Global Political Economy QOTD

Yglesias:

Whatever else [austerity] does, it should certainly succeed in persuading European governments that stockpiling foreign exchange isn’t just for Asians anymore. If the world succeeds in coming out through the other side of this crisis, you should expect to see even more countries joining the perpetual surplus brigades leading to even more demand for safe dollar denominated financial assets. That, in turn, means either big U.S. budget deficits or else some bold new innovations in financial engineering to meet the demand.

The rest of the post is well worth reading. I'm not sure this is the right way to think about the next 10 years, but it's certainly one way to do it. And it's a scary way to do it, since we don't seem to be good at channeling the global savings glut into productive uses.

Global Imbalances FOTD

By “Northern European,” I mean the 6 countries on the list above that lie between Switzerland and Norway. They have a $455 billion [current account] surplus, as compared to China’s $303 billion.

More here.

This Is What Adjustment Looks Like (an ongoing series)

Martin Feldstein:

China’s government may be about to let the renminbi-dollar exchange rate rise more rapidly in the coming months than it did during the past year. The exchange rate was actually frozen during the financial crisis, but has been allowed to increase since the summer of 2010. In the past 12 months, the renminbi strengthened by 6% against the dollar, its reference currency. ...

There are two fundamental reasons why the Chinese government might choose such a policy: reducing its portfolio risk and containing domestic inflation.

Consider, first, the authorities’ concern about the risks implied by its portfolio of foreign securities. China’s existing portfolio of some $3 trillion worth of dollar bonds and other foreign securities exposes it to two distinct risks: inflation in the United States and Europe, and a rapid devaluation of the dollar relative to the euro and other currencies. ...

Looking back on the past year, the 6% rise in the renminbi-dollar exchange rate might understate the increase in the relative cost of Chinese goods to American buyers because of differences in domestic inflation rates. Chinese consumer prices rose about 6.5% over the past year, while US consumer prices rose only about 3.5%. The three-percentage-point difference implies that the “real” inflation-adjusted renminbi-dollar exchange rate rose 9% over the past year (i.e., 6% nominal appreciation plus the 3% inflation difference.)

There are obviously political interests in China for keeping the RMB's value low, but the most recent Five-Year Plan calls for increasing households' purchasing power above the rate of economic growth. We may start to see (more) political cleavages in China pitting consumers and against producers. Remember: politics exists even in authoritarian regimes.

Actually, Let's Not Start a Trade War With China Just Now

(click for larger image)

Brad DeLong links to Jared Bernstein, who suggests some policies that Obama could pursue (without deficit spending) to help the U.S. employment malaise. Many of them are fine, but this one isn't:

Currency Management: this would be a very bad time to let up on countries who subsidize their exports by suppressing their currency values in foreign exchange markets, most notably China. I’d push the Levin bill on this. And it’s bipartisan: the darn thing got 99 R votes in the last Congress!

The Levin bill proposes slapping tariffs on goods coming from countries that manipulate their exchange rates to boost exports. Levin has proposed a variant of it for years (here's one from 2006), but finally got traction during the recession. Krugman agrees that this is a good idea, but I think there are a number of problems with it.

1. It's most likely illegal. If China is violating trade rules with its exchange rate policies, then the USTR should take them to the WTO. The fact that that hasn't been done at any point over the past decade, despite the fact that it would have been politically popular, indicates to me that the USTR believes it would lose such a case. There's a reason why exchange rate policy has been referred to the IMF (which conducts monitoring and surveillance but has no authority) rather than the WTO. It's also not clear that China is violating any WTO rules. For one thing, the WTO doesn't have a lot to say about which exchange rate regimes are legal and which aren't. And although using the exchange rate to subsidize exports could be illegal, there's a fairly high bar to clear. This (several years old) thread on the excellent International Economic Law and Policy blog describes the three simultaneous conditions under which currency manipulation could be WTO-illegal: 1. It must entail a "financial contribution"; 2. It must be specific; 3. It must confer a benefit on exporters. The comments to that post get into specifics, but according to IELP, "If [currency policy] is contingent in law or de facto upon export performance, it is then prohibited and deemed specific automatically".

The graph above shows the nominal dollar-yuan exchange rate over the past five years. Does it look like the exchange rate is contingent upon export performance? The yuan has appreciated against the dollar by nearly 25% over the past five years, and I'm not sure the trend clearly indicates responsiveness to changes in Chinese export performance.

2. There are growing concerns about inflation in the U.S. These concerns may be misguided, but they play well in Republican circles and among certain Governors at the Federal Reserve. Slapping an import tariff on China would cause immediate price spikes across a wide range of consumer goods, which would likely lead to increased calls for the Fed to tighten monetary policy. That, of course, would not be good for economic recovery. Nor would it be good for standards of living. A Chinese undervaluation of the yuan is equivalent to the Chinese giving us free money. Let me say that again: a Chinese undervaluation of the yuan is equivalent to them giving us free money. It's not clear to me that trading lower standards of living for more jobs is a net win. Jobs are certainly important, but they're not the only important thing.

Moreover, as we've discussed on this blog repeatedly, the nominal exchange rate is less significant than the real exchange rate, and the real exchange rate is shifting faster than the nominal rate as inflation in China out-paces inflation in the U.S.

3. It's not at all clear that a tariff targeted specifically at China's exchange rates would have any effect on U.S. jobs. Not only would importers suffer, but there is no reason to believe that manufacturing jobs would come back to the U.S. en masse. Manufacturing employment was collapsing before the recession (see also here), and even if China lost some jobs via a U.S. tariff those jobs would likely go to Vietnam and Taiwan and South Korea and any number of other places before coming back here. A tariff would make U.S.-produced goods cheaper relative to Chinese goods (in U.S. markets), but would not affect the price of Vietnamese goods at all. The magnitude of this shift, and the timing of it, isn't obvious to me, and to some extent it offsets #2 above, but the world is dynamic.

4. Those dynamics are not limited to economics; they also involve politics. The Chinese would not simply accept tariffs as the new cost of doing business. They would fight back. First, they would take the U.S. to the WTO. Second, they would likely enact retaliatory tariffs. The WTO cases would take years to be resolved (i.e. hopefully after the recovery from the recession), but the tariffs would immediately damage U.S. exporters. Obama's stated policy goal is to double American exports over the next several years. It's going to be hard to do that if you can't sell into the world's fastest-growing major market, now the second-largest economy on the globe.

5. The U.S. runs the risk of pot-meets-kettle reactions from the rest of the globe. The world already believes that U.S. monetary policy, with interest rates at 0% and two rounds of quantitative easing already conducted, constitute "currency manipulation" of a different sort. Putin called it "hooliganism", Brazil imposed capital controls, S. Korea has expressed concern about exchange rates at the G20, etc. I agree with Krugman and others that this criticism is over-blown; the U.S. is in a deep recession and should be using monetary expansion to help get out of it. But a round of tariffs targeting exchange rate policy will leave the U.S. open to a dose of its own medicine. Other countries are already wary of U.S. policy, and more aggressive measures could quickly lead to a cycle of more prevalent beggar-thy-neighbor policies. Right now it is critical that international economic cooperation move forward, not back. We've seen from the Japan crisis how badly economies are damaged when global supply chains are disrupted.

6. The U.S. needs to know its role. The global economy is still terribly damaged. 1937 isn't the worst analogue. Right now the U.S. needs to do everything it can to keep markets open, maintain international cooperation, provide liquidity into the global system, and maintain a market for goods. In other words, it needs to live up to Kindleberger's charge. That involves allowing some free-riding. It involves setting policy based on global, not domestic, circumstances. Myopically trying to get back every lost job as quickly as possible runs the risk of damaging global economic relations over the medium- and long-run, which could easily have adverse effects on growth and prosperity. Letting China sell us goods at below-market prices seems like a very small price to pay for averting a seriously negative outcome.

This Is What Adjustment Looks Like (An Ongoing Series)

A dollar decline is what we would expect from a country with a large current account deficit and weak demand-side of the economy. And that's what we're getting. This is a bad thing for consumers, but a good thing for producers (at least exporters), and right now the country needs jobs more than anything. It's bad the US's external creditors, but good for the US's internal debtors (including the sovereign). If the dollar stays low, it will be interesting to see how other countries react. Another round of competitive devaluations? Internal macroeconomic adjustment, leading to a rebalancing?

I don't think this has much to do with QE2; it's exactly what we'd expect from a country in the US's position. But changes in the dollars value will force change on the US's trading partners, which is more or less everyone. It will be interesting to see what choices other countries make.

This Is What Adjustment Looks Like (An Ongoing Series)

Increasing inflation in China causes a real exchange rate appreciation. Michael Pettis:

[T]he month-on-month increase in prices suggests that inflation is running at just under 13% annually, although month-on-month numbers are always suspect because they don’t correct for seasonality and one or two big numbers can have a disproportionate effect. Still, although the CPI inflation number was below market expectations it is nonetheless well above the PBoC’s comfort level, which is officially 4%. In December the year-on-year rise in prices was 4.6%.

This stubbornly high inflation number, coupled with good growth numbers and a surge in exports will, I suspect, give Beijing the sense that it has room to tighten, so I expect that we will continue to see measures such as interest-rate and minimum-reserve-requirement hikes to slow down economic growth. In keeping with this on Friday the PBoC announced yet another 50-basis-point hike in minimum reserves (making it the fifth hike in five months).

But will these measures bite? My guess is that they will at first, but that when they do they will be quickly reversed. Any real attempt to reduce the sources of overheating will cause economic growth to slow too quickly, and Beijing will change its mind, especially if, as I expect, inflation peaks soon and starts to decline.

Let’s face it – most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible. I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly. I don’t believe anything has changed.

More at the link.

Iceland Is Not A Good Example For Running An Economy

Krugman posts the above graphic showing GDP declines in the Baltics as compared to Iceland. He uses it to argue that the Baltics, which chose internal devaluation rather than sacrifice their exchange rate pegs to the Euro, did much worse than Iceland, which had no currency peg to defend, and so devalued their currency rather than their internal economy. The below picture, covering roughly the same time period, shows this:



Ignore that sharp downward tick at the end and what you see is that the krona fell by roughly half against the euro from the end of 2007 to its 2009-2010 levels, which then stayed fairly constant. To which Krugman says:

Now it’s true that the Baltic countries have been able to maintain their fixed exchange rates. And this is crucial because ….?

I'm not sure if "crucial" is the right word, but a 50% currency devaluation hurts a small open economy like Iceland quite a lot. Before the crisis Iceland mostly produced two goods: fish and finance. It imported almost everything else, and many of those imports came from the eurozone. When its currency dropped in value by 50%, that means that those imports became 100% more expensive. This represents a huge drop in standards of living.

Krugman approvingly references this IMF report on Iceland, noting:

Iceland, as even the IMF says, has been able to “preserve the Nordic social model”; there has been a lot of distress, but not much extreme hardship.

Yes, but according to that report Iceland has only been able to preserve the Nordic social model by exploding sovereign debt from under 30% of GDP pre-crisis to over 115% of GDP now. Of course, servicing that debt becomes much more expensive when the krona is devalued. The IMF also suggests that to get its fiscal house in order Iceland will need to go on its own austerity program to run a 6% of GDP primary surplus over the medium-run. Also note that the Icesave situation has not been resolved; Iceland may yet need to redistribute funds to depositors in Britain and the Netherlands. This will be much more expensive with a devalued currency, but Iceland's IMF funding is contingent upon reaching an agreement.

None of this is to say that the Baltics have had it any better. Output and employment losses have indeed been more severe there, partially because they kept their exchange rate pegs, but also because they are just generally not as well developed politically or economically as Iceland (a member of the OECD with strong economic ties to Europe's center, remember). The point is that these crises are just not easily resolved. The choice between internal devaluation and currency devaluation is not simple for small open economies. Both involve major reductions in standards of living, even if only one of them shows up in the GDP statistics.

Adjustment in the Eurozone

Martin Wolf says rough times are ahead for the eurozone:

What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck. ...

The late Charles Kindleberger of MIT argued that an open economy required a hegemon. One of its roles is to be spender and borrower of last resort in a crisis. The hegemon, then, is the country with the best credit. In the eurozone, it is Germany. But Germany is a lender, not a borrower, and is sure to remain so. This being so, weaker borrowers must fulfil the role, with dire results for their credit ratings. ...

A wave of defaults - private and even public - threaten.

The crisis in the eurozone's periphery is not an accident: it is inherent in the system. The weaker members have to find an escape from the trap they are in. They will receive little help: the zone has no willing spender of last resort; and the euro itself is also very strong. But they must succeed. When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.

Well, many economists (esp. American economists) thought it wasn't an optimal curency zone. But then again, neither is the United States. Right now California should be practicing different fiscal and monetary policies than Minnesota, but it can't. But these problems are exacerbated in the eurozone.

Interestingly, the European Commission recently published a sneering paper titled "The euro: It can’t happen, It’s a bad idea, It won’t last. US economists on the EMU, 1989-2002." It takes a look at pessimism among American economists on the prospects for the euro, and concludes that they were universally wrong: the euro has been a big success, they say, so neener neener.

But is it that simple? The last sentence of Wolf's op-ed is key... the American economists were absolutely right that the eurozone is not an optimal currency union, but does that really matter? P. O. Neill comments at A Fistful of Euros:

And whether that matters is ultimately a political decision. To dig into the pop culture well, the US-based economists who form the sample in the Jonung-Drea paper were giving the Star Trek answer: “Damn it Jim I’m an economist not a politician.” Looking at the predicament of Ireland, Greece, Spain, Portugal, and Italy, they may still be right.

One of my favorite IPE books is Beth Simmons' Who Adjusts? It's about economic policies in the interwar period, specifically about the determinants of states' policies when faced with a choice between devaluing their currency (i.e. abandoning the gold standard) in an attempt to maintain full employment or maintaining the strength of the currency while accepting the misery of deflation. In other words, it's about whether states adjust internally or externally. The modern analogue is whether troubled states will make domestic structural adjustments or whether they will flout the ECB's authority and try to pass on the costs of adjustment to other states in the eurozone. And if they choose the latter, what the ECB will do: allow it, or play hardball.

If I manage to find any spare time in the coming weeks I hope to re-read it. I expect this to be one of the most intriguing (and important) issues in the global economy in the coming year.

Who Adjusts?

Now that things have slowed down a bit, regular posting should resume. There's been a lot going on in the past few weeks, but I'm going to let most of it pass since I'm late to the party.

In a recent e-mail, Dr. Oatley mentioned that he thought that my regular postings on financial regulation were somewhat missing the point: the real blame for the economic crisis lies with the large external imbalances that have been building over the past decade. Even though I think that regulatory regimes are interesting and important, I think Dr. Oatley is exactly right to emphasize macroeconomic factors. So I was interested to read ECB Executive Board member Lorenzo Bini Smaghi's recent take on the same topic:

A strengthening of the IMF was agreed after the Asian crisis in the 1990’s, and the G-7 summit in Cologne in 1999 mandated the Fund to play a strong surveillance role to ensure greater transparency and encourage early adjustment by countries with unsustainable balance-of-payments positions.

But, over the last decade, the expectations raised by this mandate have not been met. Some emerging economies did not let their currencies float but, instead, continued to peg them at undervalued exchange rates in order to promote their exports and build up reserves as a form of insurance in case of crisis.

Moreover, the IMF has not succeeded in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions. Nor have advanced economies, particularly the United States, taken IMF advice fully into consideration. The accumulation of large surpluses, especially in emerging Asian economies and oil-exporting countries, enabled the US to finance its current-account deficit. It also lowered long-term interest rates in the US and made monetary conditions there more expansionary.

In the context of this testy exchange, "some emerging economies" can only mean China. And I suppose it's not surprising that an ECB official would deflect blame from EU countries despite the fact that Germany, for example, also ran large current account surpluses in the run-up to the crisis.

But is it right to criticize the IMF for not succeeding "in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions"? Not really. Until a crisis hits, the IMF is basically powerless. It can monitor behaviors and help boost transparency, but it has little formal authority to coerce states into allowing their currencies to float, say. How exactly is the IMF supposed to "convince" states to stop acting in their own self-interest? Smaghi doesn't provide an answer, but doesn't see much help coming from multilateralism, arguing that emerging economies that want a larger role in the IMF mostly want to weaken conditionality while increasing access to cheap credit.

Gee, it almost sounds like the global economy needs maintenance from a strong state. But Smaghi never proposes that Europe step into the breach. Actually, he never mentions Europe, or even a single European country, at all. Instead, the U.S. and China are somehow expected to voluntarily cede authority to the IMF while eschewing domestic political concerns to bring their current and capital accounts into balance. Well, color me skeptical.

Interestingly enough, the quickest, easiest feasible way to moderate imbalances is a higher peg for the yuan against the dollar. But this isn't necessarily something that Europe would like to see. So if the U.S. and China act more prudently, it may come at the expense of the Eurozone. What would Smaghi say then?

Rethinking China

The Economist says that the Great Adjustment is well underway in China:

The good news is that the [current account] surplus is already shrinking. The strong rebound in China’s economy in the second quarter—pushing GDP 7.9% higher than a year ago—came entirely from domestic demand. This sucked in more imports, while exports continued to slump. ...

China’s real domestic demand is likely to grow by at least 10% this year. In fact, the popular perception that China has always relied on export-led growth is rather misleading. Its current-account surplus did soar from 2005 onwards but until then was rather modest. And over the past ten years net exports accounted, on average, for only one-tenth of its growth.

So what's the bad news? The rising domestic demand comes from investment, not consumption:

The problem is more that the mix of domestic demand between consumption and investment is unbalanced, and becoming even more so. In 2008 private consumption accounted for only 35% of GDP, down from 49% in 1990 (see chart 2). By contrast, investment had risen from 35% to 44% of GDP. This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large. This is China’s most glaring economic imbalance.

Consumption makes up only 35% of Chinese GDP, compared to 70% in the U.S. The Chinese savings rate remains over 50% (!), and the vast majority of that comes from households and companies. Part of that comes from the fact that China has a very weak social safety net, but another part remains the undervaluation of the RMB, which hurts the purchasing power of Chinese consumers. From 2005 to early this year the RMB appreciated substantially against the dollar, but has since fallen back as China re-pegged to the dollar. One estimate quoted in the article claims that the RMB should appreciate by as much as 25% to reach trade-weighted parity with the dollar.

Still, China appears to have turned a corner in its transition away from an export-led growth model. Now the emphasis must become transitioning towards a greater role for domestic consumption.

ht: Mark Thoma

Who Adjusts? A Continuing Series

Nobody, says Martin Wolf, and that's too bad.

Brad DeLong, on the other hand, sees a severe tightening of the balance of payments gaps... but not necessarily in a good way.

Hegemoaning

The argument that U.S. hegemony is beneficial on net to the rest of the world is most famously made in this book, but the arguments in support depend on the U.S. behaving a certain way. I was planning to write a post on how the United States is not fulfilling its unofficial responsibilities as hegemon to provide public goods in the midst of a global economic slowdown, but I see that Drezner has beaten me to the punch:

There's something else going on that should bother IR scholars. One of the benefits of having a hegemon is supposed to be greater provision of global public goods. According to hegemonic stability theory, if the United States is really still the hegemon, then it should be providing the following things:

Provisions of liquidity
Market for distressed goods
Long-term counter-cyclical lending
The U.S. did all of these things during the Asian financial crisis, for example.

This time around, the U.S. grade is not as high.

Drezner says the U.S. is doing the worst at counter-cyclical lending, linking to this NY Times piece that discusses how the continuing strength of the dollar indicates that the U.S. is hoarding capital that is strongly desired by other countries.

There's an aspect of this that may yield benefits for the rest of the world, however, especially countries that heavily rely on exports. The Times piece is about private capital flows to the U.S. Treasury, which have then been turned around and disbursed to the American populace as fiscal stimulus. If the stimulus has any positive effect at all, it will mean that U.S. consumers are spending their stimulus checks. And with the dollar high relative to almost every other currency in the world, that means that American consumers will be importing a lot. In other words, the American stimulus could function as something of a subsidy to the exporting industries of the rest of the world, which could boost employment and government revenues in places like Eastern Europe and Southeast Asia that desperately need a boost.

Indeed, this aspect is exactly what U.S. policymakers were hoping to avoid in the stimulus bill. Thus, the "Buy American" provisions. But those only apply to government infrastructure projects (and possibly not even then); American consumers are free to spend their money however they like. And discount chains like Walmart, which are often heavy importers, can reap some countercyclical benefits in a downturn. The net result could be a transfer from private investors to the U.S. Treasury, from the Treasury to American consumers, from consumers to retailers selling (imported) inferior goods, and from those retailers to the export-biased economies in the developing world.

It's not clear that this sort of movement is what the global economy needs, as it could prolong needed adjustment, but it is line with the theoretical role of the hegemon as a global stabilizer. The mechanism is more indirect, but that doesn't mean it isn't real.

On the (De)Merits of Liberal Illiberalism

Economic infidel Emmanuel (hey, he asked for it) fulfilled his promise to further explain his support for a low-level trade war between the U.S. and China. It's a long post, summoning Adam Smith and Jesus Christ among other luminaries, but I feel it is short on persuasion. For one thing, in my last post I proposed two scenarios for achieving a re-balancing of accounts: the first is Emmanuel's trade war; the second, a mix of currency revaluations (i.e. the RMB strengthening against the dollar) and domestic policies to encourage domestic spending in China (e.g. social welfare spending). If the real problem is as Emmanuel sees it, then the second scenario attacks the problem head-on by addressing the factors causing the account imbalance; instigating a trade war doesn't address the problem at all except by slowing overall economic activity. This proposed cure seems much worse than the actual disease, especially from the Chinese point of view. Emmanuel didn't speak to my question directly, but his post indicates that he prefers the war nonetheless. I remain unconvinced, as I hope to explain below.

I certainly agree that the current trade regime between the U.S. and China is not "free". But Emmanuel points out several ways in which the trade policies are illiberal, complains about them, and then proposes more illiberalism as a counterweight! He's proposing illiberalism as a liberalism-in-disguise. It's a sort of Wouldn't it make more sense to advocate for China to allow the RMB to appreciate, the U.S. to let the dollar depreciate (we've been trying our damnedest!), and for China to weaken its system of export subsidies in favor of policies likely to stimulate domestic spending (e.g. some version of an EITC or something)? In past posts (and later in the one under discussion), Emmanuel has been sympathetic to those views, so why has he jumped on the protectionist bandwagon now?

Emmanuel correctly points out that there is a social justice aspect to this. But it's not clear that it cuts always and only in the direction that he intends. If a trade war ensues, the first thing to happen will be a somewhat major rise in unemployment (above and beyond the jobs lost to opportunity costs), especially among the already-poor in China. And if employment drops, it will be difficult for China to boost domestic consumption. The necessity of boosting Chinese domestic consumption is the central issue here, as I think Emmanuel and I both agree. So if Obama starts a trade war with China, the Chinese people lose jobs and become poorer, domestic consumption falls further, and Chinese welfare has dropped. Where's the social justice in that? Perhaps the statistical account imbalance has lessened, but at great cost in welfare.

Emmanuel similarly complains about zombie corporations, and cites the Japanese experiences of the past decade or so. I have that experience in mind as well, but I don't understand how propping up inefficient local industries through mercantilism is supposed to decrease the number of zombie firms. Indeed, the opposite is likely to be true, as the U.S. has already seen (viz.: the Big Three automakers, and the U.S. steel industry). Creating more domestic protections -- through subsidy or import tax -- will further soften the underbelly of American industry, and prolong the adjustment Emmanuel is seeking.

He is similarly wrong about America's debt obligations. While American debt is certainly not negligible, it's also not extreme. American debt levels as a percentage of GDP are somewhat middle-of-the-road for OECD countries. Japan, Italy, France, Greece, Belgium, even Germany (!) all have higher debt-to-GDP ratios than the U.S., which is right around the OECD mean. Of course, the U.S. debt level is sure to go up in the next few years, but the point is that there is still some wiggle room before the debt burden becomes unmanageable. One other not-insignificant point is that all of the U.S. debt is dollar-denominated, which makes servicing that debt much easier, especially over long time horizons.

So we agree on the need for structural adjustments in both the U.S. and China, but we disagree on the mechanism. Emmanuel seems to think that adjustment is best achieved through a trade war, whereas I think that a trade war will prolong the adjustment period by propping up national champions and zombie firms. And, as Bhagwati is fond of saying, it's much easier to enact protectionist measures in bad times than it is to retract them in good times: once interests are entrenched, they tend to stay entrenched (see, e.g., the U.S. Farm Bill). To me, a better policy would be keep trade open, lower the existing barriers to trade, make the playing field equal for producers of Chinese domestic goods, and boost the American export sector through greater currency parity. This could lessen the pain of the transition by not killing aggregate economic activity.

Is my option politically feasible? Emmanuel seems to think not; that only a trade war can force the Chinese and American governments to take the necessary steps. This is not obvious to me, and in fact it seems more likely that the opposite is true: if the U.S. puts up tariffs, the Chinese may respond with even greater export subsidies, or even greater currency manipulation. In fact, the recent pattern of Chinese behavior indicates this as the most likely outcome. And if that happens, then what? I'd rather work for actual liberal policies rather than illiberal liberal ones, even if the changes are incremental rather than drastic. In my view, a small positive change is preferred to a large negative change any day of the week. I fear that Emmanuel's approach is one step forward, two steps back.

Should We Hope For More Protectionism?

Emmanuel at IPE Zone says that a trade war between China and the U.S. might not be such a bad thing after all:

I will have more on why a trade war could be a potentially welcome development as the US and China wage a tit-for-tat strategy of faulting each others' trade practices and launching sanctions. Unlike conventional economists who view protectionism as an unambiguous bad or anti-globalization types who view trade as little more than the work of Satan, there is more to it than that. As always, the IPE Zone is less about pleasing either crowd than about forging ahead with fresh thinking on various problematiques. Yes, a trade war may just be the thing to remedy global economic imbalances currently roiling globalization. All we need is an Obama-induced escalation. Watch this space.

I will, but color me skeptical. There's a reason "conventional economists" are frightened of a trade war: it distorts economic activity, increases inefficiencies, carries the deadweight loss of the tax and of the lost scale returns, and so reduces output. In the midst of the worst global economy since the Great Depression, that seems to be the last thing we should be seeking. Additionally, the Chinese economy is heavily dependent on exports; if that system collapses suddenly rather than gradually, then it seems inevitable that social welfare will decrease sharply, and the brunt of it will be felt by the Chinese.

Emmanuel seems to think that these negative prospects will be out-weighed by an improvement in "global economic imbalances". But will they? Let's go through the logic. Suppose the Chinese government -- now facing a potentially severe domestic recession -- is facing two policy choices: attempting to rebalance their economy by boosting domestic consumption, or instigating a trade war with the U.S. to protect local industries. In the first scenario, the Chinese government could let the value of the RMB rise relative to the dollar; this will hurt exporting producers, but will make imports relatively cheaper. If coupled with a shift in subsidies from export industries to domestic consumption programs (e.g. direct subsidies to Chinese consumers, through unemployment insurance or some other social welfare plan) then domestic consumption might be boosted while the balance-of-payments gap narrows. The shift from an extremely export-biased economic model to a more balanced model would not be without some pain, of course, but that adjustment is going to have to happen eventually anyway.

In the second scenario, the Chinese and Americans end up in a trade war. Because 40% of the Chinese economy is in exporting industries, national income falls precipitously while unemployment rises. This lessens domestic demand for goods in China, and the Chinese economy slips into a deep recession. The value of the RMB slips further, making imports even more expensive and diminishing local demand further. The current account surplus narrows, but only because overall economic activity has decreased. In this scenario, spiraling is a very real danger.

Both scenarios lead to the re-balancing Emmanuel seeks, but the second seems to entail much more pain. And this pain wouldn't remain local; it would trickle down throughout all the export-biased economies in Asia. All to say, I have no idea what Emmanuel has in mind, although I'm very interested in finding out.

The New Economic Order: Same As the Old Economic Order

Dani Rodrik:

It will be a watershed year, ushering a new world economic order--with the disorder most likely coming first. I just don't have the foggiest idea what this new order will look like.

It will be a time when we will all have to change our tune and have to think out of the box. I for one will worry more about growth in the advanced countries than in the developing world, will be warning against the dangers of protectionism, will be singing the praises of the IMF (if its recent actions and pronouncements are a guide), and will fret about too much state intervention. Changing times require changing lines...

Rodrik is certainly not the first to predict a "new world economic order". All sort of talking heads, pundits, economists, political scientists, and politicians have been saying the same. Like the others, Rodrik is short on details ("I just don't have the foggiest idea" is a typical comment). But Rodrik is one of the smartest and most intellectually-honest international economists working, not a soundbyte-seeking talking head or politician, so his pronouncements are certainly worth noting. If he thinks a new economic system is in the cards, then I'll take the notion seriously.

But I don't understand his basis for making such a claim. In the same post he says "the crisis has demonstrated the deep divisions within Europe—on everything from financial regulation to the requisite policy response" and concludes that the best that we now can hope for Europe is that they don't "undermine" the policy actions of the United States. Rodrik also says that China's influence on the global order is likely to decline as they shift their focus to domestic concerns, and that the I.M.F. has been and will continue to be one of the biggest players in this crisis. Meanwhile, falling gas prices signifies a decrease in influence for the energy-exporting countries (e.g. Iran, Venezuela, Russia) that had recently been flouting the U.S. and the 20th-century economic institutions.

So... the influence of China, Russia, and Europe declines and the influence of the U.S. and I.M.F. increases. How does this represent an over-throw of the old economic order?

To be sure, some tweaks to the system will be made on the margin. Perhaps some sort of international banking standards (such as reserve requirements) will be enacted, but these were not the primary cause of the crisis. Perhaps some sort of Tobin tax is put in place to prevent future Iceland-like implosions (although I doubt it). Perhaps greater regulation of ratings agencies will be put into place, but that would likely happen at the domestic, rather than international, level. What else do you want? Replacing mark-to-market accounting practices? Mandating maximum leverage levels? Again, these things may have exacerbated the crisis, but they didn't cause it.

In any case, marginal tweaks to the system do not a New World Order make. Indeed, it seems most likely that the most significant changes to the international financial system in the next year will be the changes made to the domestic financial structure of the U.S. And if that is true, then how can it be said that the age of the liberal international economic order is coming to a close?