China and the U.S. Depression--Posner

I agree with Becker that China is not responsible for our current depression. It is true that China's trade imbalance with the United States--it exports much more to us than we to them, and so has built up huge dollar balances that it has invested in the United States, mainly as Becker points out in the form of purchasing federal government bonds--was a factor in keeping interest rates low in the 2000-2005 period. And it is true that those low interest rates are a major culprit in the housing bubble and the ensuing financial collapse. The usual effect of an increase in the supply of money is to lower interest rates, because interest is the price of money. But low interest rates were a policy of our Federal Reserve under the chairmanship of Alan Greenspan, who remained chairman until the end of the 2000-2005 period; the Federal Reserve can create all the money it wants; and so even if there had been no Chinese investment in the United States, interest rates would probably have remained low. I say "probably" rather than "certainly" because the cheap Chinese exports to the United States were one of the factors that enabled the Federal Reserve's policy of low interest rates to avoid creating serious inflation. Had there been inflation, the Fed would have raised interest rates, killing the housing bubble before it became serious. Because houses are bought mainly with debt, cheap credit encourages home buying; and since the stock of housing expands only slowly, an increase in the demand for homes can and did result in a steep increase in home prices, which turned into a speculative bubble. Furthermore, China is of course not the only country with a positive trade balance with the United States. I do think that China's trade policy was bad for the United States. I do not think that it is healthy for the United States to run huge budget deficits, whether they are financed by China or by anyone else. One reason that we are in a depression and not merely the "severe recession" that is the preferred euphemism is that, because of those deficits, we cannot spend our way out of the depression without increasing the national debt to a point at which either horrendous inflation or huge tax increases will be required to pay it down. But I would not "blame" China for giving us what we very much wanted, which was cheap goods and the financing of our debt. Nor do I think that China's trade policy is foolish from China's standpoint. In a fascinating chapter of The General Theory of Employment, Interest and Money, Keynes offered the following qualified defense of mercantilism (the policy of accumulating foreign exchange by running a persistent export surplus). Suppose a country has weak domestic demand for goods and services, perhaps because its people are poor or they lack confidence in their economic prospects and therefore hoard money rather than spending it. Because of this weak demand, labor and other productive resources will tend to be underemployed--unless producers have foreign markets. By stimulating exports, the nation can increase the utilization of its productive resources, which by reducing unemployment can increase consumer confidence and thus increase spending and in turn investment. Average incomes in China are very low, domestic demand therefore weak relative to potential output, and so it may make sense for China to encourage production for export, especially if it has a comparative advantage in producing goods that foreign countries such as the United States demand. Moreover, because average incomes in China are so low, there may not be much demand for the types of product that the United States produces, and this would be an independent reason for our trade imbalance with China. But it would not explain China's large dollar balances, unless no other country produces the types of product that Chinese consumers could afford to buy.

Comments

[Alex]

Judge,
In your example, exports are stimulated by keeping the domestic currency weak. This is done, ultimately, by printing currency in excess domestically. You say this stimulates investment, and it may domestically. Foreign direct investment, however, will require extra compensation for the government's commitment to inflating the currency. Further, in free capital markets, holders of the domestic currency will not sit idly by and allow their purchasing power to evaporate. Holders of currency will flee that currency, confirming the result that you predict in the short run. In the long run, the policy is unsustainable as the counterparty to the transaction (the United States) will be unable to justifiably claim that the debt will be repaid with real interest.

[Alex]

Judge,
In your example, exports are stimulated by keeping the domestic currency weak. This is done, ultimately, by printing currency in excess domestically. You say this stimulates investment, and it may domestically. Foreign direct investment, however, will require extra compensation for the government's commitment to inflating the currency. Further, in free capital markets, holders of the domestic currency will not sit idly by and allow their purchasing power to evaporate. Holders of currency will flee that currency, confirming the result that you predict in the short run. In the long run, the policy is unsustainable as the counterparty to the transaction (the United States) will be unable to justifiably claim that the debt will be repaid with real interest.

[Jack]

Both of our Profs offer a lot of subjective "thinks" "not blames" along with some estimate? that US goods are priced so much higher --- that, well, "what's the use of complaining". Yet, since we have some exports to China surely at the margin their "beggar thy nation policies" hurt some businesses here some of the time.

Isn't The Deal in our (selectively) globalized world that of going at it with whatever you have, cheap, perhaps even indentured labor and all, but at LEAST allowing all of our currencies to float in an honest market?

As Posner touches on; China's unfair trade practices surely disadvantages other nations with cost structures closer to theirs both in stealing factories and jobs from the Mexico's and others while making Mexico's attempts to export to them "too pricey" as well.

Posner's comments (justifications??) for China:

"Because of this weak demand, labor and other productive resources will tend to be underemployed--unless producers have foreign markets. By stimulating exports, the nation can increase the utilization of its productive resources, which by reducing unemployment can increase consumer confidence and thus increase spending and in turn investment."

......... would seem to be tempting policies for the US or any nation operating at well under capacity; after all we know that the last 20,30 or 40% that a machine or factory produces are typically far more profitable than the first 50% But therein lies the trap; if nations rich and poor following those policies create protectionist trade wars we all lose the advantages of relative advantage.

What it needed to avoid such a scenario? All of the major nations need to play fair and take their piece of the world wide recession. In China's case while letting the yuan float up, they would slow their growth rate but their people would live a bit better and have a viable currency with which to shop for consumer or even capital goods in other nations.

It seems difficult to justify one huge nation getting the contracts through a 20% "good guy" preferential discount. After all President Clinton only (prematurely perhaps?) gave China MFN status not MORE favored nation over others status.

[Michael F. Martin]

Moreover, because average incomes in China are so low, there may not be much demand for the types of product that the United States produces, and this would be an independent reason for our trade imbalance with China.

When? Had the currency peg been removed earlier, the average citizen might have had the buying power to purchase more U.S. products by now.

[todorosky]

Well, i dont quite agree with judge posner by saying that the Chinese are not willing to spend cos "its people are poor or they lack confidence in their economic prospects and therefore hoard money rather than spending it". It's true to say that the average income in China is low compared to international standard. But the reason why they dont want to spend is much more because the lack of a good welfare system,like pensions, medical care coverage, education etc. And the housing prices in recent years are insanely high. People save money to prevent disease (since farmers don't get a good medical care coverage) and pay for educational fees for their children and maybe most importantly, to grant loans from banks to purchase or build a house (apartment).It's not that they don't want to spend, but rather, they have too many things to consider before spending,especially for those farmers and rural workers in cities. But still, thanks judge ponser and prof becker's post.

[blake]

Chinese policy also gave huge subsidies for foreign companies moving in to take advantage of the cheap labor. But in order to take advantage of it they had to import the know how, train the Chinese peasants, and set up a huge manufacturing infrastructure. If those companies had not been subsidized heavily there would have been not much incentive to hop the ocean into a third world country with a bizarre and unpredictable government.

[Bertrand Horwitz]

The Becker/Posner responses are surprising.That Posner would defend price control by quoting from Keynes'"General Theory..." was totally unexpected. We need to know why during a severe global recession (Posner's "depression")the world economy will more likely recover if China looks to its own benefit by pegging its exchange rate.Milton Friedman thought Keynes'"Theory of Money" in which he demonstrated, among others, the need for flexible rates was far better than his "General Theory...", but it was written and published before the onset of the Great Depression.

Becker,Friedman's best student, surprised me by ignoring one of Friedman's significant contributions to economic theory and practice, his classic "The Case For Flexible Exchange Rates".China, in real terms now the largest international trader in the world,has fixed its rate, though there has been a modest 20 percent upward revaluation since 2005, a period during which the growth rate of its reserves reached historic highs.Both the IMF and the WTO do not permit intentional pegging with the view of increasing exports, yet Becker (and Posner)find it has economic value and not just for China.

Friedman has emphasized that support for flexible exchange rates does not imply unstable (fluctuating) exchange rates.Indeed, both theory and experience reveal that when rates are free to vary they are highly stable.At the Davos meeting recently,the Chinese Vice President responsible for economic policies expressed a clear opposition to fluctuating rates.Why, then, is it acceptable for China to fix its rate but not for many other countries- yen, euro, dollar, etc.- to do the same even though they are now flexible? Friedman has also underscored his belief that a flexible global system will not work unless "a substantial fraction of international trade is in private (nongovernmental) hands". Does Becker believe that this condition applies to China? I long for a deeper analysis.

[StatsGuy]

China's purchase of T-bills will be proven foolish only when the US absorbs so much debt that the risk of default becomes impossible to ignore.

As US tax revenue plummets, world asset values collapse, US middle class assets (home ownership and 401ks) are vaporized, the debt becomes an increasingly large part of total world wealth.

It is time to have a real conversation about printing money directly (rather than trying to "get banks lending again"). This crisis ceased to be a lending crisis 2 months ago and became a demand crisis. Creditworthy borrowers with good collateral can easily obtain (very cheap) credit.

Our pathological dependency on banks to keep our money supply growing - while making one-sided bets - has proven crippling.

It is time to print money, and spend it - extending 4.5% interest rate loans to all homeowners (covering the difference by having the Fed float a 0% loan) is a good and fast way to spend it. A 2 month tax holiday would do as well.

However, the money _needs_ to be created by a 40 year 0% loan floated by the fed, or some similar mechanism. NOT by floating more T-bills in auctions that suck vast amounts of currency out of the private economy.

The arguments against inflation are growing weaker by the day as the debt load mounts at an accelerating rate and income (both personal income and national income) decline.

Obligations that should never have been made were made by our parents and will be paid by our children - and rather than investing, those assets were consumed. Our children are being enslaved to debt.

So while we talk about banks making bad loans, e must recognize that some countries made bad loans. China made a bad loan - and it made this loan with the express purpose of allowing the US to consume more by keeping the Yuan undervalued. Now everyone is paying the price, and there are only two ways out:

1) Inflation now

2) US national bankruptcy in 5 to 10 years

If the US tries to cut its budget now, or to absorb another 3-4 trillion dollars in debt to rescue the banking "system" and to stimulate the whole world economy, we will inevitably go bankrupt. I rather suspect this will have a more damaging impact on interest rates than printing a trillion or two now to reflate asset values and reignite the economy.

Moreover, when the US prints money, it creates a strong incentive for other countries to follow suit or see their exports get hammered. Thus, printing money in a deflationary environment has a POSITIVE CONTAGION EFFECT - This is directly the opposite of fiscal stimulus which is a Prisoner's Dilemma game in which every country tries to suck off their neighbor's stimulus.

[Jack]

Stats: It's interesting to speculate on what might happen in the future were current trends to continue. As most others I'm more than disgusted with the mess we have; but is it fatal? I don't think so.

"Obligations that should never have been made were made by our parents and will be paid by our children - and rather than investing, those assets were consumed. Our children are being enslaved to debt."

......... I too have been a deficit hawk since Reagan abandoned Stockman's plan to "starve the beast" and instead ran up huge deficits. But! even today it takes only two percent of GDP to pay interest on the debt. I'd rather we didn't have that added burden, but though there has been lots of consumption we've built and are passing on most of the homes, commercial buildings, highways et al that a static population would need for half a century. Of course the population is not static and more of everything will have to be added, but my point is that on balance "the kids" aren't necessarily being left a raw deal.

A few thoughts on:

"So while we talk about banks making bad loans, e must recognize that some countries made bad loans. China made a bad loan - and it made this loan with the express purpose of allowing the US to consume more by keeping the Yuan undervalued. Now everyone is paying the price, and there are only two ways out:"

......... As our Profs point out we had the same "concern" during the "Japanese decade"........ and there are some interesting "stats" to consider. If we continue to grow GDP at the rate of 2.5% per year, GDP will double in 28, but on my more optimistic days, I wonder if all the tech we've developed in the last decades can be harnessed to give us a higher rate of GDP growth? If it were just one percent higher, GDP would double in just 20 years.

Applying the same thinking to China which has been growing at 8% or so, we'd expect their GDP to double in just nine years, and to double again by year 18. Giving them a $13 trillion economy and the US a $20-$25 trillion economy.

But something very different happens in those 20 years. First off "we" even with the help of Europe can not consume enough Chinese exports to create the above scenario. Like the US, Japan, and others before them they will have to create their own consumer based society. So we'd expect China's standard of living to rise, export growth rate to slow and for them to find things around the world to import. Perhaps their interest in Africa stems from knowing the "advanced" nations can not absorb all of their output.

It's horrifying to consider the energy requirements and pollution all the doubled GDP's of just 20 -30 years from now if we don't all change our ways of providing it!

[neilehat]

All of this bears on the perennial problem of "Free Trade" vs. "Fair Trade". Any emerging National Economy is going to implement the macroeconomic policy of Mercantilism and so becomes the dominant principle of economic action. Regardless of what the I.M.F. or the World Bank says.

The mature Industrialised World is just going to have to get used to the idea of a declining generosity of the Modern Industrial State. Such that, Livable wages, Health Care, Retirement benefits, etc. become a thing of the past.

Long live the Corporatocracy! May the few live well at the expense of the Many.

China? Just the tip of the iceberg.

[Anonymous]

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[StatsGuy]

@Jack

Forgive me for being Cassandra, but:

The presumption that the economy will continue to grow at 2.8% per year seems rather optimistic (not pessimistic) due to the combination of a shrinking middle class and an aging population. One can also make a technological argument - US patents as a percentage of world patents have been in decline for over a decade (largely due to a lack of basic research for the last 20 years). Assuming technology-driven growth lags basic research by 20 years (or even longer), we will be hard pressed to innovate as rapidly as we have in the past 2 decades.

Perhaps more frightening, the worker to retiree ratio is in the process of being cut in half, while _at the same time_ the debt to GDP ratio is increasing. Entitlement spending is projected to explode. The US as a whole is like the proverbial 60 year old, who a few years before turning 65 suffers a significant pay cut and suddenly realizes the virtue of planning for retirement.

Also, total US Debt (private and public) has nearly tripled in the past 3 decades, making it clear that the expansion of the last few decades was largely artificial - driven not by fundamentals, but by debt-expansion that must now contract (through a combination of repayment, bankruptcy, and/or inflation - and I've already argued that we could use a little more inflation and a little less bankruptcy).

So the fact that interest on the debt consumes only 2% of our GDP (rapidly approaching 3%) is rather understating the problem. That 2% to 3% actually translates into over 20% of our national budget (our federal income). If we were to try to balance the budget (wipe out the deficit) by extracting 2% to 3% of our GDP through taxes or budget cuts, the effect (even in a normal economy) would be almost devastating.

A smaller country could manage this through export led growth, since most countries represent a small portion of total world demand. The US, for better or worse, is not like Chile, and so the classic IMF "rules of engagement" don't really apply here.

You might consider this on China's end too - China had to raise interest rates not too long ago to fight inflation, but had they allowed the Yuan to float upward faster (and not absorbed so much ForEx currency), this might have helped slow the economy slightly and perhaps alleviated the cost of raw materials - and built domestic demand.

Now, however, it's far too late for that - yet they continue to cripple their economy by spending ForEx earnings to buy US debt... The world would be better off if China spent some of its currency reserves on building its own economy - preferably through a MASSIVE investment in clean energy and water supplies, which is rapidly becoming a desperate situation for them. And this would force the US to stop selling T-bills to China, and float its own loans (i.e. reflate).

I suppose China is fearful that if they stop buying T-bills right now, this could cause a crisis in confidence in the dollar and instantly devalue that massive hoard of ForEx. So maybe their plan is to float the dollar a bit longer by buying T-bills, and spend down their dollar reserves before the value of those reserves are cut in half.

The fear on the part of Bernanke is probably that visible inflation would drive up interest rates on the massive US debt, which is funded largely through short-term notes (this is an historically new development, and incredibly short sighted). This could increase interest-as-%-of-GDP to well over 2% to 3%, and would be crippling.

My best guess is that Bernanke is trying to walk a tightrope - keep interest rates low but keep the money supply expanding to stimulate the economy, and "grow" out of the debt. I cannot see how this will work over the next 5-10 years. The only thing that has permitted it to work so far has been the world-wide panic and continuing devaluation of other assets (or, more accurately, the FEAR that those assets would continue to devalue). Soon enough, those assets will bottom to such a degree that it will become riskier to hold T-bills than hold stocks or commodities (or whatever).

Then, after causing untold damage to the world economy, the panic will shift the other way as investors flee T-bills. This will _force_ Bernanke to float the T-bill auctions, which will reinforce those fears. And then we'll have _real_ inflation.

Bernanke would be better off (and China too, in the long run) if they just floated one massive loan to the US at 0% interest to cover US debt financing for the next 3 years (this would be about 3 to 4 trillion dollars). This would be big enough, with a long enough time horizon that investors would not have to worry about immediate printing of more money.

HOWEVER, they _would_ worry about printing more money down the line (5 years from now) unless the US simultaneously cut entitlement programs (in a credible way).

If we don't see something decisive and bold soon, we're in some serious trouble.

My best hope is the G20 - simultaneous quantitative easing across all countries in the G20 (and a commitment to lower entitlements and increase investment in clean energy) would be the closest thing to panacea I can imagine in this crisis. It would also send a signal to the world markets that governments _can_ cooperate.

The US could easily force this consensus by threatening unilateral devaluation if the world does not follow (and I suspect they would follow). The question is whether we have the guts and brains to do this.

Judging by my observations on Obama's advisors, I suspect the answer is no. I am vaguely hopeful I am wrong.

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[Mark]

Judge Posner,

You write above you agree with Dr. Becker that "that China is not responsible for our current depression".

My problem is, I have not seen a reference from him that the US is in a depression.

What am I missing?

Thank you.

[neilehat]

Clean Energy? Clean Energy is a contradiction in terms. Any Energy production process creates waste, much of it either hazardous or toxic. Even the sun, perhaps the most efficient and environmentally friendly, produces huge quantities of by-product radiation, mostly hazardous.

As the Underdeveloped World "modernizes", that is, becomes Industrialized, Energy consumption will continue to rise dramatically. Until scarcity occurs and the whole operation comes crashing down around our heads. Or the "Energy Wars" kick in.

[Jack]

Stats...... those are all good comments and I agree with most of them or at least find them "not wrong". With so many big, and rapidly changing foreign countries "the game" is becoming extremely complex! like 3D chess! For example (assuming a functioning oil "market" if a recovery from deep recession runs the world up against the production limits and oil SOARS again, the world econ power changes dramatically.

The thing has gotten too big and complex for easy discussion much less finding a pancea. For example Japan got IN to much of their trouble by being Japan, Inc. and having zero interest loans. Can anything produce bubbles and irrational "investment" more than zero interest?

(Ha! just now many business guys would be happy IF they could GET loans at all!)

GDP may have strong downward pressures for many of the reasons you mention. But! turn the coin over...... if, say the auto biz is to be a 10 million unit biz, instead of 17 million, there is 350 billion not spent on cars to be saved or spent otherwise.

Then are, or have we reached some fundamental limits? Some years ago an econ book titled "The End of Work" was published. For a couple of decades I've thought our economy, severely, demand limited and today that is surely the case. Here our automation can make most of what we buy cheaply and w/o employing all of our work force. Add in "our Chinese and Indian slave labor" and we've NO chance at full employment.

So....... we continue with flat median wages, more desperation "at the bottom" being "lucky to have a job at all" and too few sheckels to even get our "plant" utilization to 50 or 70%

So what DO we have? A nation that is still wealthy in that we've a $40,000 average per capita income which is plenty. But we also have a stalled out $50k HH income which is being eroded by energy and H/C which is NOT "plenty". A mfg plant and import system that will provide all we need, but a deep recession.

So "class warfare" rhetoric aside, a part of what MUST happen is that of getting median and lower wages moving up in concert with productivity gains......... so they CAN "go shopping".

I suspect that is much of what this admin will be about. I'd hope H/C reform may help hold the line on cost increases for all but more of the benefit will accrue to the lower wage folk. Likewise programs like the $8K for first time home buyers will benefit mostly lower income people.

Still! it may be a long time, or never, that the US achieves full employment.

The international scenario has got to be a wild guess! As there WILL be pain for all as America's huge market contracts it is as you say, a matter of how the players cooperate or try to duck their share of the pain. As post 9/11 things will never be the same again.

Neil Yes! I mentioned above how fast some of the economies will double and redouble in size and it's horrifying to consider the amount of energy required! I actually think our DC guys, Pickens and all are on the right track......... as we have to begin to break the cycle and develop various alternatives. Just now solar may cost more......... but say getting caught flat footed w/o solar and wind may cost us a lot more in only a few years.

[aşk]

tes ara youu is te hss

[Thales]

"interest is the price of money"

Technical correction: Interest is the price of the *use* of money, or the annual rate of rental income on money, if you prefer. If one dollar buys one apple, the *price* of the dollar is one apple.

[Saint Darwin Assisi's cat]

Thank you for referencing "General Theory of Employment..."

[watzabatza]

i salute China of being a business-minded... it depends upon the US to depress China.

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