The great stall of China  

The SMH has an article noting the slowdown in China and the large drop in resource consumption this implies - The great stall of China. This highlights an issue which is going to be painful for Australia in the coming years, given the assumption by both government and business that we can remain prosperous just by digging up dirt and shipping it offshore. Once the developing world has industrialised, demand for raw materials will drop, then, as we move to cradle to cradle style manufacturing systems and a clean energy economy, it will slowly disappear almost entirely.

CHINA may never again power the Australian economy like it has over the past five years, posing huge risks to the local economy, ripping billions from exports, and almost certainly driving the budget into deficit.

In figures significantly worse than the Rudd Government was anticipating, China's National Bureau of Statistics yesterday said annual growth almost halved from 13 per cent in 2007 to 6.8 per cent in the year to December - below the arbitrary 8 per cent threshold that Chinese leaders say creates risks of social instability.

Citigroup calculates the economy shrank 0.1 per cent in December from the September quarter - the first contraction in at least 16 years.

Frank Xu, the head of mergers and acquisitions at China International Capital Corporation, said 2008 was likely to mark the peak of China's appetite for Australian resources, particularly iron ore. He said the resources boom, which inflated Australian commodity export prices by 150 per cent over five years, was driven by China's unprecedented and unsustainable growth in exports and building of factories and infrastructure.

"If you look at each one of those drivers, they're going to decline," he told the Herald in a rare interview.

"The part that was not sustainable was the investment that goes into producing capacity for more steel companies, more cement plants, more equipment manufacturing, more power generators, because if you don't have demand for the output then these plants are going to be wasted."

Mr Xu, who advises most of China's giant resource and heavy industry companies, said it was "physically inconceivable" China would return to the resource consumption rates of the past. "We simply don't have enough land, we don't have enough clean air to support such growth, at some point it has to slow down and even decline in absolute terms," he said.

As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it. I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more. I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history). One of the points he makes – in fact it is probably the main point of the book – is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis. It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis. Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold. They were also the ones most harmed by the 1930s crisis. I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions. Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

1. The first I have discussed many times. Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports. However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries. As international trade collapsed – especially after the US tried to force the adjustment abroad by the passage of import tariffs – domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically. It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending. This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment. Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.

2. To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending. The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract. When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster. According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all. The first and most obvious is the scale of China’s overcapacity problem. China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929. Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts. For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods. In that direction lays trade friction, which would have a devastating impact on Chinese businesses.