A plea for a G2

As China and the US shunt their way towards a trade war, I offer this excerpt from The Great Crash of 2008 as a roadmap for economic co-operation between the powers. I co-authored the book with Ross Garnaut but this section was written by the good professor. Sadly, I see little chance of this happening...

Bipolar cooperation for economic stability
The maintenance of global economic stability and growth is among the issues that can no longer be solved without cooperation between China and the United States. It is clear that there were risks in early twenty-first century imbalances for surplus and deficit countries. China could have set out to reduce its surplus by increasing domestic expenditure. To avoid unwelcome inflationary pressures (and inflation had emerged as an issue immediately before the Crash), it would have had to raise the foreign exchange value of the yuan earlier and more than it did. Alternatively, it could have ignored the inflation risk and held the yuan steady while increasing expenditure. This would have led to higher inflation within China which, in turn, would have raised the real (inflation-adjusted) exchange rate, slowed export growth and raised imports. Regardless of how the increase in the real exchange rate were achieved, exports would have grown more slowly and imports more rapidly.

An increase in expenditure is easier said than done, at least if it is to be useful in raising current and future standards of living. There is a limited capacity to plan and implement efficient government programs. The household consumer is not so easily persuaded over a short period that her interests are served more by increased consumption than increased savings. That said, the early success of the Chinese Government in quickly increasing domestic expenditure after the Great Crash of 2008 suggests that more could have been done earlier. It is notable that the rapid expenditure increases since October 2008 have been dominated by investment. If it had been possible to substantially increase expenditure in China before the Great Crash, we cannot be entirely sure whether this would have led to lower, similar or higher growth rates than were actually achieved. The increase would probably have been focused mainly on investment, broadly defined to include education and other avenues to the improvement of the productive capacity of the labour force. It’s a shocking thought that this would have generated an even higher rate of growth.

The rising real exchange rate would have forced the accelerated restructuring of the export and import-competing sectors of the economy. Labour-intensive production would have declined more rapidly, and the emergence of newly competitive and more technologically sophisticated, capital-intensive production would have been more rapid. The maintenance of high employment and a socially acceptable distribution of income would depend heavily on the composition of the expansion of government expenditure.

If China had adopted such an alternative strategy before the Crash, the crisis would have been less costly for it and its international partners.

The United States would have faced unpalatable choices. There would have been a more challenging inflation environment, one in which the funding of private and public deficits was more difficult and costly. Interest rates and taxation would have had to be higher and government expenditure lower. President George W Bush’s wars would have been contested more strongly on economic grounds. Economic growth, incomes and employment would have been lower than they were. But through these means, the US deficit would have fallen more or less commensurately with the Chinese surplus. The United States would have been less vulnerable to the Great Crash.

What if the United States had not been prepared to do these hard things in response to Chinese adjustment? The result would have been higher global inflation and interest rates, and probably greater vulnerability to financial instability. This would have been a bad outcome for China, the United States and the world as a whole. On the other hand, what if the United States had heeded the warning signs in external deficits before the Great Crash, and alone had tried to take preventive action? Could it have unilaterally taken steps to reduce its deficits, thereby forcing China to accept lower surpluses? If the US Government had been less profligate with expenditure or tax cuts, and had run much lower budget deficits in the George W Bush era, this would have lowered the exchange rate (and also long-term interest rates). Export growth would have been stronger and import growth weaker. This would have fed back into smaller Chinese exports and larger imports. China’s external surplus would have been lower. In the absence of countervailing increases in Chinese expenditure, growth would have been lower in both China and the United States. Unilateral and unreciprocated action along these lines would not have been an attractive option.

The best result would have been active coordination of macro-economic policy, within which increased expenditure in China coincided with expenditure restraint in the United States. Cooperation would have created less risky and more rewarding policy options for both countries.