As the recognition grows around the world of the eerie similarities between China last year and the United States in 1929, it is worth considering why the Depression in the US was so severe in order to understand some of the risks the mainland might face.
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Can China avoid US pre-Depression errors?
Michael Pettis
2 February 2009
As the recognition grows around the world of the eerie similarities between China last year and the United States in 1929, it is worth considering why the Depression in the US was so severe in order to understand some of the risks the mainland might face.
Economists speak of three factors that compounded the difficulties facing the US economy:
1. Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export. However, just when the 1929 crash caused US consumption to decline, it also interrupted the financing of trade-deficit countries, and international trade collapsed - especially after the US tried to force the adjustment abroad by the passage of import tariffs. This forced the US into a position in which domestic demand was not nearly high enough to absorb everything US factories produced.
2. Although the US was fiscally strong, it failed to take advantage of this strength and barely expanded government spending. This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings.
3. Excess money expansion caused by the massive accumulation of reserves in the 1920s led to overinvestment and risky lending. When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction converted a sharp economic slowdown into a disaster.
Compared with the US in 1929, China fares better on some measures, but not all. The first is the scale of overcapacity. Its trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 - about 0.5 per cent of global GDP - but its economy is less than one-fifth the relative size of the US economy in 1929. Beijing must avoid the US mistake in 1930 of increasing export competitiveness and reducing domestic demand for foreign goods. In that direction lies trade friction, which would force a collapse in mainland overcapacity.
China is reasonably strong fiscally and there is widespread recognition, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand. Unfortunately, it is not yet clear how aggressively the government will expand fiscally and whether it will do so fast enough to replace declining exports.
Like the US in the 1920s, the mainland experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive growth in money supply. When this happens, the financial system often responds by taking on excessive credit risk and overinvesting. Given the complexity of the formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.
How the People’s Bank of China will respond to any signs of sharp money contraction is probably the most important question to answer, and the most difficult. The mistakes made by the US central bank in the 1930s have been so widely discussed, there is no doubt the PBOC will do all in its power to counteract any monetary or credit contraction.
Unfortunately, the PBOC is not as free to manage domestic monetary policy as the Federal Reserve was in the 1930s, because its primary obligation is to manage the foreign-exchange value of the currency.
This means that monetary policy on the mainland is determined largely by net inflows or outflows on the trade and capital accounts. With international trade falling, it is probably only a question of time before the trade surplus begins to shrink sharply, and there is evidence some of the hot money that poured into the country a year ago is starting to leave.
This may be the biggest unexpected risk the country faces. If net outflows are large, the PBOC may be left with limited ability to manage monetary policy correctly, and in fact it may be forced to preside over a monetary contraction, which would worsen the difficult economic adjustment to the problem of overcapacity.
It is vitally important that policymakers recognise the monetary constraints under which they work and prepare contingency plans.
Michael Pettis is a professor of finance at Peking University
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