Storm, The (16 page)

So far much of the growth of China (and India) has been internally driven, based on the spread of technology, improved practices
in agriculture, and the growth of manufactures and services to meet internal demand. Particularly in China, there has also
been an opening up to trade (and some foreign investment), both for the purpose of achieving access to raw materials not available
domestically and – more tentatively – for the intrinsic benefit of trade competition, specialization and access to new ideas.
In sheer aggregate terms, this process has not yet advanced all that far: China accounts for around 10 per cent of world trade
(as against 4 per cent in 2000) and India barely 1 per cent. But it is changes at the margin that drive markets. To make the
same point more dramatically, if simplistically, China and India, by joining the world economy, have effectively doubled the
global labour force. It will be a long time before peasant farmers in rural backwaters of Bihar or Sichuan join the world
economy. But the virtually limitless potential for trade and outsourcing to tap into this labour force is, in itself, proving
an influence on business decisions and on wage-bargaining and costs in relation to many activities in richer parts of the
world.

The pattern of specialization that has emerged is pretty much as the textbooks would have predicted. Asian economies use an
abundance of labour to produce for world markets manufactures and traded services with a high labour content, and conversely
import raw materials and capital goods. The impact on the world economy has been to change relative prices: pushing
manufacturing prices down and raw material prices up. The simple model explaining this process was first set out by John Stuart
Mill in 1848 (though he was more concerned with food prices than with oil). Raphael Kaplinsky has argued that China turned
the terms of trade against itself by about 25 per cent, a big gain to the rest of the world (though China more than made up
the loss through higher volumes traded).

The impact of the big Asian economies on the world economy has been heightened by the fact that the fall in manufacturing
prices and the increase in raw material prices did not occur simultaneously but consecutively. In the early part of the century,
it began to be noticed that the prices of many manufactured goods and many traded services were falling: not just clothes
and shoes, but many consumer goods and engineering products. The effect was sufficiently large to push down the rate of inflation
to below target levels, permitting a reduction in interest rates. Rather prematurely, some commentators saw the end of inflation.
The overall impact on Western economies was benign in the short run, increasing the rate at which they could grow without
triggering inflation and increasing consumer purchasing power by reducing the cost of living. At the time, this fortuitous
windfall was presented as the consequence of brilliant economic management on the part of Gordon Brown and his peers. Few
anticipated that there would be a nasty sting in the tail in the form of increased oil and food prices as the law of diminishing
returns kicked in. It has been asserted at various times that the impact of China and the other emerging economies has been
‘disinflationary’ and ‘inflationary’. It has been both at different times.

What is less ambiguous is the impact of changes in relative prices on the distribution of income. Owners and producers of
raw materials, energy, agricultural goods and high-technology products have benefited, and mobile capital has benefited from
access to new markets and access to low cost labour. Workers in competing industries – and, arguably, workers more generally,
especially but not solely the unskilled – have been hit. The opening
up of the world economy has brought into play a vast new labour force, so the obvious predicted consequence is that the returns
to capital will increase relative to the benefits to labour. It is the same phenomenon on a much larger – global – scale that
Marx observed in the nineteenth century as the rural masses poured into the cities of England (his ‘reserve army of the unemployed’),
holding down wages to subsistence levels and financing capital accumulation. It is not necessary to follow his argument to
its extreme logical conclusion to see that in recent years real wages in developed countries, faced with this competition
from Asia, have tended to lag behind productivity growth, while corporate profits have appeared to rise as a share of developed
country income. In practice, technology, saving labour and deepening the use of capital, may well have been a more important
factor than trade with Asia, but the two have interacted. Thus the emerging economies help to explain the apparently high
share of profits in the national income, the relatively slow growth of real wages, as well as the combination of high oil
and food prices with falling manufacturing prices. If the impact were limited to a change in relative prices and their distributional
consequences, that would be important enough. But it has also been accompanied by major imbalances that have contributed,
indirectly, to the wider crisis within the Western world’s financial system.

When historians look back on the current period what they will find most odd, and different both from previous historical
experience and from the predictions of theory, is the massive flow of savings from relatively poor countries such as China
into rich countries, particularly the USA. The current account deficit – which is the mirror image of the net inflow of foreign
capital – in 2008 was estimated to be over $700 billion for the USA and around $100 billion for the UK ($165 billion for Spain).
The biggest surplus countries (net exporters of capital) are emerging economies – China at around $400 billion, other east
and
south-east Asian countries combined at around $130 billion, and the oil exporters, as discussed in the last chapter, with
around $500 billion combined. Some rich countries continue to perform the traditional capital exporting role (Germany, Japan,
the Netherlands and Switzerland), but their combined surplus – around $650 billion – is less than the deficit of the USA.
It is these savings flowing into the international financial markets, mainly into the USA, that have supported consumption-led
growth but have also generated the bubble economy whose collapse we are currently grappling with.

It is paradoxical and counter-intuitive that relatively poor countries should be supplying savings to the rich. In the late
nineteenth century, Britain exported capital to the rest of the world. It accommodated this by running a current account surplus.
Simple common sense, as well as more sophisticated theory, suggests why this was sensible. British investors earned a higher
return than at home, and emerging economies – such as Argentina, Australia, Canada and the USA – were able to use the inward
investment to finance their rapid development. Yet now we have a perverse situation where investors (or governments) in emerging
economies invest in American government securities rather than in their own countries, while the world’s economic superpower
apparently cannot generate enough savings to finance its own investment. The explanations for this strange phenomenon are
several and tend to vary according to whom the author is seeking to blame.

The simplest and most direct explanation is that American (and British) consumers, and also governments, have been happily
living beyond their means, but have been able to get away with it because of the easy availability of credit financed by the
banking system, the expansion of which has been made possible by access to savings overseas. American households ran a surplus
financial balance (savings minus investment) of 5 per cent of GDP before the Reagan boom years of the 1980s, but this fell
to a deficit of around 8 per cent of GDP in 2005–6. The share of gross personal
savings fell from 7 per cent to 2.5 per cent of GDP in the same period. The federal government’s financial balance fell from
very little to a deficit of about 5 per cent of GDP in 1983, and has fluctuated around that level ever since. This slippage
was financed from abroad, with large current account deficits (currently placed at around 5 per cent of GDP) and a steady
decline from a net foreign asset position to one of net liabilities.

The other way of looking at the same problem is from the Asian end. China has followed in the tradition of high levels of
thrift of other Asian emerging economies such as Japan, Korea and Taiwan. No doubt the austerity engendered under communism
discouraged heavy spending, and, until recently, the lack of availability of consumer goods also played a role. Also the lack
of social safety nets means that the Chinese save for education, retirement and healthcare. However, the real drive behind
Chinese savings is not frugal households – household saving, at 10 per cent of GDP, is actually lower than in India – but
Chinese state-owned companies, which pay out no dividends, and the Chinese government itself. Gross savings as a share of
the Chinese economy have reached an extraordinary 50 per cent, so there is capital to export even with an equally extraordinary
40 per cent going into investment. In other words, Chinese savers have generated considerably more savings than the economy
has been able to absorb productively, even with the enormous surge in investment in infrastructure and industry.

But seen from an Asian perspective (and also, coincidentally, from an orthodox monetarist point of view), it is the USA, and
the US monetary authorities in particular, which are to blame for allowing the situation to get out of control. Keeping nominal
– and real – interest rates down, which was the legacy of Alan Greenspan’s fear of recession, encouraged rapid credit growth
and a boom in housing markets. Inflation was hidden because Asian manufacturers were keeping down the prices of goods. In
reality, inflation was appearing in asset markets, notably housing. What should have happened, according to the critics, is
that as costs fell
due to the impact of Chinese labour on world markets, the benefits should have been passed on by making prices fall, so increasing
real incomes. Instead, the main central banks saw deflation as a threat, not an opportunity, and cut interest rates unnecessarily,
keeping inflation going. Investors were prompted by low interest rates to pursue higher returns in new-fangled risky assets,
leading eventually to the credit crunch.

On this view, the Chinese savers are both heroes and victims: plugging the hole in the US (and UK) savings deficits, and then
being ripped off by poor returns. And as the excessive spending spilled out into world markets, creating a big US trade (and
current account) deficit and driving the dollar down, the savings-surplus countries faced an invidious choice. They could
allow their exchange rates to appreciate, making their exports uncompetitive, or they could peg their currencies to the dollar
(as China did), which forces them to intervene in currency markets, piling up reserves and potentially creating inflationary
pressure. A little reflection will suggest that the weak link in the Asian response is their defence of currency pegs. Why
should it matter if their exports become somewhat less competitive?

Western, especially American, critics answer the question unsympathetically and blame China for pursuing a deliberately mercantilist
policy of holding down its exchange rates – until recently, pegged to the dollar – to help promote exports. This the Chinese
have done by buying up lots of US Treasury bonds, keeping interest rates low in the USA, fuelling debt-led consumption, and
allowing Americans to buy lots of Chinese imports. This has been called a system of ‘vendor finance’. In its extreme forms,
this argument portrays the USA as a helpless junkie manipulated into dependence by its cunning oriental drug-pusher, taking
its revenge for the Opium Wars inflicted on it by the West. Angry Congressmen have threatened to punish China for this manipulative
dominance obtained through unfair use of the exchange rate.

A more sophisticated and less emotive version of this argument
nonetheless places responsibility firmly on the Chinese and other countries with a ‘savings glut’, as Mr Bernanke has called
it. The thrifty Chinese are, in fact, villains for not making good use of their savings by investing them productively at
home or abroad (individual Chinese are not allowed to own foreign assets). This failure generates huge capital flows, drives
down long-term interest rates and the cost of capital, and these low interest rates create ‘bubbles’ in property markets and
excessive borrowing in open countries like the USA. The heroic Americans act as ‘borrowers of last resort’, running a current
account that has protected the world from recession – until now, when the process has ground to a halt. But the bottom line
is that the Asians are to blame. They haven’t learned how to spend.

The Chinese could answer that they have studied the experience of Japan and Korea, which achieved considerable success, leading
to high living standards, through the growth of export-led manufacturing, with ‘competitive’ exchange rates and a restrictive
– often overtly protectionist – approach to imports. China has a more liberal approach to imports than Japan has ever had,
but there is still a strong element of mercantilist thinking: exports good, imports bad. Lessons, too, were learned from the
Asian financial crisis a decade ago, when Asian countries with large current account deficits, which then included Korea,
were seriously punished by the financial markets when confidence was lost and governments found themselves facing painful
conditionality from the IMF. But since China’s reserves are now well in excess of annual imports it is clearly over-insuring
against the risk of balance of payments problems.