Recovery Without Rebalancing

The Economist has a long hard look at the glimmers of green shoots of hope we've all been discussing, and comes away a bit skeptical. The problem is this: government policy will probably put an end to the decline in output, but from where do we get new demand?

As the inventory adjustment ends and the stimuli kick in, America's slump is sure to ease. Cushioned by the government, the economy may even begin to grow again before too long. But it is hard to see the ingredients for a recovery that is robust enough to stop unemployment rising. Weakness abroad will crimp exports. America's banks are propped up with public capital, but their balance-sheets are clogged with toxic assets. Consumer spending and firms' investment will be dragged lower by the need to pay back debt and restore savings. This will be a long slog. Private-sector leverage, which rose by 70% of GDP between 2000 and 2008, has barely begun to unwind. At 4%, the household savings rate has jumped sharply from its low of near zero, but it is still far below its post-war average of 7%. Higher unemployment and rising bankruptcies could easily cause a vicious new downward lurch...

For the time being, the brightest light glows in China, where a huge inventory adjustment has exaggerated the impact of falling foreign demand, and where the government has the cash and determination to prop up domestic spending. China's stimulus is already bearing fruit. Loans are soaring and infrastructure investment is growing smartly. The IMF's latest forecast, that China's economy will grow by 6.5% this year, may prove conservative. Yet even China has its difficulties. Perhaps three-quarters of the growth will come from government demand, particularly infrastructure spending.

American consumers are tapped out, and China has huge reserves at its disposal. The hopeful conclusion everyone has attempted to reach is that China will begin consuming more and America producing more -- that the engine of recovery would be a rebalancing of global trade patterns. As Brad Setser writes, however, IMF forecasts indicate that this is unlikely. Quite the opposite, in fact. Global imbalances may soon boil down almost entirely to one very straightforward imbalance -- China's surplus will be America's deficit. And the financial implications are pretty clear. Setser notes that China's $2.3 trillion in claims on the world would double in the next four years, based on its projected surplus.

What does this mean, exactly? Well, one thing it could mean is that IMF projections are off, but let's assume for the moment that that's not the case. In that case, it means you have in China a country convinced that an undervalued RMB and export-led growth are important to its development, even if that means continued accumulation of claims beyond a level with which it already seems somewhat uncomfortable. But that also implies an America growing enough to support continued imports from China, which in turn implies economic growth and a somewhat functioning banking system.

But if The Economist's outlook is in the right ballpark, that outcome is in doubt. America may need to spend hundreds of billions of dollars or more on a banking rescue, and it may need to top up its stimulus plan, also to the tune of hundreds of billions of dollars. Those steps would prove to be tricky, politically, but they'd also probably make policymakers nervous. Somewhere out there is an American debt level that will precipitate a sudden stop in dollar demand and some very unpleasant macroeconomic choices.

The logical outcome staring out at me is the negotiation, in some form, of a new international financial framework between America and China. Forget decoupling, the two nations are more inextricably linked than ever (and not just in macroeconomic terms). A deeper level of communication and understanding between the two powers is an inevitability anyway, and it makes sense to begin the conversation with the financial crisis.

What would it involve? Presumably a commitment by China to keep buying American debt, so that America can clean up its banks and do its next round of stimulus. Similarly, there would be an American commitment to meet certain Chinese macroeconomic demands (the most important of which would be not to default, and not to inflate). Beyond that, the sky is the limit. Is this a reasonable expectation? A very rapid turnaround in American growth in the second half of the year would make it less likely, as might domestic politics in either country. But it wouldn't surprise me.