Brad DeLong: Alignment Problem Shifts to China

Brad DeLong says that today, "the principal source of international economic disorder is made in China":

Alignment problem shifts to China, by J. Bradford DeLong, Commentary, Project Syndicate: Now that the dollar has dropped 43 percent from its high against the euro, the process of global financial rebalancing is seriously under way. ... At the moment, Europe is feeling most of the pain, as the euro's value has risen furthest and fastest against the dollar. But Latin America and Asia will start to feel distress as well, as the US sheds its decade-long role as the global economy's importer of last resort.

As long as imbalances of world trade and capital flows unwind slowly and smoothly, the magnitude of any global economic distress should be relatively small. Of course, it will not seem small to exporters and their workers who lose their US markets, or to Americans who lose access to cheap capital provided by foreigners.

Yes, the US might enter a small recession -- the odds are roughly 50-50... A formal recession, however, is not an overwhelming probability and is likely to be small.

The prospect of a truly hard landing -- one where global investors wake up one morning, suddenly realize the US current accounts cannot be sustained, dump dollars and crash the global economy -- is becoming less likely with each passing day.

Under two scenarios -- both concerning China -- the unwinding of global imbalances could cause regional if not global depression.

In the first scenario, China keeps up its attempt to maintain full employment ... not by stimulating domestic demand but by trying to boost exports further by keeping the yuan stable against the dollar and falling in value against the euro.

The effort to maintain the dollar-yuan exchange rate ... has already led to an enormous increase in the Chinese economy's financial liquidity. The consequences of this are now manifested in property and stock market inflation, but not yet in rampant and uncontrolled consumer price inflation -- at least for now.

But if China does not accelerate the yuan's revaluation, the world might see a large burst of consumer inflation in China in the next two or three years.

If so, the consequences will be a choice between stagflation on the one hand and the destructive run-away inflation of post-World War II Latin America on the other. The fall-out from this scenario, however, would be largely confined to Asia.

The second scenario is more dangerous for the entire world. In this scenario, once again China continues to attempt to maintain full employment by keeping the yuan undervalued. But this time, the Chinese government manages to restrain domestic inflation, so the US' trade deficit with Asia stops falling and starts rising again.

Five or six years hence, the world economy faces the danger of a sudden crash in the value of the dollar and the euro against Asian currencies.

Four years ago, I would have said that the principal source of international economic disorder was made in the US. That has passed as a result of the dollar's decline and the ebbing political strength of right-wing populist factions in the US that seek ever-greater redistribution to the rich fueled by ever-increasing tax cuts and ever-rising long-term deficits.

Today, the principal source of international economic disorder is made in China, owing to factions inside its government that hope to avoid a more rapid appreciation of the yuan's value. I cannot judge the strength of these factions, or whether they know that the falling US account deficit and dollar may reduce the urgency of adjustment in the rest of the world, but not in China.

Former US president Richard Nixon's treasury secretary, John Connally, once told a group of European leaders that while the dollar was the US currency, its misalignment was Europe's problem. Today, the misalignment of the dollar -- and the euro -- against the yuan and other Asian currencies is increasingly becoming Asia's problem.

Comments

[hari]

Chinese inflation has already takenoff, and may become
a serious problem for the BoC.

[save_the_rustbelt]

Correct me if I am wrong, but Delong has never admitted that trade hurts many American workers, or perhaps he just doesn't care. He certainly hasn't much admitted much down side to NAFTA.

[pgl]

It sounds like Brad D. is recommending a more significant yuan appreciation. Brad Setser notes that on a trade weighted real basis, the yuan has not appreciated at all despite Chinese inflation.

[dissent]

It seems to me that Brad's scenarios in which China resists yuan appreciation versus the dollar are far more likely than he acknowledges. There is no signal at all that the Chinese are willing to tolerate an appreciation. That puts Brad's odds of a major global recession/depression at much higher than he estimates.

[Bruce Wilder]

Brad DeLong: "if China does not accelerate the yuan's revaluation, the world might see a large burst of consumer inflation in China in the next two or three years."

I love Brad DeLong. Everyday, I marvel at energy, curiosity and scholarship on display on his blog.

But, I have been reading his posts on international trade and funds flows for years, now, and I know he is clueless.

International trade and funds flows cleave to some sort of equilibrium, otherwise trends and patterns could not assume the stability that they exhibit. But, I don't see the evidence for the idea that an imaginary general equilibrium forms an attractor. Maybe, the back-of-an-envelope general equilibrium analysis favored by DeLong (and many others) is a useful way of identifying the undoubtedly growing pressure on the existing and actual equilibrium pattern, which has remained established for many years. But, it does not, itself, model a practical replacement pattern, nor does it explain why the existing equilibrium pattern took and held the shape it did.

If you cannot explain the pattern of the last 10 years, and you cannot identify practical patterns that might be chosen for the next 10 years, maybe you should just shut up.

If I were the Chinese, I'd be really scared. Somehow, China found a way to form a stable equilibrium pattern of trade and fund flows, which spurred very, very rapid economic growth. The U.S., with Brad DeLong leading cheers from the shadow of Silicon Valley, was willing to watch as America's industrial Midwest was impoverished, and its financial system destabilized by a housing bubble driven by predatory lending, but what the hey! The important thing was impotently criticizing the Bush tax cuts.

A key attractor for the equilibrium China formed was a very low peg of yuan to dollar. And, a second key attractor was a very low domestic cost of living. The yuan was worth very little abroad, but was worth enough at home, that a Chinese wage in dollars was extremely low, but still a living wage, domestically.

By itself, the low value of the yuan would have been a big problem, handicapping China in its purchases abroad, but China's domestic economy does not make many purchases abroad, and its international economy trades in dollars.

In principle, in terms of a back-of-envelope general equilibrium analysis, such as Brad DeLong is performing here, an appreciating yuan ought to be a no-brainer for the Chinese authorities: an appreciating yuan allows China to privilege itself in a world of rising commodity prices, while beggaring the U.S. The effects on Chinese exports can be partly offset by the increasing efficiency and productivity of Chinese manufacturing as well as the reduction of import costs, but this can also be an occasion for improving the terms of trade (stick it to Wal-Mart!).

The problem for Chinese policymakers is something Brad DeLong is ill-equipped to explain. He cannot explain how the old equilibrium (which was a persistent disequilibrium with respect to a back-of-the-envelope general equilibrium -- hence the years and years we have endured of assurances from economists that this pattern cannot be sustained indefinitely) managed to take on the shape it did, or maintain the stability it did. Nor can he outline what another such stable pattern would look like.

Chinese officials have the same problem. They liked the stability of where they were. And, they do not know how to get to somewhere else.

In some ways, I imagine they feel like someone riding a bicycle across a tightrope. An gaping audience understands that a bicycle on a tightrope high above the earth is not their idea of an equilibrium, and their intuition predicts that the bicycle will reach "general equilibrium" on the ground. The tightrope walker, of course, knows that gyroscopic stability means that there actually is a stable equilibrium available, as long as he keeps the bicycle moving. For him, the problem is that he cannot stop or steer.

My impression is that China cannot stop or steer. To shift gears, China will have to pause, and in the pause, a crash -- a sharp recession -- is inevitable. Japan went through this in the 1960's, when their growth was very rapid.

I quote a passage from DeLong's commentary that I thought was particularly clueless. The low fx value of the yuan and the Chinese domestic price structure are complements. One cannot change without the other also changing. An upward valuation of the yuan AND a domestic inflation will BOTH have to happen.

(Note: I recognize that the doctrine that inflation is always and everywhere a monetary phenomenon is pervasive. I subscribe to it myself. But, unfortunately, that leaves us without a good word to denote systematic changes in price structure. China's domestic price structure must change fairly radically, and its is this process, which I am sure China's officials do not feel confident that they can manage. A substantial monetary inflation would be helpful, in my view, in lubricating this change. But, the critical component of the change is a rise in real wages, accompanied by extending and deepening the money economy.)

[Meh]

Bruce Wilder: Interesting post. Tangentially it touches on a question I've asked before, which is: "How did previous fast growing Asian countries do it?"

Now of course, part of the answer is that they did pause and have some bust to go with their boom.

But it also seems to be, from the cursory look I've had, that the way we measure "inflation" in the context of a stable economy doesn't really tell us everything about the situation in the cases of developing countries playing catch up.

It's true that inflation in South America has been a regular problem, but the history of Japan and Korea seems to show that you can (fairly stably) carry higher levels of inflation than Brad DeLong is comfy with when you're in a phase of large scale growth and transition from a rural to an urban economy.

Any thoughts?

says...

It's true that inflation in South America has been a regular problem, but the history of Japan and Korea seems to show that you can (fairly stably) carry higher levels of inflation than Brad DeLong is comfy with when you're in a phase of large scale growth and transition from a rural to an urban economy.

AIUI, South America's problems stem from mismanagement of currency boards syatems and resulting lack of monetary credibility (in addition to other institutional problems), rather than inflation per se.

By contrast, East Asian countries succeeded in attracting foreign capital investment which has powered their economic development.

[Bruce Wilder]

[No name] has it exactly wrong. East Asia self-financed its development with enormous domestic savings. South America, by contrast, relied on foreign investment. South American countries also seem to have difficulty collecting taxes.

says...

If East Asian nations did not rely on foreign investment for their development, why were they so badly hit by the 90's Asian crisis? See especially South Korea, which has now recovered to become the 9th largest economy in the world.

[anne]

Brad DeLong always needs to be attended to closely, but I think he can be argued with on this matter. I think this time, the dollar is our problem not China's problem. This time, we are the source of international political and economic instability, and decidedly not China. From the perspective of spurring international growth to relative investment market stability to the possibility of political stability, I am inclined to look internationally and especially to China and India and Brazil along with western Europe, Japan, Australia and Canada.

There is a China now, that we seem incapable of knowing for the international force that it is. A vastly well-managed international force, considering the increasingly successful "management" of the economic affairs of 1.3 billion. I watch Mexico beset by flooding, and China beset, and I am astonished by Chinese management.

[anne]

"If East Asian nations did not rely on foreign investment for their development, why were they so badly hit by the 90's Asian crisis?"

China was not hit, but rather roared in growth through even ignoring (imagine the nerve) the pooh-poohing advice of Milton Friedman.

Brad Setser was always worrying about China suffering foreign exchange losses, that do not worry China, but Setser never seemed to worry about serious economic and strategic losses that were occuring not in China but here. We have squandered more than 2 trillion dollars on destruction, to our continual strategic loss, why other countries have grown more productively than in term of tanks.

[ken melvin]

Thanks Bruce.

[Farrar Richardson]

Frankly, Bruce Wilder,

I think Brad Delong's analysis is more convincing than yours.

I do, however, think that his second scenario is highly unlikely, because it is becoming increasingly difficult for the Chinese BOTH to avoid revaluation AND keep inflation under control. In fact, it appears that the wage price spiral is already underway.

Since none of us seem to be China experts, the outcome will probably surprise us all three of us.

[paine]

"I love Brad DeLong. Everyday, I marvel at energy, curiosity and scholarship on display on his blog."

bruce now i see what was b4 my eyes
all these past months
i'm under a pledge not to delongkampf
and won't

note this label

"right-wing populist factions "

for the supply side redeemers
of private enter-prise ???

cui bono ???

[paine]

what's often lost sight of here

in the call ...my call too ...
for fuller employment
effective demand mangement inside china

yes that would allow the rmb to rise
and china's exports to cool off
like the secular rise of the yen in years gone by

but there is another path
toward global balance
with more international market vigor

vastly increased chinese imports

of non staples and resources

this a semi-party run economy can do ....

the rmb undervaluation scam
with its attendent fdi landslide
could co exist with rebalanced trade
ie even as
exports continued to rise

ie the other pathh allows
a-ccelerated global
trade open-ness not de-ccelerated

and with rebalancing
is
a real option
if "the party" accelerated imports
above their spontaneous market driven levels
by spending all that foreign cash

[paine]

i suspect
the culturally degrading spectacle
of past saudi non productive potlatching
causes great inhibitions however
among the party elite
to import much else then necessaries

recall the goal is robust self sufficency where possible
the kold war 50's -60's
are not forgotten

the makings of a second free world
"commercial encirclement "
could return to the main land
even now
with one big enough gust of foul wind
from the intersection of penn ave and wall street

[dave smith]

Brad, do you really think that tax cuts for a few rich US citizens was the largest destabilizing force in the world 4 years ago?

[TJIC]

DeLong talks about the "redistribution [ of money ] to the rich".

This "redistribution [ of money ] to the rich"...where is the money
that's being redistributed coming from?

His ideological posturing that the government somehow has the INITIAL and MORAL claim on utility created by people, and changing the tax structure to let people keep more of their earnings is "RE" distribution mars an otherwise decent essay.