joint program of fiscal expansion. The trade-deficit countries should expand moderately so as to slow down the adjustment period and to give maximum traction to fiscal expansion on the part of the trade-surplus countries. China must be given at least three or four years to make concerted efforts to boost domestic demand to the point where global imbalances are more manageable.
The problem is that U.S. (and European) demand contraction is occurring at a shockingly rapid pace. There is a real risk that the adjustment process in China will careen out of control. In order to manage this risk, U.S., European, Japanese and Chinese policy makers must quickly come to a firm understanding of how significant the global adjustment is and how dangerous the process will be for China, and design a multiyear plan of demand expansion in which China is given time to adjust its overcapacity. If major economies focus only on domestic adjustment, China will almost certainly choose the path of defending its ability to export overcapacity onto the rest of the world, while the trade -deficit countries will discover the expansionary impact of trade constraints. In that case it is hard to imagine how China and the world can avoid disaster.
Michael Pettis is a finance professor at Peking University and the author of The Volatility Machine (Oxford University Press, 2001).
Excerpt – Far Eastern Economic Review, by Michael Pettis, Jan/Feb 2009
It’s 1929 Again
Although there are great differences between 1929 and 2008, the global payments imbalances that led up to the current crisis were nonetheless similar in many ways to the imbalances of the 1920s. A few countries, dominated by one very large one, ran massive current-account surpluses and in the process rapidly accumulated reserves. In the 1920s it was the U.S. that played the role that China is playing today. The U.S. economy was plagued in the 1920s with overcapacity caused by substantial increases in U.S. labor productivity. This in turn was a consequence of significant investment in the agricultural and industrial sectors and mass migration from the countryside to the cities.
Although U.S. capacity surged in the 1920s, domestic demand did not rise nearly as quickly. As a consequence, the U.S. ran large annual trade surpluses ranging from 1% to 3% of GDP during the 1920s, or 0.4% of global GDP (China, although only 6% of world GDP, has run trade surpluses of roughly the same magnitude). U.S. overcapacity didn’t matter when there was sufficient foreign demand. It could be exported, mostly to Europe, while foreign bond issues floated by foreign countries in New York permitted deficit countries to finance their net purchases.
But as the U.S. continued investing in and increasing capacity, without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process. When bond markets collapsed as part of the crash, bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for most foreign borrowers to continue raising money, and by effectively cutting off funding for the trade-deficit countries, it eliminated their ability to absorb excess U.S. capacity.
The drop in foreign demand required a countervailing U.S. adjustment. Either the U.S. had to increase domestic consumption, or it had to cut back domestic production, but there was unfortunately more to the crisis than simply the drop in foreign demand. With the collapse of parts of the domestic U.S. banking system, domestic private consumption also fell. The slack in demand should have been taken up by U.S. fiscal expansion, but instead of expanding aggressively, as John Maynard Keynes advised, President Roosevelt expanded cautiously. When the credit crunch came and the world was awash in American-made goods that no one was willing or able to buy, it was unreasonable, as Keynes argued bitterly, to expect the rest of the world to continue purchasing U.S. goods, especially since the financing of their consumption had been interrupted.
Since U.S. production exceeded consumption, the need for demand creation, according to Keynes, most logically resided in the U.S. But Washington had other ideas. In 1927 and 1928 there were already unemployment pressures, and the 1929 collapse in demand exacerbated those pressures. This prompted U.S. senators to respond in 1930 with the notorious Smoot-Hawley Tariff Act aimed at boosting demand for domestic production. They attempted to divert demand for foreign goods to U.S. goods–basically to export their overcapacity–and in so doing force the brunt of the adjustment onto their trading partners. Their trading partners, not surprisingly, retaliated by closing their own borders to trade, causing international trade to decline by nearly 70% in three years, thereby shifting the brunt of the adjustment back onto the U.S.
The trade tariff made things worse not just because impediments to trade are costly to the global economy, but rather because it set off a trade war in which other countries forced the U.S. broadly into balance. In two years, U.S. merchandise exports declined 53%, while the trade surplus declined by 63%. Excess production over consumption had to be resolved largely within the U.S., and since much domestic investment had been aimed at the export sector, the collapse in exports brought a concomitant decline in domestic investment. The U.S. either had to engineer a substantial increase in domestic demand by fiscal means, as Keynes demanded, or adjust via a drop in production and employment. It did the latter.
Today China is facing a similar problem. With the collapse of bank intermediation, U.S. households and businesses are cutting consumption and raising savings. This is a necessary adjustment. Most analysts, perhaps thinking they are echoing Keynes’s analysis of the problem in the 1930s, call on the U.S. government to engage in massive fiscal expansion to replace lost private demand. But this is not what Keynes would have recommended. If declining U.S. private consumption is met with increasing public consumption, 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. 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 private consumption to rise quickly enough is unrealistic, it has to be public consumption–a large fiscal deficit.
Might China and smaller Asian countries repeat the U.S. mistake of the 1930s? Perhaps. 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. The proper place for new demand to originate is, as in the 1930s, in trade-surplus countries. They should be engaged in expanding demand, not expanding supply. If they try to export their way out of a slowdown, there will almost certainly be another trade backlash, in which case the full force of the adjustment will be borne by the trade-surplus countries, again as in the 1930s—with the proviso that although China’s trade surplus as a share of global GDP is comparable to the U.S. trade surplus in the 1920s, China is a much smaller economy, and so its trade surplus represents a much higher share of its GDP.
In order to make the transition workable and avoid trade friction, the world’s major economies must engineer a joint program of fiscal expansion. The trade-deficit countries should expand moderately so as to slow down the adjustment period and to give maximum traction to fiscal expansion on the part of the trade-surplus countries. China must be given at least three or four years to make concerted efforts to boost domestic demand to the point where global imbalances are more manageable.
The problem is that U.S. (and European) demand contraction is occurring at a shockingly rapid pace. There is a real risk that the adjustment process in China will careen out of control. In order to manage this risk, U.S., European, Japanese and Chinese policy makers must quickly come to a firm understanding of how significant the global adjustment is and how dangerous the process will be for China, and design a multiyear plan of demand expansion in which China is given time to adjust its overcapacity. If major economies focus only on domestic adjustment, China will almost certainly choose the path of defending its ability to export overcapacity onto the rest of the world, while the trade -deficit countries will discover the expansionary impact of trade constraints. In that case it is hard to imagine how China and the world can avoid disaster.
Michael Pettis is a finance professor at Peking University and the author of The Volatility Machine (Oxford University Press, 2001).
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