Rogoff: Rebalancing the US-China Economic Relationship

Kenneth Rogoff is worried that we'll rebuild the same economy we had before the crisis and risk another financial meltdown:

Rebalancing the US-China Economic Relationship, by Kenneth Rogoff, Commentary, Project Syndicate: As the global economy stabilizes, there is a growing danger that the United States and China will slip back into their pre-crisis economic patterns, placing themselves and the rest of the world at risk. ... Short-run stability certainly seems attractive right now. But if the US-China trade and debt relationship merely picks up where it left off, what will prevent recurrence of the same unsustainable dynamic that we just witnessed? After all, huge US foreign borrowing was clearly a key factor in creating the recent financial mess, while China’s excessive reliance on export-driven growth has made it extraordinarily vulnerable to a sudden drop in global demand.

A giant fiscal stimulus in both countries has helped prevent further damage temporarily, but where is the needed change? Wouldn’t it be better to accept more adjustment now in the form of slower post-crisis growth than to set ourselves up for an even bigger crash?

True, both the US administration and China’s leadership have made some sensible proposals for change. But is their heart in it? US Treasury Secretary Timothy Geithner has floated a far-reaching overhaul of the financial system, and China’s leaders are starting to take steps towards improving the country’s social safety net.

Both of these measures should help... Nevertheless, there is cause for concern. As the world seems to emerge from its horrific financial crisis, it is human nature for complacency to set in, and the domestic politics of the US-China trade and financial relationship is deeply rooted. ...

Another reason to worry is that the global recovery is still fragile. US and Chinese leaders have fought the crisis with not only massive fiscal stimulus, but also deep intervention into credit markets. Such extraordinary fiscal largesse, all at taxpayers’ expense, cannot continue indefinitely.

World Bank President Robert Zoellick has rightly warned that all this massive temporary fiscal stimulus is a “sugar high” that will ultimately pass without deeper reforms. As I have argued before, the endgame to the financial bailouts and fiscal expansion will almost certainly mean higher interest rates, higher taxes, and, quite possibly, inflation.

For better or for worse, it may not be possible to turn back the clock. The US consumer, whose gluttony helped fuel growth throughout the world for more than a decade, seems finally set to go on a diet. ...

Frankly, higher US personal saving rates would not be a bad thing. It would almost certainly help reduce the risk of an early repeat of the financial crisis. The obvious candidates to replace them are Chinese and other Asian consumers...? Outside Japan, Asia policymakers certainly don’t seem amenable to exchange-rate appreciation

Since the beginning of this decade, at least a few economists (including me) have warned that the global trade and current-account imbalances needed to be reined in to reduce the chance of a severe financial crisis. The US and China are not solely responsible for these imbalances, but their relationship is certainly at the center of it.

Prior to the crisis, there was plenty of talk, including high-level meetings brokered by the International Monetary Fund, but only minimal action. Now, the risks have spilled out to the entire world. Let’s hope that this time there is more than talk.  If US and Chinese policymakers instead surrender to the temptation of slipping back to the pre-crisis imbalances, the roots of the next crisis will grow like bamboo.  And that would not be good news for the US and China, or anyone else.

I think he gives himself a bit too much credit for foreseeing the crisis, the type of financial meltdown he and others predicted - a sudden unwinding of international imbalances - didn't occur.

But the question is how much risk there is of a big international meltdown in the future, and this is what Rogoff is worried about. On that score:

Where’s the money coming from?, by Paul Krugman: The huge borrowing by major governments, the U.S. government in particular, has confused many people — and not just Niall Ferguson. What I hear again and again is either the assertion that all this borrowing must drive up interest rates, or worries that the Chinese won’t be willing to lend us the money.

We know as a matter of principle that these concerns are misplaced: if there were a shortage of savings, the economy wouldn’t be depressed. Indeed, one way to think about our current problem is that the world as a whole wants to save more than it’s willing to invest.

But it’s always nice to have some real-world data illustrating a principle. From Brad Setser, private and public borrowing in America, as a percentage of GDP:

We’re actually borrowing less from foreigners than we were before.

Rogoff asks "where is the needed change?" We are already undergoing structural change, we have a smaller financial sector, a smaller housing sector, a smaller domestic automobile sector, and an increase in household saving. And though the actual degree of change that we will see in things like household saving is unknown, we will see permanent change. Thus, the type of structural reforms Rogoff would like to see are, in fact, underway already and they will continue. But because so much has to change - minor tweaks to the economy won't be enough - it will delay the recovery relative to the more usual case when the economy is able to return to what it was doing before.

As the financial, housing, and domestic automobile industries shrink, resources and labor are freed up and become unemployed. They must, somehow, find their way into other sectors. Some have to move geographically, and that process can be lengthy. Building new industries that can absorb the idle resources takes time, rebuilding the financial sector, household deleveraging, one of this will happen overnight. (And it doesn't help that, on top of all this, housing markets are notoriously slow to adjust so that the needed shrinkage and adjustment driving the structural change is itself a slow process.)

So the process will be slow. Does deficit spending to combat the recession slow this adjustment process down even further? Is Rogoff right that we'd be better off just letting things crash and burn so that the new and improved version can be rebuilt faster?

The economy is already changing as described above, and in other ways too, and it is doing so about as fast as it can. Any faster than this, which would involve even more unemployment and more stagnation of resources and the economy, more ensuing foreclosures, etc., and we'd risk undermining the very foundation we want to rebuild upon. Structural change and social programs to help people who are struggling due to poor economic conditions are not at odds with each other, and infrastructure spending supports rather than hinders future growth and change.

We will get the change we need, it's underway already, and that change does not require the government to sit by idly while people struggle with the poor economic conditions. Worries about inflation and high interest rates, and about the negative effects of higher taxes on those who can more than afford them are overblown. Those worries should not stand in the way of extending a compassionate hand to the struggling, or to spending money to stimulate the economy and build the social and physical infrastructure we need to support robust economic growth in the future.