Fed’s mis­take was to ex­trap­o­late Chi­nese pol­i­cy­mak­ers have been quicker than their US coun­ter­parts to face up to the per­ils of poli­cies ini­ti­ated in re­sponse to 2008 cri­sis

China Daily (Canada) - - COMMENT -

The temptations of ex­trap­o­la­tion are hard to re­sist. The trend ex­erts a pow­er­ful in­flu­ence on mar­kets, pol­i­cy­mak­ers, house­holds, and businesses. But dis­cern­ing ob­servers un­der­stand the lim­its of lin­ear think­ing, be­cause they know that lines bend, or some­times even break. That is the case to­day in as­sess­ing two key fac­tors shap­ing the global econ­omy: the risks as­so­ci­ated with United States’ pol­icy gam­bit and the state of the Chi­nese econ­omy.

Quan­ti­ta­tive eas­ing, or QE (the Federal Re­serve’s pro­gram of monthly pur­chases of long-term as­sets), be­gan as a no­ble en­deavor – well timed and well ar­tic­u­lated as the Fed’s des­per­ate an­ti­dote to a wrench­ing cri­sis. Coun­ter­fac­tu­als are al­ways tricky, but it is hard to ar­gue that the liq­uid­ity in­jec­tions of late 2008 and early 2009 did not play an im­por­tant role in sav­ing the world from some­thing far worse than the Great Re­ces­sion.

The com­bi­na­tion of prod­uct­spe­cific fund­ing fa­cil­i­ties and the first round of quan­ti­ta­tive eas­ing sent the Fed’s bal­ance sheet soar­ing to $2.3 tril­lion byMarch 2009, from its pre-cri­sis level of $900 bil­lion in the sum­mer of 2008. And the deep freeze in cri­sis-rav­aged mar­kets thawed.

The Fed’s mis­take was to ex­trap­o­late – that is, to be­lieve that shock ther­apy could not only save the pa­tient but also fos­ter sus­tained re­cov­ery. Two fur­ther rounds of QE ex­panded the Fed’s bal­ance sheet by an­other $2.1 tril­lion be­tween late 2009 and to­day, but yielded lit­tle in terms of jump-start­ing the real econ­omy.

This be­comes clear when the Fed’s liq­uid­ity in­jec­tions are com­pared with in­creases in nom­i­nalGDP. From late 2008 to­May 2014, the Fed’s bal­ance sheet in­creased by a to­tal of $3.4 tril­lion, well in ex­cess of the $2.6 tril­lion in­crease in nom­i­nalGDPover the same pe­riod. This is hardly “mis­sion ac­com­plished,” asQE sup­port­ers claim. Ev­ery dol­lar ofQE­gen­er­ated only 76 cents of nom­i­nalGDP.

Un­like the US, which re­lied largely on its cen­tral bank’s ef­forts to cush­ion the cri­sis and fos­ter re­cov­ery, China de­ployed a 4 tril­lion yuan fis­cal stim­u­lus (about 12 per­cent of its 2008 GDP) to jump-start its sag­ging econ­omy in the depths of the cri­sis. Whereas the US fis­cal stim­u­lus of $787 bil­lion (5.5 per­cent of its 2009 GDP) gained limited trac­tion, at best, on the real econ­omy, the Chi­nese ef­fort pro­duced an im­me­di­ate and sharp in­crease in “shov­el­ready” in­fra­struc­ture projects that boosted the fixed-in­vest­ment share of GDP from 44 per­cent in 2008 to 47 per­cent in 2009.

To be sure, China also eased mon­e­tary pol­icy. But such ef­forts fell well short of those of the Fed, with no zero-in­ter­est-rate or quan­ti­ta­tive-eas­ing gam­bits – only stan­dard re­duc­tions in pol­icy rates (five cuts in late 2008) and re­serve re­quire­ments (four ad­just­ments).

The most im­por­tant thing to note is that there was no ex­trap­o­la­tion ma­nia in Bei­jing. Chi­nese of­fi­cials viewed their ac­tions in 200809 as one-off mea­sures, and they have been much quicker than their US coun­ter­parts to face up to the per­ils of poli­cies ini­ti­ated in the depths of the cri­sis. In the US, de­nial runs deep.

Un­like the Fed, which continues to dis­miss the po­ten­tial neg­a­tive reper­cus­sions of QE on as­set mar­kets and the real econ­omy – both at home and abroad – China’s au­thor­i­ties have been far more cog­nizant of newrisks in­curred dur­ing and af­ter the cri­sis. They have moved swiftly to ad­dress many of them, es­pe­cially those posed by ex­cess lever­age, shadow bank­ing, and property mar­kets.

The jury is out on whether Chi­nese of­fi­cials have done enough. I think that they have, though I con­cede that mine is a mi­nor­ity view to­day. In the face of the cur­rent growth slow­down, China might well have re­verted to its ear­lier, cri­sis­tested ap­proach; that it did not is an­other ex­am­ple of the will­ing­ness of its lead­ers to re­sist ex­trap­o­la­tion and chart a dif­fer­ent course.

China has al­ready de­liv­ered on that front by aban­don­ing a growth model that had suc­cess­fully guided the coun­try’s eco­nomic de­vel­op­ment for more than 30 years. It rec­og­nized the need to switch from a model that fo­cused mainly on ex­port- and in­vest­ment-led pro­duc­tion (via man­u­fac­tur­ing) to one led by pri­vate con­sump­tion (via ser­vices). That change will give China a much bet­ter chance of avoid­ing the dreaded “mid­dle-in­come trap”, which en­snares most de­vel­op­ing economies, pre­cisely be­cause their pol­i­cy­mak­ers mis­tak­enly be­lieve that the recipe for early-stage take­off growth is suf­fi­cient to achieve de­vel­oped-coun­try sta­tus.

The US and Chi­nese cases do not ex­ist in a vac­uum. As I stress inmy new­book, the code­pen­dency of China and the US ties them to­gether in­ex­tri­ca­bly. The ques­tion then arises as to the con­se­quences of two dif­fer­ent pol­icy strate­gies – US sta­sis and Chi­nese re­bal­anc­ing.

The out­come is likely to be an “asym­met­ri­cal re­bal­anc­ing”. As China changes its eco­nomic model, it will shift from sur­plus sav­ing to sav­ing ab­sorp­tion – de­ploy­ing its as­sets to fund a so­cial safety net and thereby tem­per fear-driven pre­cau­tion­ary house­hold sav­ing. Con­versely, the US seems in­tent on main­tain­ing its cur­rent course – be­liev­ing that the low-sav­ing, ex­cess-con­sump­tion model that worked so well in the past will con­tinue to op­er­ate smoothly in the fu­ture.

There will be con­se­quences in rec­on­cil­ing these two ap­proaches. As China redi­rects its sur­plus sav­ing to sup­port its own cit­i­zens, it will have less left over to sup­port sav­ing-short Amer­i­cans. And that is likely to af­fect the terms on which theUS at­tracts for­eign fund­ing, leading to a weaker dol­lar, higher in­ter­est rates, ris­ing in­fla­tion, or some com­bi­na­tion of all three. In re­sponse, US eco­nomic head­winds will stiffen all the more.

It is of­ten said that a cri­sis should never be wasted: Politi­cians, pol­i­cy­mak­ers, and reg­u­la­tors should em­brace the mo­ment of deep dis­tress and take on the heavy bur­den of struc­tural re­pair. China seems to be do­ing that; the US is not. Code­pen­dency points to an un­avoid­able con­clu­sion: The US is about to be­come trapped in the per­ils of lin­ear think­ing. The au­thor, a fac­ulty mem­ber at Yale Univer­sity and for­mer Chair­man of Mor­gan Stan­ley Asia, is the au­thor of a new book Un­bal­anced: The Code­pen­dency of Amer­ica and China. Project Syn­di­cate

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