The Great Carry Trade II: more on the Problem of China

Yesterday I explained why I consider that we’re in the midst of an era that could be termed the Great Imbalance. I go along with the the view apparently held by Nouriel Roubini that the so-called “Great Moderation” – the period of low inflation – is/was a mirage.

The point is that there is more than one tectonic shift taking place: low inflation has been caused, not by monetary conditions alone, but primarily by a historic reduction in the power of labour to raise wages and hence prices. Inequality is rising, full employment in developed countries is a half-forgotten phenomenon, jobs move around the world as part of globalisation; whereas the disruption of this supposedly happy state of affairs is caused by, well, trade imbalances.

A year ago I reported how the FT’s Martin Wolf had put his finger on the button (in fact, he’s written an entire book on the topic). Today I open my FT and see the argument outlined again, this time by Martin Feldstein in a piece titled “Why the renminbi has to rise to address imbalances”.

Feldstein argues that the US must increase household savings and China must increase domestic demand and “exchange rates must also adjust”. But this logical relationship is wrong. Exchange rates are the driver here. If the renminbi is allowed to rise against the dollar, American household savings and Chinese demand will adjust automatically.

Feldstein correctly notes that in the next phase of the Great Imbalance the euro will be drawn into the fray. The renminbi has dragged the dollar down. We’re going to start to see imports from Germany substituted by domestic Chinese (and American) products. (Europe will likely blame protectionism, and if they retaliate that would be a self-fulfilling diagnosis). Of course it will all be explained as due to the development of China, things they’re doing right that we’re doing wrong. The low dollar will be easily explained as a shift away from the dollar as a reserve currency since China will naturally hold more euros – a counterpart of its trade surplus with the region. But in fact all this will be the result of misaligned currency exchange rates!

Perhaps we should ask ourselves why China follows this policy when India does not. One problem India may avoid but China must face in the future is the sustainability of their industry. It’s all very well making things cheaply in external money terms, but we also have to consider whether they are being made efficiently in terms of physical real-world resources: labour, energy, the cost to the environment and so on. If these are being systematically mispriced – and it’s difficult to see how they could not be – then there will eventually be a reckoning, a crisis in China and a Great Rebalancing.

At the risk of oversimplifying, the difference with Japan, perhaps, is that, through successful industrial policies, Japan achieved export-led growth more by greater efficiency (such as quality) compared to the competition. This was sustainable even in the era when Japan was popularly termed “the Land of the Rising Yen”.

Feldstein’s conclusion is that:

“Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.”

I don’t know. I think they need to start now, or maybe not to be starting from here at all. It seems to me that, in the real world, economic shifts are marked by destructive crises. We’ve probably got a few years before the wheels come off again. Or, if governments use the time wisely, maybe the train can yet be switched to a level track. Interesting times.