China and America’s Collective Economic Future

Adapted from the 2009 Confucius Lecture at McMaster University in Hamilton, Ontario.

Most analysts, commentators and policymakers seem not to understand that the largest economy in the world is in a balance sheet recession, reinforced and amplified by a deep and continuing credit system crisis. There have been two other balance sheet recessions in the last one hundred or more years – the Great Depression and the now almost twenty year recession/deflation in Japan. So far most comparisons and expectations have revolved around this being a more severe recession of the post-war type. I do not believe one can look ahead and get it right if one does not understand this time really is different, but for the worse, not the better. A balance sheet recession is not only different in degree. It is different in kind.

The normal business cycle is an income statement issue. It often comes about when an external shock – central bank interest rate increases or a sustained rise in energy prices – cools the demand side of the income statement and keeps the economy within its supply capabilities. Traditional fiscal and monetary tools work. A balance sheet recession is caused by a toxic mixture of inflated asset prices and too much debt or leverage. Easier money does not work, because most people do not want to borrow more and most tax cuts do not work because they are into debt reduction, not investment or consumption.

The path to recovery and cure is simple to see but it will be hard and slow. The two real economic keys to recovery are jobs and balance sheet repair – both slow and unavoidable processes. The two policy keys to lasting patient recovery are global rebalancing and central bank stimulus withdrawal.

The answer to our collective futures may, in a somewhat oversimplified way, be said to depend on how the U.S. goes about living within its means and how China goes about broadening its economic base to include more consumption and a larger services economy.

It is important there be no misunderstanding about what is at stake today in the world’s largest economy, the United States. The American public is worried and many are suffering. They know that if their taxes, and borrowing in their name, had not come to rescue the financial system, not a single one of the great Wall Street banks and investment banks would be standing. So a rising stock market thanks to the government and to increasing corporate profits thanks mainly to job cutting; large Wall Street bonuses; and current account surplus countries that maintain part of their growth with exports for which the U.S. has to borrow, is a potentially toxic mix that could move U.S. politics beyond what even the most skilled and sensible President could deal with. Americans do not yet seem to fully grasp this danger. But neither do the key current account surplus countries seem to grasp it. Almost everyone still fails to understand that the U.S. has been so damaged by the crises and the policy and political failures which preceded the crises that it must have help, or the conditions of the thirties will be the consequence. This is where the high stakes of our current moment in history now rest.

No other country made the U.S. live beyond its means. Nor did any other country make China or Japan or Germany rely on an export model that was destined to be unsustainable. If China, in particular, had chosen to rely on less exports as its model, it would have made it very hard for the U.S. to live so far beyond its means, and much of what the world now faces would have been avoided. Similarly, if the United States had decided to live within its means, it would have made it very hard for China, as well as Japan and Germany, to get cornered by its export model, and much of what the world now faces would have been avoided.

Yet at some point, if an agreed way forward is not forthcoming, either the United States will have to decide that it can no longer go ever further into debt, or markets will decide that for them. At that point, if the United States economy is not to relapse, the measures to avoid that would then need to be based on the proposition that the global order as we know it cannot be rebalanced in an orderly way. The U.S. would then have to start living within its means and find a way to enable it to stimulate its economy without increasing its net country debt. What it could then be forced to do would be called protectionism. But it would not really be that. It would not be aimed at protecting people or industries from competition, but at protecting the key U.S. balance sheets from collapse and of being able to address the job challenges on which its social and political order are based. It would be forced to acknowledge the inability of the international community to work successfully to achieve a viable balanced global order. No sensible U.S. President will wish to find himself facing this unpalatable reality. But unless things change, that is what he and the United States will face.

China should not count on the U.S. any time soon doing what it should do, which is to start living within its means. If a mutual approach cannot be achieved, this is China’s best hope for a good outcome for it and the global economies and for sustaining the globalization project.  To achieve it, China will have to steadily increase domestic demand and reduce export demand as its growth model. Finally, if China does not choose this route, then like the United States, it will have to move to plan B. This will be based on the reality that the U.S. shoulders can no longer carry the current account surpluses of other countries on the previous scale. The United States will feel forced to restrict the inward flow of goods until there is a more balanced global economic order. Once force is set in motion, because discussion has failed, the outcome is no longer controllable or predictable.