Friday, November 28, 2008 2 comments ++[ CLICK TO COMMENT ]++

How bad is the situation in China and are we witnessing another Smoot-Hawley-type disaster?

Regardless of your views of the causes of the Great Depression--did the FedRes really cause it?--it is hard to argue against the notion that the Smoot-Hawley tariffs started the trade war that likely destroyed the US, and indeed the world, economies at that time. Some conservatives seem to feel that the incoming Democratic government of Barack Obama may pass a Smoot-Hawley-type legislation. Speaking as someone who is left-leaning but is not American, although there is strong support for tariffs from the left, I highly doubt the Democrat government would pass such legislation without being provoked. I'm concerned about some protectionism movement but I don't feel it is anything significant.

However, there is some rising concern that the party that is in position to make the mistake is not the US. Rather it is China. This is a radical thought that hasn't entered the mainstream consensus. China may end up doing what the US did in 1930. Yves Smith of Naked Capitalism references a post by Michael Pettis, a professor of Chinese finance at Peking University:

Export subsidies, depreciating RMB – all of this might seem to make sense if you look at China as divorced from the global balance of payments system. These measures to boost exports are, after all, pretty standard ways of increasing production.

But if you think of China’s role within the global balance of payments, it seems to me that this is little more that a form of Smoot-Hawley-with-Chinese-characteristics. Global demand is slowing, just as it did in the 1930s, and China as the leading source of global overcapacity is trying to address its global demand problem by shifting the burden abroad.

If you think of China as being the yesteryear USA, and USA as Europe of the 1930's, you can see where this argument comes from. Michael Pettis' post is well worth reading if you have any interest in macro issues or China so do check it out.

The skeptics and bears, including me, argue that China has massive overcapacity in manufacturing, among other things. USA in the 1920's had overcapacity in manufacturing and that is why they wanted to limit imports via a tariff. One of the proper things for USA at that time would have been increase local consumption to absorb the excess production capacity, while it also reduced its capacity.

If you go with the bearish view and assume China has excess capacity in production, the ideal solution would be for them to absorb it via internal consumption, along with some reduction in production capability. Yet, what China is doing is to keep propagating the excess capacity (the stimulus packages are an example of this.) If China devalues its currency--no sign of such plan yet--it would be similar to the Smoot-Hawley tariffs in (i) hurting all others and possibly starting a trade war, and (ii) maintaining the excess capacity.

The problem in China is serious. The issue is not so much that people are being impoverished and starving to death. This isn't USA/Europe of the 1930's or China of the 1970's. Rather, the issue is the maintenance of the totalitarian regime in power. You are seeing one of the reasons totalitarian governments eventually collapse. Contrary to what some Americans think, USSR did not collapse because of USA (although it helped.) Instead, it fell on its own after its economy couldn't mask the incompetence of the government apparatus. Anyway, the problem with China is that the Chinese government will do its best to maintain high growth. Doing so alleviates unemployment problems that may lead to an overthrow of the government.

So, how bad is the unemployment situation? The truthful answer is that no one knows. Like most numbers coming out of China, no one has any clue. The Economist does an admirable job trying to pierce through the clouds. It is an article well worth reading in order to understand what the numbers are hard to figure out. It cites a bunch of studies and has the following chart illustrating the situation:

There is good news and bad news. The good news is that the unemployment rate has steadily declined in this century. The official rate may show that unemployment was flat for the whole period--totally nonsensical given China's growth--but that's partly because it did not count layoffs at government-owned businesses.

The bad news is that the situation is projected to get worse. In fact some projections are for Chinese GDP to grow slower than at any point since the early 90's. The Economist also points out that the number employees hired per unit of GDP has declined over the decade. This is mainly due to productivity improvements, which results in less workers needing in the manufacturing-dominated Chinese economy. The only hope, it seems, is to increase service sector jobs since more jobs are created per unit of GDP than in manufacturing. Unfortunately, this is a very difficult shift so the Chinese government still seems focused on propping up its suffering manufacturers.


2 Response to How bad is the situation in China and are we witnessing another Smoot-Hawley-type disaster?

December 3, 2008 at 10:40 AM

I haven't spent a lot of time thinking about this, but how does the fact that China holds vast quantities of US currency play into your theory, and fit the historical perspective?

My gut feel is it makes it rather different.

Sure there will be political tinkering by politicians in the West to do something and/or minor bungling by the Chinese who have to appease their peers rather than voters, but I think they're smart enough to know that if there's a country in the world that needs world trade to prevent rioting in the streets, it's China.

December 3, 2008 at 12:33 PM

MONEVATOR: "how does the fact that China holds vast quantities of US currency play into your theory, and fit the historical perspective?"

The situation obviously isn't identical but there are some similiarities.

China holding large foreign exchange reserves is similar to USA sucking up huge quantities of gold in the 1920's. USA was running trade surpluses while Europe was running deficits.

The problem I see is that the interests of individual countries is not the same as for the collective. In the 20's and early 30's, what USA did would seem reasonable from America's point of view, but it bankrupted most European nations. Similarly, right now, what China is doing seems sensible for a China-centric point of view but it can adverse impact others.

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