Back in the late 1970s, I lived on the south side of Chicago. One summer day, I was walking across Lake Shore Drive on a pedestrian bridge and I saw a big old 70s car (perhaps a Pontiac Bonneville) weaving wildly left and right across the road. Suddenly it veered toward a beach crowded with people. Just before reaching the beach it slammed into a tree, which created a huge U-shape gouge in the front of the car. Four teenage girls got out, dazed and bleeding. Ten minutes later an ambulance truck arrived and the young women were carted inside. But then the ambulance wouldn’t start. Another 10 or 15 minutes went by and police vehicle came by with jumper cables. Just a normal day in the late 1970s on the south side of Chicago.
I mention this because of the sickening feeling I had watching the accident play out in real time. Watching the accident felt slightly surreal, as there was nothing I could do. I have the same feeling watching China repeat Japan’s monetary policy mistakes of the 1990s and 2000s. Here’s a Bloomberg headline:
Markets Sound Alarm Over Deflationary Spiral in China
And the subhead:
Investors are increasingly concerned that China risks sliding into an economic malaise that could last decades.
The problem in Japan during the late 1990s was an unwillingness to engage in monetary stimulus for fear that it would lead to excessive yen depreciation. Replace “yen” with “yuan” and you have a fairly complete explanation of China’s current malaise.
In the 1990s and 2000s, many western experts recommended the Japanese adopt quack remedies such as fiscal stimulus, which completely failed to provide growth in nominal GDP. Only when the Abe government switched a contractionary fiscal policy combined with monetary stimulus in 2013 did Japan begin to see modest growth in NGDP.
Unlike Japan in the 1992-2012 period, China does currently have some growth in NGDP. But a sharp slowdown in NGDP growth can be painful, even if the absolute rate of growth remains positive. The US had positive NGDP growth in 1982, but the sharp slowdown from 1981’s NGDP growth rate created a severe recession.
If I am correct, why don’t other pundits see this problem? Many reasons:
Reasoning from an interest rate change: China has relatively low nominal interest rates, which have been declining over time. I hope I don’t need to explain the problem with this indicator.
Confusing real and nominal variables. China has a big trade surplus; therefore many pundits believe the yuan is undervalued. Actually, it’s overvalued. The same confusion occurred with the Japanese yen in the 1990s and 2000s. Trade balances are impacted by the real exchange rate, but China needs a weaker nominal exchange rate.
Reasoning from an exchange rate change. A decline in the exchange rate generated by a higher savings rate will indeed lead to a bigger trade surplus. But currency depreciation generated by monetary stimulus need not lead to a larger trade surplus, as the “income effect” often outweighs the “substitution effect”. Growth sucks in imports.
Not understanding that China’s real problem is partly nominal. Yes, China has structural issues, made a bit worse by Xi Jinping’s partial retreat from previous market reforms. But the underlying structure of China’s economy is still strong enough to generate reasonable output growth, as along as monetary policymakers allow for sufficient nominal growth.
China is a middle-income country with a per capita GDP roughly on par with Mexico. Unlike Europe and Japan, it still has plenty of room to grow under its current economic system. If it adopted a Singapore-style free market regime, it would have even more room to grow.
Causation is an ambiguous concept, which depends on which policy counterfactuals are the most useful. Thus you could say that China’s deflation is caused by an overvalued yuan. Or you could say that assuming a fixed value of the yuan, the deflation is caused by bad supply-side policies. Both claims are defensible. The question is which solution is the most feasible, the most useful?
Ironically, China is really, really good at doing the very hardest parts of development, such as quickly building lots of excellent high speed rail lines, subways, airports and expressways. They also have plenty of housing construction, perhaps too much. Even the US no longer knows how to build enough infrastructure and housing. In contrast, China is increasingly inept at doing the easiest parts of development, insuring that they have printed enough money. Even Zimbabwe knows how to print money.
China is a country more skilled than the US at the hardest parts of development, and less skilled than Zimbabwe at the least difficult parts. I understand how absurd that seems, but the claim that Japan’s problems could be addressed by printing money also seemed absurd until Abe raised their inflation target from zero to 2%, and allowed the yen to depreciate sharply. And that sort of claim appeared absurd for the US, at least until FDR devalued the dollar in April 1933.
In a recent interview, Tyler Cowen asked me to explain why China doesn’t end its deflation, and I struggled to come up with an answer. I do know that in the 1990s and 2000s, the US government strongly pressured Japan to avoid yen depreciation, i.e., our government basically bullied them into deflation. (Yes, bullying didn’t start with Trump.) But I’m not sure if this is the problem with China. I’ve read reports that they are concerned that yuan depreciation might lead to a flight of capital. I don’t even understand why China maintains capital controls; it doesn’t seem like it is in their interest to do so.
But when you look at all of the bad advice China is getting from respected foreign pundits, all the quack remedies being proposed, is it so hard to believe that their own policymakers might be confused by the situation, making the same mistakes as those previously made in Japan?
Here’s an 1883 woodblock print triptych by Yoshitoshi, showing a very sad scene from an old Japanese tale:
Why is it that China is good at building rail lines, subways, and other infrastructure? Are these areas less regulated than in the US, despite the overall statism? (I know that's true in some areas in Sweden, for one.) As their working populations shrinks and ages rapidly, presumably building infrastructure will become harder.
Very clarifying. There is also the similarity of real estate assets collapsing in value a la early 1990s Japan. A highly managed financial sector is an obvious common element.
I have used the rai stones of Yap as an analogy for the trading of never finished, never occupied apartments. If everyone agrees something has value, and there is a shortage of alternative assets, then …. On the other hand, such agreement can be fragile to a change in the underlying parameters.
China has roughly the same population as the Americas. A country that has the equivalent of New York City and the boondocks of Colombia in the same country is indeed an interesting policy challenge.