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Transcript: The Chinese economy is experiencing a severe slow down with its true state obscured by reported GDP growth. The government's response to economic challenges involves increased investment spending (whether the investment is productive or not) along with directed lending to favored industries.
These measures will boost GDP statistics – as GDP doesn’t distinguish between activity
that increases a country’s wealth and activity that doesn’t, but achieving growth that
is beyond the real growth capacity of the economy through malinvestment causes debt
to grow faster than GDP. If the investment was productive, you would instead see GDP growing faster than debt.
It might surprise some viewers to learn that despite all of the growth that has occurred in China, the Hang Seng Index is today at a level it first reached 27 years ago in 1997, long before China joined the WTO. China’s real estate sector, which until recently contributed about 20 percent of the country’s economic growth has now become a drag on the economy. The property collapse which began in 2021 killed off construction activity in the country, cut into household wealth and dampened consumer confidence. China is currently battling deflation, with consumer prices experiencing their sharpest decline in 15 years in January, marking the fourth consecutive month of decrease.
To revive growth, Chinese policy makers are pushing money into manufacturing and exporting – instead of real estate and infrastructure this time, which risks igniting a new wave of trade tensions, not just with developed economies, but with emerging markets too, who are struggling to industrialize.
The US and EU have stepped up their complaints about China’s overproduction in the last year. Europe has initiated a series of trade investigations and the US presidential election occurring later this year is expected to once again feature Donald Trump and could see Republicans and Democrats competing to institute increasingly severe protectionist policies.
India and Vietnam have both announced investigations into the dumping of Chinese made goods which they say are causing significant damage to local manufacturers. Turkey imposed a 40% additional tariff on EV imports from China.
International trade has become increasingly complex in recent years as countries hoard certain goods that they require and look to export others. China’s renewed focus on manufacturing and exporting can be seen everywhere, from surging bank loans to the industrial sector to investment in industrial parks to becoming the largest exporter of finished cars by volume last year. China's biggest manufacturing successes of late have been the "new three" products that the government has gotten behind. The export value of electric cars, batteries and solar panels grew 42% on-year in the first three quarters of 2023. China has even come out and said that its EV push has gone too far.
The country's vice minister of industry and information technology in January pledged to reduce EV makers’ overcapacity, saying that the government will take “forceful measures to prevent superfluous projects.”
This is not to single out China as the only country pursuing a strategy of growth through exports. Japan, Singapore, South Korea, Taiwan and Germany all have a disproportionately large manufacturing share of GDP, along with disproportionately low consumption which means that they rely on exports to resolve the imbalance between the two.
Politicians around the world frequently announce new plans of exporting their way to economic success – but every country can’t increase exports and cut imports, as someone has to buy all of these exported goods.
We find ourselves at an interesting crossroads today where the countries that have historically been willing to run persistent trade deficits like the US and UK are now pursuing new industrial policies aimed at reducing their trade deficits. With surplus economies doubling down on exports, and deficit economies discussing protectionist strategies, the policies of many of the largest global economies are in clear conflict.
In today’s video let’s discuss how governments provide support or defense to industry, and how a trade war between surplus and deficit economies could resolve itself.
To be clear, the Chinese growth model is not particularly Chinese, a number of countries have taken this approach in the past, and it always seems to work out the same way where you see a period of rapid healthy growth, followed by a period of very rapid unhealthy growth (driven by a surge in debt), finally leading to a difficult adjustment period.
The model involves – systematic central bank intervention to keep the currency cheap, low wage growth, where wages grow slower than improvements in worker productivity, and financial repression where the state allocates credit, and the central bank keeps interest rates below the natural (or equilibrium) rate.
Each of these interventions in the economy have an effect, not unlike a tax on household wealth, and much like taxes – these interventions are simply a transfer of resources from one group within an economy to another.
Maintaining an artificially low exchange rate is no different to putting a tariff on imports while subsidizing exports. It transfers wealth from those who might want to buy foreign goods to those in the business of selling goods to foreigners.
Keeping wage growth below growth in worker productivity is another tax that transfers wealth from workers to employers.
Financial repression where interest rates are set artificially low - transfers wealth from savers to borrowers, considering the household sector is generally made up of savers, and the business and government sectors are usually borrowers, low interest rates are a transfer from households to business and government.
When a country sets both the borrowing and lending rates, they are not only transferring wealth between these two groups, but the spread (or difference between the borrowing and lending rate that they choose) is a transfer of wealth to the banking system – once again coming from depositors.
These types of economic intervention, which are designed to boost manufacturing and exporting, work through two channels which relate to each other. Transferring wealth to manufacturers through cheap labor, cheap loans and a cheap currency gives businesses capital to build manufacturing capacity while also giving them a cost advantage when competing with foreign companies who don’t have these advantages.
Because all of these subsidies come at the expense of the household sector, disposable income is kept low within the country and consumers are unable buy all of the additional goods that are being produced.
Maximizing production while suppressing consumption through these transfers means that more goods are being manufactured than there is demand for in the country, which means the surplus must be exported. Exports quite simply have to be greater than imports, as the transfers make foreign goods prohibitively expensive within the country. That is before any import tariffs or restrictions are included.
The subsidies don’t have to come from the household sector, but they do have to come from somewhere. If a country subsidizes factories by providing them with low-cost energy, and energy producers are forced to take the loss, then the transfer is occurring between two different industries within the country and this type of transfer is much harder to track in terms of trade impact.
Policies like these that force households to subsidize industry can be expected to generate faster growth in production than consumption, as growth in household consumption typically requires household income growth.
When production grows faster than consumption within a country, that surplus production needs to be exported. Because one country’s trade surplus or deficit has to be matched by an opposite deficit or surplus abroad, policy distortions like these implemented in one country force balancing changes to happen abroad. Every country is affected by the actions of it’s trade partners.
The Chinese economy is extremely lopsided, it makes up 18% of global GDP, but only 13% of global consumption. The Economist points out that even among emerging economies, China stands out: it consumed 7% less per person than Brazil did in 2022, though it produced about 40% more in terms of GDP.
To be clear, none of this has anything to do with cultural differences as commentators often like to claim, it is driven primarily by government policies. The Economist Albert Hirschman argued in the 1970’s that successful development models work and then make themselves obsolete as soon as they resolve the problems they were designed to address.
As soon as the model has become obsolete, the country needs to shift to a new economic model, and if they don’t, a new set of imbalances develop brought about by the excesses of the old model being run for too long. Hirschman points out that no country ever shifts model on time, usually because the old model created a series of institutions and constituencies that benefited disproportionally from the way things were being done.
Any rebalancing would likely come at the expense of this powerful constituency who are often able to block any changes, making it extremely difficult to readjust to the new economic necessities. As I said earlier, China is not the only country to have pursued these strategies.
We can look to the United States in the 1920’s, The Soviet Union in the 1960’s, Brazil in the 1970’s and Japan in the 1980’s to see how this model works.
The Economist in writing about Germany describes how “A highly skilled workforce, harmonious labor relations and restrained wage growth: all have long underpinned Germany’s economic success.”
While this might describe the last twenty five years, it’s not how Germany was viewed in the 1990’s when the country frequently ran current account deficits.
When the eurozone started in 1999, German policy makers decided that unemployment was unacceptably high. In 2000, trade unions and employers’ associations came to an agreement that productivity increases should not be used to push up real wages but instead for agreements that increase employment. They sought high employment and stability above wage growth.
This agreement between labor unions, businesses and the government to restrain wage growth in Germany reduced household income, which reduced household consumption and boosted exports. Growth in unit labor costs were kept low in Germany - in many years they were even negative which stood in contrast to comparable countries like the US, the UK, France, or Italy, where unit labor costs increased, often at rapid rates.
This difference between Germany and peripheral Europe was one of the causes of the European sovereign debt crisis in 2011. A shortage of skilled workers in recent years, combined with inflation and less docile trade unions may be bringing those low stable wages in Germany to an end.
Pandemic supply chain disruptions stalled German factories in recent years, and the end of cheap Russian gas along with decommissioning nuclear power stations might mean that Germany’s days as an export superpower may be coming to an end. In a world where more and more countries aim to export their way to economic growth, someone has to agree to buy all of the surplus production and issue the necessary debt to finance trade deficits.
Historically the most open economies in the world have agreed to provide this balancing function, but that willingness appears to be going away. US policymakers have begun to pay more attention to trade imbalances, first under Trump and then under Biden, who have both implemented protectionist policies that appear likely to grow over time. Both US and European policymakers are today discussing economic and national-security policies that are not unlike China’s strategies of prioritizing national economic strength and renewal over the idealism of the open, “liberal,” “free market,” global economies that they talked about in the past.
It has been argued that Latin American and African countries could end up absorbing some of the global excess manufacturing, but without a huge increase in foreign investment needed to allow them to run the necessary long-term deficits, they will be unable to do this for long, even if they wanted to.
Trade surplus countries often feel that their surplus is brought about due to their national virtues of thrift and hard work. You just have to look at the comments on my recent video on Chinese EV exports to Europe, to see furious comments from people who claim that the more efficient Chinese manufacturers are being discriminated against by lazy Europeans, and that no one accused Europeans of flooding China with cars in prior years.
They forget that the European cars sold in China were all built in China in joint ventures with Chinese firms that involved transfers of technology to their Chinese partners.
Similarly, during the European sovereign debt crisis, there was a lot of talk about the hard working conservative Germans, and the lazy irresponsible Greeks, with no mention of how wage suppression in Germany boosted manufacturing and reduced consumption leading to an export driven economy, and how the peripheral Europe absorbed German savings.
The claims of superior national character are mostly nonsense, in the same way that claims of inferior national character were nonsense in the past when these countries were impoverished.
Hopefully you can see that economic distortions introduced by policy makers have more of an effect on exports and savings than culture does. One way or another, in a world of weak demand growth, demand has today become a more valuable economic asset and is easier to withdraw than supply.
In most historic trade conflicts, the biggest exporters of goods have usually suffered the most. Good examples being Japan in the 1980’s and The United States in the 1930’s.
So, if subsidies, foreign exchange manipulation and suppressed wages are the offensive weapons of a trade war, what are the defensive weapons? Well Tariffs are one of the main defensive weapons that countries deploy. A tariff being a tax on imported goods, or particular classes of imported goods.
It may seem obvious why tariffs would work, they make foreign goods more expensive and thus relatively less attractive to domestic buyers. You might think that domestic buyers simply buy more locally produced goods once tariffs have been imposed and fewer imported goods and that this change of preferences improves a country’s trade balance, but that is not exactly the way tariffs affect trade.
The best book that I’ve read on trade imbalances and trade intervention is The Great Rebalancing by Michael Pettis, it has been extremely helpful in researching this video.
In the book he explains that a tariff on a good that is not produced domestically (so has to be imported) which could even be a necessary good with inelastic demand will still reduce a trade deficit, and that is because the real impact of tariffs is the effect that they have on real household income and domestic production, which then affect the relationship between total domestic savings and total domestic investment.
Because real household income is a function of both the nominal amount of household income and the cost of goods and services that households purchase. Raising the cost of a good reduces the real value of household income.
Tariffs like the one described are simply transfers of wealth from households to government. If the government doesn’t use that tax revenue to increase government spending and instead uses it to buy back its outstanding bonds, the country’s trade deficit declines and its savings rises – even if the same amount of that good is imported.
It is important to note that it does matter how the tax revenue is spent. A consumption tax on all goods would have had the exact same effect on the nation’s trade deficit as the tariff described in the above example. Tariffs, much like subsidies, and taxes simply transfer resources between different sectors of the economy, and these transfers affect the levels of production and consumption in an economy which affect the balance of trade.
In the above example, where there was no domestic producer of a necessary good, wealth was transferred from the household sector to the government sector. In a situation where there is a domestic producer of the good in question, resources are transferred from households to that business sector instead, with maybe some money going to the government sector too. Subsidies, tariffs and currency manipulation all affect a country’s trade balance by affecting the savings and investment rates, and anything that affects the gap between savings and investment must automatically affect the trade balance.
This also means that anything that affects the gap between production and consumption
also affects the savings rate. Thus, a wide variety of policies, whether intended to be trade intervention or not, will have that effect if they include any explicit or hidden tax transfer that affects the relationship between total production, total consumption and total investment.
A good example being the German labor union deal struck in 2000. Pettis argues that the global trade and capital system of the past forty to fifty years is among the most unbalanced, distorted, and protectionist in economic history, not because of the number of deviations from WTO-proscribed behavior but simply because of the scale of global trade imbalances. He argues that in an efficient and open trading system, large, persistent trade imbalances are rare and occur in only a very limited number of circumstances.
He argues that while free market policies make the greatest sense overall - in the current distorted trading system, policies implemented by deficit countries to reduce their deficits, achieve that goal by partially reversing the existing imbalances, which in turn force the surplus countries to either improve the distribution of income in their domestic economies or force them to absorb the demand-contracting consequences of their beggar-thy-neighbor policies themselves.
Exporting goods to the rest of the world as an economic growth strategy is getting more difficult today as there are greater calls for protectionism in deficit economies. On top of this, Western countries have grown increasingly nervous about relying on authoritarian states for necessary goods which could be withdrawn in the event of a conflict.
Chinese policymakers have attacked the recent EU anti-subsidy investigation into EV exports as “naked protectionism” and have criticized discussions of supply chain “de-risking” in western countries, but western critics argue that China’s policymaking has been protectionist and interventionalist for decades, with targets to increase domestic supply chain self-reliance.
Foreign companies complain they are facing greater and greater obstacles to accessing the Chinese market – which they were mostly shut out of already, so these things work both ways. Most economists agree that a world embroiled in various forms of trade protection is a world that is worse off.
A contraction in international trade would be expected to reduce global growth and global GDP. This is by no means a new idea, it was as well understood in the 1930’s as it is today but still during the great depression, countries, seeking to protect their own positions, engaged in trade behavior that left them all worse off.
A 2009 paper by Eichengreen and Irwin called “The Roots of Protectionism in the Great Depression” shows how in a world of contracting global demand policymakers around the world focused not just on boosting domestic demand but also on capturing a greater share of foreign net demand.
The authors show that The Great Depression was a breeding ground for protectionist policies and that a key factor behind the different trade policies chosen was a nations' adherence to the gold standard.
The countries that held to the gold standard were the most likely to implement trade restrictions, while those that abandoned it were able to resort to currency devaluations.
The countries that devalued their currencies saw rapid improvements in their trade balances and suffered much less from the global contraction.
Others, like the US and European “gold bloc” countries, were unable to adjust their currencies and suffered much of the brunt of the adjustment as imports became more competitive against their domestic industries, especially in relation to countries that were less constrained.
The countries who held to the gold standard instead resorted to what the authors call the “second-best” adjustment mechanisms – which are tariffs, import quotas, exchange controls, and so on. The paper highlights how Trade wars can occur and how harmful they can be to all involved.
Most deficit countries don’t recognize how difficult a rebalancing would likely be for surplus countries, and most surplus countries don’t recognize how vulnerable they are to potential trade restrictions from deficit countries and how limited their ability to retaliate would be.
As I mentioned earlier, in most trade conflicts, the biggest exporters have suffered the most, as their economies are most dependent on international trade. A much higher percentage of Chinese, Japanese and German jobs rely on exports than do American jobs. Americans might find themselves with fewer goods, but that is better than the high unemployment rates which would be experienced in export driven economies in the event of a trade war.
It would appear that Chinese authorities are quite aware of the problem of low domestic consumption, and that they acknowledge the need for change. Jin Xiandong, Chinas top economic state planner announced last summer that China’s economic recovery is faced with insufficient demand, weak momentum, and weak confidence.
In his speech he vowed to “restore and expand” consumption with a wide-ranging plan that includes boosting household income, improving the business environment for private firms and stabilizing youth employment. The only way that China could manage to increase domestic consumption – which policymakers do appear to understand, is to reverse the existing transfers, redirecting wealth and income from local governments to households.
An increase in the consumption share of GDP would partially offset the contraction in China’s net exports that this would cause. If a shift to a lower growth rate was accompanied by a shift to more labor-intensive industries, it is possible that unemployment could remain manageable.
A rebalancing of global trade could be expected to benefit all participants in the long run, for example, in the long run, in order to return the wealth that China has stored abroad in deficit countries, these deficit countries do need to run surpluses so that they can become net exporters of capital. If they were stuck always importing , they would never earn the foreign exchange necessary to pay back debts.
As to what would drive an eventual rebalancing, it seems unlikely to me that policy makers will simply decide to back down from all of their trade interventions, as no leader wants to see an economic slowdown occur on their watch. Historically we have seen these things end in a crisis, which can be painful but fast as happened in The United States in the 1930’s, or slow and drawn out as it has been for Japan which is still struggling with the legacy of its overinvestment surge.
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