China is in big trouble, but what about rest of world?

Paul Krugman

So, will China’s problems cause a global crisis? The good news is that the numbers, as I read them, don’t seem big enough. The bad news is that I could be wrong, because global contagion often seems to end up being worse than numbers say it should.

And the worse news is that if China does deliver a bad shock to the world, we are remarkably unready to deal with the consequences.

For those just starting to pay attention: It has been obvious for a while that China’s economy is in big trouble. How big is hard to say, because nobody believes official Chinese statistics.

The basic problem is that China’s economic model was only sustainable as long as the country could grow extremely fast, justifying high investment. This in turn was possible when China had vast reserves of underemployed rural labor. But that’s no longer true, and China now faces the tricky task of transitioning to much lower growth without stumbling into recession.

A reasonable strategy would have been to buy time with credit expansion and infrastructure spending while reforming the economy in ways that put more purchasing power into families’ hands. Unfortunately, China pursued only the first half of that strategy. The result has been rapidly rising debt and a threat of financial meltdown.

New numbers have reinforced fears of a hard landing, leading not just to a plunge in Chinese stocks but to sharp declines in stock prices worldwide. And some smart people think that the global implications are really scary; George Soros is comparing it to 2008.

Yes, China is a big economy, so what happens there has implications for all of us. But it’s a big world. Even a drastic fall in Chinese imports would be only a modest hit to world spending.

What about financial linkages? One reason America’s subprime crisis turned global in 2008 was that foreigners turned out to be badly exposed to losses on U.S. securities. But China isn’t very open to foreign investors so there’s very little direct spillover from plunging stocks or even domestic debt defaults.

All of this says that while China itself is in big trouble, the consequences for the rest of us should be manageable. But I have to admit that I’m not as relaxed about this as the above analysis says I should be.

Financial linkages may be part of the story, but one also suspects that there is psychological contagion: Good or bad news in one major economy affects animal spirits in others.

So I worry that China may export its woes in ways back-of-the-envelope calculations miss. And if my worries come true, we are woefully unready to deal with the shock.

Monetary policy would probably be of little help. With interest rates still close to zero and inflation still below target, the Fed would have limited ability to fight an economic downdraft. And while fiscal policy would surely work, how many people believe that Republicans would be receptive to a new stimulus plan?

Now, my best guess is still that things won’t be that bad — nasty in China, but just a bit of turbulence elsewhere. And I really hope that guess is right, because we don’t seem to have a plan B anywhere in sight.