Tag Archives: China

2016 is nothing like 2008, but there’s trouble ahead for the world economy

In my New Year post I did not write much about finance, but made some rather throwaway comments that the economy could take a turn for the worse in 2016.  Having just read Martin Wolf’s rather sanguine piece in the FT, I hadn’t quite understood that my views were in line with conventional wisdom in the financial markets – and this not at all a position I like to be in. But pessimism is in, and reflected by lower share prices worldwide. This has filtered through to left wing commentators, like Will Hutton, who gleefully want to show that “austerity” or “neoliberalism” is leading to a repeat of the 2008 crash (though Mr Hutton is too good a writer to use those particular totems). This is definitely company I don’t want to keep. Time to dig a bit deeper.

It helps to think back to what happened in the last turndown, the crash of 2008 – as this is foremost on people’s minds. At the start of 2008 the banking system was in deep trouble, although on the surface things were quite calm, if gently sinking. “Holed below the waterline” was the description that I used at the time – alas I was not publicly blogging until three years later, or my reputation might have been made. Trust was breaking down because the banks were dealing a lot with each other, or off-balance sheet offshoots, rather than with the public or businesses. And things were starting to go wrong, beginning with US sub-prime mortgages. The huge tangle of interbank transactions and derivatives meant that nobody knew how the losses would play out or where – so everybody was tainted. Things kept superficially calm until quite late in 2008, when Lehman Brothers collapsed, threatening a chain reaction that would have brought much of the world’s banking system to a screeching halt. Since the banking system is at the centre of everyday life in developed economies the result could have been catastrophic.

That catastrophe was largely avoided, but only because governments bailed banks out to keep the whole system afloat. Even then the damage to the non-banking economy was severe, and government finances, especially here in the UK, were ruined. What was so alarming about the whole episode was that a fairly routine downturn in the business cycle infected part of the US mortgage market, which then completely disproportionately went on threaten the whole system. Defenders of Britain’s Labour government still can’t believe it was anything to do with them – though in fact ten years of complacent economic management had left the country highly vulnerable to such a chain reaction.

Why are people worried now? Well one thing that helped the ameliorate the disaster in 2008 was that emerging markets, especially China, were less badly affected, and in China’s case, government stimulus helped keep things afloat. Now that side of things is unravelling. The Chinese economy is slowing, and in the process it is undermining world markets for commodities such as oil, which presents the threat of widespread damage in the developing world. The Chinese situation arises partly because the country has hit an awkward point in the evolution of its development, and partly because their stimulus package after 2008 was largely wasted and bad debts are threatening its banking system. Indeed the whole soundness of China’s growth strategy is coming into question (its second, state-directed phase , rather than Deng Xiaoping’s original liberalisation from 1978).

This is serious, and no mistake. The role China has played in the world economy in the last quarter century is hard to exaggerate. What is happening there is much bigger than the US subprime crisis that was at the heart of the 2008 debacle. But it doesn’t have the same destabilising features that caused such a fierce chain reaction – which were in plain view as 2008 started. China is not at the heart of a cat’s cradle of complex derivatives sitting in off-balance sheet funds, with almost every international bank taking part. And the huge power of the Chinese state, and the depth of its financial reserves, means that the country’s financial system will collapse slowly rather than suddenly. The western banking system is a much soberer thing than it was in 2008 too, even if many left wing commentators would have you believe that nothing has changed. For these reasons 2016 does not look like 2008. A meltdown, or near meltdown, does not look likely.

But there could be a slower moving form of trouble. Secular stagnation, the affliction of the world economy I referred to recently, is here to stay. Western economies will slow. Worse things may be in store in the developing world. Share prices may well fall badly – many markets have been overpriced for some time.

And in Britain? In my New Year post I suggested that 2016 might be the year the economy here started to turn sour. That comment wasn’t based on any deep thinking. Britain is unusually dependent on the international economy, as is evident from persistent trade and current account deficits, and a value for Sterling that is hard to justify based on its “real” economy. So, with things going awry in the world economy, Britain might be vulnerable. The Pound could come under pressure; foreign investors could desert London’s property market causing a chain reaction; or a downturn in the City’s finance sector could do the same thing. On the other hand, capital flight from the developing world could benefit London in particular, allowing the country to weather the storm. Some left wing commentators have been trying to stoke alarm about the level of personal debt – but that doesn’t stand up to close scrutiny. Neither should we pay much heed to Labour’s economic adviser, David Blanchflower, who on the radio this morning suggested that Britain was less ready to deal with a crisis than in 2008, because interest rates were already rock bottom. That vastly inflates the effects of interest rate policy on crisis management. David Cameron’s and George Osborne’s luck could hold. I struggle to understand the alarmism on the political left – it will merely undermine its already shaky reputation for economic grasp.

it seems to me that 2016 will be the start of a good old-fashioned cyclical downturn for the world economy, with no more than the usual localised financial crises. Personally I think this will morph into a period of more prolonged secular stagnation that will put paid to economists’ lazy assumption that 1-2% rates of growth are a law of nature.

And that should pose some very challenging questions for the art of economics. But that’s a topic for another day. Meanwhile government bonds are a better bet than shares; cash is not a bad bet either; don’t mortgage up to your eyeballs in property; and interest rates aren’t going up.

 

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The Chinese test the limits of a state managed economy

Political commentary on economic growth operates between two poles. On the one side the right argues that the state should get out of the way, and allow entrepreneurial businesses full scope to do their thing. On the other, the left says that growth is driven by investment, much of which must be directed by the state to be effective. Both are right, of course, and the balance depends on the circumstances. But China offers a fascinating case study in this discourse.

Until the rise of Deng Xiaoping in 1978, China offered a good example of a failed, state-led economy, alongside the Soviet Bloc amongst others. The economy was made up of state owned enterprises (SOEs) and state directed cooperatives, operating according to production quotas, all part of a state plan. But the economy took off as the shackles of state control were released.

This seems to follow the right’s playbook, but what happened was in fact much more subtle. The state quotas and SOEs remained in being, but a private sector economy was allowed to flourish alongside it. This contrasts with what happened in Russia after the collapse of the Soviet Union in 1990. There, following the advice of right-wing US economists, the state system was dismantled, with SOEs sold off and production quotas abolished. You can’t be half-pregnant, these advisers suggested. That was disastrous, of course. The SOEs were acquired by well connected crooks, who formed a governing oligarchy. Essential state support systems collapsed. A flourishing economy did not emerge until a natural resources boom saved things.

Meanwhile, China’s pragmatic approach delivered spectacular growth, which led to a rapid diminution of poverty. After a first phase in which private enterprise transformed agriculture, a growing private sector flourished in producing manufactured goods for export. It was one of the most brilliant acts of economic government the world has ever seen. They took no advice from westerners. But the Chinese governing elite was left with some difficult questions. Sooner or later the SOEs and political structures would present limits to growth, and would have to be reformed. Commentators, inside and outside the country, confidently predicted that the Communist Party would have to release its grip. But that is not how things have played out.  The Party did reform SOEs to make them more responsive to market economics, but they did nothing that would threaten its own monopoly of political power.

Instead, as the 21st Century has progressed, a new model of growth has emerged. Alongside a vigorously competitive private sector, a massive programme of state-directed investment has sustained growth. That meant growth rates of 10% or so, even through the world recession of 2008/09. Something like 35% of Chinese national income is directed towards investment, much of it through SOEs. This has now swung towards the left-wing model, and those suspicious of capitalism and democracy have taken inspiration. A wise government, unconstrained by the petty-corruptions of democracy, has led the way to continued spectacular advance – and throwing out all that austerity nonsense too.

But, as Martin Wolf writes in the FT this is all coming into question.  The Chinese economy is slowing down. To an outsider this might look like an orderly transition. Growth rates of 7% are still high by almost anybody’s standards; the government’s aim of moving to an economy led by consumption rather than investment looks natural enough – this will improve the wellbeing of the Chinese people. And yet deep flaws in the Chinese model are being exposed. China has rather little to show for years of massive investment – at least in terms of economic returns, rather than monuments in steel and concrete. And behind the investment lurks piles of debt – representing the savings Chinese people. Chinese productivity has been static.

And slowing the growth rate from 10% to 7% may sound easy, but it creates real strains on financial systems, with all the time lags built into it. It implies a much larger dislocation. But with a stock of useless investments, SOEs who are not used to making themselves more efficient and effective, and a financial system threatened by excessive debt, doubts are growing about how feasible even 7% is as a growth figure. And since China plays such a big part in the world economy, it is no wonder that financiers across the globe are getting jittery.

This has some resonance in domestic politics in the developed world. The left’s criticism of austerity policies since 2008 has been virulent, and joined by many respectable macro-economists. Surely, they suggest, the state should have shored up demand with a programme of investment. Labour leadership frontrunner Jeremy Corbyn’s economic proposals are thick with this sort of thinking. But this only works in two circumstances. First is that the pre-crash economy was sustainable, and can be revived quickly, so all that is needed is to cover a temporary lapse in demand. In this event it hardly matters if the investment itself is useless (digging holes and then filling them in, and so on). But in Britain at least there was good reason to question the sustainability of the pre-crash economy: a large current account deficit, a structural deficit on state finances, a bloated finance sector, a declining oil and gas sector. Besides it is all now a bit late.

The second way in which investment can shore up an economy is if that investment produces decent economic returns in due course, allowing debts to be repaid. The unfolding problems in China are showing what happens if investment is badly directed. There are plenty of other examples (Japan is another good one). The trouble is that the more you try and turn investment on and off like a tap, to regulate the macro-economy or in an explicit drive for growth, the more likely investment is to be wasted. The money is directed according to political imperatives, not economic ones. This is something that macro-economists, who don’t like to look behind their beloved aggregated and averaged statistics, often miss. In the UK the criticism that the government did not invest enough after the crisis remains a valid one – but it would not have been easy to pump in the sort of funds that the wider economy needed to keep on an even keel.

Time will tell on China. Its leaders are not to be underestimated. But they are demonstrating that you can have too much state direction for a healthy economy.

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