US 2nd quarter GDP figures - investment remains the key issue for US recovery

By John Ross

The publication of the US 2nd quarter GDP figures highlighted several striking and interlinked structural trends in the US economy. These go considerably beyond the well publicised slowing of the US economic recovery. They again make clear that the trajectory of the US economy will be determined by what happens to US fixed investment

The data confirms the US recovery is weak

Unsurprisingly, because it was anticipated, and as has been widely reported, the data confirmed the slowdown in US economic recovery. Taking the latest revised figures, annualised US GDP growth decelerated from 5.0% in the 4th quarter of 2009, to 3.7% in the 1st quarter of 2010 to 2.4% in the 2nd quarter.

US GDP remains 1.1% below its peak level in the 4th quarter of 2007. At the 2nd quarter’s rate of growth previous peak US GDP will not be regained until the 4th quarter of 2010.

Such figures have essentially decided the debate between those who argued that because the US downturn was very severe its economy would spring back strongly from recession, and those, such as the present author, who pointed to the underlying structural situation of the US economy and therefore argued recovery would be weak compared to previous US post-war business cycles.

Figure 1 illustrates how much weaker the present US economic recovery is than in previous post-war cycles. In the previous most serious post-war cyclical downturn, that following 1973, the US economy regained its previous peak level of production after eight quarters. In this recession after 10 quarters the US economy has still not recovered its peak GDP level.

As also widely reported, the new GDP data now calculates the US recession was deeper, and started earlier, than previously estimated. Peak US GDP is now analysed as having occurred in the 4th quarter of 2007 rather than the 2^nd quarter of 2008 as previously estimated. The trough of US GDP in the 2nd quarter of 2009 is now calculated to have been 4.1% below the cyclical peak level - the previous deepest fall in a US post-World War recession, that after 1973, was 3.2%.

Figure 1

The fall in US investment

The driving force of the depth of the US recession is also clear. It was due to the decline in US fixed investment. As shown in Figure 2, measured in constant 2005 prices, US GDP in the 2nd quarter of 2010 was $147 billion below its 4th quarter 2007 level. However several components of US GDP are already above their 4th quarter 2007 levels - inventories are up $63 billion, government consumption up $112 billion, and net trade up $135 billion. Consumer expenditure was below its 4th quarter 2007 level but only by $80 billion. But US private fixed investment was down $412 billion - dwarfing all other contributions to the recession.

Figure 2

Decline in investment centred in non-residential sector

This decline in US private fixed investment was not primarily due to the fall in residential investment created by the sub-prime mortgage crisis - as may be seen from Figure 3. The decline in US residential fixed investment, again in 2005 dollars, was $172 billion whereas the decline in non-residential fixed investment was $241 billion.

Figure 3

Fixed investment and inventories

A further feature indicating the specific pattern of US recovery is the financing of gross domestic investment - i.e. fixed investment plus inventory accumulation. Although, as noted above, US fixed investment remained severely depressed, nevertheless for the first time for four years there was a small upturn, of 0.5%, in the percentage of US GDP devoted to fixed investment in the 2nd quarter - fixed investment rose to 15.6% of GDP from its low of 15.1% in the 1st quarter of 2010. This reflected a stabilisation of the share of residential investment in GDP and a slight increase in the share of non-residential investment - see Figure 4.

Figure 4

However it is clear that the majority of the saving necessary to finance the small upturn in overall gross investment has come from a worsening of the US trade balance - i.e. from foreign borrowing. Since the low point of the recession, in the 2nd quarter of 2009, US fixed investment and inventory accumulation has increased its share of GDP by 1.6% - rising from 14.5% of GDP to 16.1%. However this increase was entirely due to inventory accumulation - the percentage of US GDP devoted to private sector inventory accumulation rose by 1.9%, from -0.6% of GDP to +1.3%. However US fixed investment declined by 0.2% of GDP in the same period - from 15.8% of GDP to 15.6% of GDP.

Precisely quantifying the contribution of borrowing abroad to the financing of inventory accumulation is not possible until the US balance of payments figures for the 2nd quarter are published in September. However US balance of payments figures are dominated by the US balance of trade. The US trade deficit has been steadily widening since the depth of the recession in the 2nd quarter of 2009 - see Figure 5.

The deterioration in US net exports in 2nd quarter 2009 to 2nd quarter 2010 was 1.1% of GDP - the trade deficit rising from 2.4% of GDP to 3.5%. This is equivalent to 69% of the increase in the percentage of GDP for investment - indicating that the majority of financing for the increased saving to finance inventory accumulation has come from abroad. Given that in this period there was no increase in fixed investment at all what is occurring is that the US economy has been borrowing abroad not to finance fixed investment but in order to fund inventory accumulation.

Borrowing from abroad to finance an inventory build up, rather than for investment in fixed assets which can increase productivity or capacity, cannot be considered a healthy pattern of growth.

Figure 5

How is the US economic downturn to be overcome?

The data above makes clear that the quantitative key to overcoming the US economic downturn remains the situation in US fixed investment. Some reports on the 2nd quarter GDP figures spoke of a 'surge' in US business investment in the quarter but this fails to place the increase in a long term context. Comparing 2nd quarter 2010 to 1st quarter 2010, total US private investment rose by an annualised 19.1% or by $84 billion in 2005 prices. This sounds dramatic until it is noted that between 4th quarter 2007 and 2nd quarter 2009 US fixed investment fell by $495 billion so that the 2nd quarter 2010's increase made up only 17% of the fall that took place to the trough of recession. Only if an investment recovery continues for many quarters will the severe fall in US fixed investment during the recession be made up.

Such a fixed investment wave, in turn, would have to be financed by an equivalent rise in savings and therefore either by a sharp increase in US domestic savings or a large inflow of foreign capital. The former would require compression of US consumption, which would be likely to create major political unpopularity for the Obama administration, while the latter would require a major widening of the US balance of payments deficit. So far, as noted above, the primary process which has taken place is a worsening of the US trade deficit.

Why does the US not launch a major state investment drive?

Some authors argue that the way out of this current situation is for the US to launch a major state financed investment programme - a coherent exposition of this argument is presented for example in Richard Duncan's The Corruption of Capitalism. The arguments of adherents of this view is that due to the debt laden situation of the US private sector, and therefore its inability to sustain large scale expenditure, the US government, to maintain economic demand, has in any case no option but to continue to run large scale budget deficits for the foreseeable future. Therefore, instead of being used to maintain consumption, as at present, the budget deficit should instead be used to increase investment. As Duncan argues:

'Trillion dollar annual deficits for the next decade may keep the United States from collapsing into a severe depression.... But they would do nothing to restore the economy's long-term viability... The trade deficit would still be massive... The country could continue to consume more than it produced as long as other countries continued to accept its IOUs. But with each year that passed, structurally the economy would become increasingly rotten...

'There is a much more attractive alternative future, in which the United States remains the world's dominant superpower with a revitalised, self-staining economy. That alternative requires a national industrial-restructuring programme in which the government would invest in 21st Century technologies with the goal of establishing an unassailable American lead in the industries of the future. That goal could be achieved at the cost of $3 trillion over 10 years.'(1)

Such a programme for reversing the US investment decline is intellectually coherent but unfortunately in practice it is impossible to deliver given the structure of the US economy. The reasons why this is the case also show why the the Obama administration has been unable to step in and launch any large scale state financed investment programme.

The first obstruction is political - any US administration pursuing such an approach would get little or no popular support for doing so. Popular political sentiment is not determined by GDP growth statistics, let alone investment statistics - about both of which most of the population knows little and cares less. Political popularity is determined by whether living standards are rising or falling. Whereas government programmes boosting consumption improve living standards, and therefore are popular, programmes boosting investment have no such direct effect and are therefore unlikely to be generate equivalent political popularity.

More fundamentally, at the economic level, large scale government intervention in investment would alter the balance between the state and private sectors in the US and increase the weight of the former. This would therefore require a sharp shift in the structure of the US economy and would also be strongly resisted on ideological grounds.

It is for this reason that while the Obama administration has been able to use the budget deficit with considerable effect to maintain both private and government consumption it has been unable to have any significant effect on US investment. As may be seen in Figure 6, expressed in current prices, the $41 billion increase in US state investment between the 4th quarter of 2007 and the 2nd quarter of 2010 offset only 8.5% of the $485 billion decline in private investment which took place in the same period.

Figure 6

Furthermore whatever increase in state investment did take place was almost entirely in the ideological acceptable, but economically unproductive, field of military spending. As may be seen in Figure 7, between the 4th quarter of 2007 and the 2nd quarter of 2010 while US Federal military fixed investment went up by $28.8 billion in current prices, Federal civilian investment went up by only $9.0 billion and fixed investment by the fifty US States went up by only $3.0 billion. Therefore not only was the total increase in US state investment far too small to offset the fall in private fixed investment but the increase in civilian state investment was negligible. Figure 8 shows the same trends in fixed price terms.

The idea of state action to overcome the investment decline in the US is therefore interesting in theoretical terms. But it is impossible to execute in the actual structure of the US economy.

Figure 7

Figure 8

China's response compared to the US

Several conclusions follow from the above data.

• It is evident why the US recovery from recession has been weak and is likely to continue to be so - a huge decline in fixed investment has to be made up.
• It is likely the US trade deficit will continue to expand. Financing a recovery in investment from US domestic savings would be likely to require compression or slow growth of US consumption which would be highly unpopular. It is therefore easier for the US economy to finance an investment recovery through expansion of foreign borrowing - i.e. to widen the balance of trade deficit.
• It is evident why China has come so much more successfully through the international financial crisis than the US. As has been analysed elsewhere the general overall characteristic of the present 'Great Recession', internationally and not simply in the US, is a severe decline in fixed investment. China's own stimulus programme however, by directly boosting investment, ensured that no such decline took place in China. On the contrary, the period following the start of the international financial crisis saw a sharp increase in fixed investment within China.The programme prescribed by Richard Duncan and others for the US - 'a national industrial-restructuring programme in which the government would invest in 21st Century technologies' - is impossible for the US to execute for reasons already analysed. However it appears to be rather close to what China is actually executing.
Far more successful economic performance by China than by the US therefore seems certain to continue in the next period with its concomitant consequences for the world economy.

Notes

1. Richard Duncan, The Corruption of Capitalism, CLSA Books, Hong Kong 2009.

Financial Times chief economics commentator calls for investment as the way out of the crisis – by Michael Burke

In recent articles in the Financial Times, that paper's chief economics commentator Martin Wolf has increasingly acknowledged that investment will be decisive in engineering an economic recovery, especially for highly-indebted countries, such as Britain. [1] He also argues that conventional wisdom about the prospects for economic recovery, and the policy adjustments that will be necessary, is wrong. 'The conventional wisdom is that it will also be possible to manage a smooth exit. Nothing seems less likely.'

The reason for his sober assessment is the trend in private sector financial balances; that is, the growing surpluses of private sector incomes over private sector expenditures. For the OECD as a whole this surplus of private sector savings is projected to reach 7.4% of GDP this year. Britain is one of six countries that will run such financial surpluses of more than 10% of GDP.

This situation, as Wolf points out, has been dubbed 'the paradox of debt' by Paul Krugman, following the Keynesian notion of the 'paradox of thrift'. The argument is that, while for each highly-indebted company or individual it makes sense to save, or in the current climate pay down debt, for the economy as a whole it is potentially disastrous. The aggregate saving reduces final demand, both for business investment and household consumption, and thereby deepens the recession. So incomes for individuals and companies falls further, and they respond by cutting expenditures further, and so on.

There are many criticisms of this notion from what has become orthodoxy over the past several years. The only serious one is that, if the private sector saves in this way but continues to consume and invest in the same proportions all that will then happen is that prices will fall, and goods and services will be cheaper at the new, lower level of spending. However, this ignores two trends that tend to occur in crises and are happening currently, most especially in Britain.

The first is that in a recession investment falls much faster than consumption. Private investment is controlled in the first place by profitability and not by the objective need for production of society. Furthermore, both individuals and companies cut back on investment in order to maintain vital consumption.

Of a total decline in Britain's GDP of £80bn, personal consumption has fallen by £29.5bn and fixed investment has fallen by £45.9bn. In fact, the fall in investment accounts for a little under 60% of the aggregate decline in GDP. This is shown in Figure 1.

Figure 1

The same pattern, whereby investment is the main driver of the recession, is replicated across the OECD. It is simply not the case that consumption and investment fall in equal proportions. Household consumption has fallen by 3.6%, compared to a fall in fixed investment of 19.3%. Investment is still falling, whereas all the other key components of GDP experienced small rises in the last quarter of 2009.

The second reason why this orthodox criticism is invalid is the level of debt. If prices fall, as orthodoxy expects, the real level of the debt only increases - as has happened in Japan since the beginning of the 1990s deflation in that country. In Britain there was a real danger of deflation, that is persistent price falls, at the end of 2008 and beginning of 2009, which has been averted by lower interest rates and a weaker pound. But a return to falling prices would mean increases in the debt-servicing burden for all income earners in Britain, including individuals, corporates and the government.

Martin Wolf argues that, while extremely loose monetary policy has been necessary, simply by itself it stores up two alternative problems, both of which lead ultimately to potential disaster. One possibility is that cheap money reignites a boom in consumption, which itself merely postpones an even bigger future financial crisis. The other possibility is that there is no recovery in consumption and the fiscal position deteriorates further, to the point of widespread government defaults.

His solution, set out more fully in the second article 'How unruly economists can agree', is that investment is the solution to both the economic slump and the crisis in government finances. 'What governments should do, instead, is ensure that deficits are credibly temporary, and growth-promoting. By all means, plan to cut the structural deficit faster than the government now intends. But do not believe that that would be the end of the matter. The actual deficit might need to be larger than that, for a long time. Try investment, instead'.

Who will invest?

This focus on investment is the correct one. But Martin Wolf's reliance on the private sector, and cutting the government deficit, is misplaced.

As we have already seen, it is the huge investment fall which is driving the recession. Only a very large increase in investment can therefore restore both prior levels of activity and government finances. Martin Wolf correctly chides many private sector economists and policymakers for wishing the world would return to the way it was before the crisis. He dismisses that hope as both misguided and forlorn. Yet his own hopes for a return to private sector investment themselves are seriously inadequate.

Many private sector economists expressed shock at the very recent data showing that the collapse in UK business investment continues unabated They shouldn't be surprised. Business fixed investment fell by 5.8% in the final quarter of 2009, down 27% from its peak in early 2008. The annualised fall is £40bn, over half the fall in GDP. Manufacturing investment is down 37.5% from its peak, construction down 54.3%, engineering and vehicles down 37.8%, transport down 29.8%.

This litany of an investment collapse, a literal investment strike, highlights a key problem for the idea that encouraging the private sector to invest will provide a sufficient answer to the crisis. Martin Wolf's proposals are private investment incentives - which may or may not work. They have a patchy record, often being taken up by businesses that would have invested in any event, and providing insufficient encouragement to create genuinely new investment. At the same time, he appears to accept the idea of cutting government spending.

While government spending has been rising modestly, and provided a very small cushion against the recession, the private sector is either too cash-strapped to invest, or will not do so because it cannot be confident of profits. The idea, then, that government should forego investment spending, and the economic support it brings the wider economy, is a reckless one. It is premised on the false notion that government investment in a situation such as the present 'crowds out' private investment, as if the economy were a fight in a phone booth. As we have already seen from the investment data, the private sector is in no hurry to invest, the investment strike continues. And taxpayers now own a swathe of the banking sector, so that government could force banks to lend to support any rebound in private sector investment that does occur. Government investment can replace lost private sector investment, especially in areas of extreme falls such as transport, construction, engineering and vehicles. The state may need to increase its direct control over those sectors to achieve that.

But, while it is possible to disagree with Martin Wolf on the likely source of investment over the next period - end entirely disagree with him on the need to cut government spending - it is welcome that influential mainstream economics commentators are now coming to the view that investment holds the key to economic recovery. In his words, 'Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.'

Source

[1]Martin Wolf 'The world economy has no easy way out of the mire' and 'How unruly economists can agree'

EU calls for Greek population to tighten belts to support wealthy Greek tax dodgers - by Michael Burke

Tactical manoeuvring is continuing among European governments to decide exactly how much of the bill will be picked up by who for the financial debacle in Greece. The one thing they all agree is that Greek workers will not be enjoying a bailout of any kind.

Along with the lowest paid and those dependent on public services, Greek workers will bear the brunt of the 'adjustment process', through wage and welfare cuts, pension reductions, an increased retirement age and other austerity measures. The tactical squabbling is that Greece is being pressed by the European Central Bank and leading EU to go even further in the austerity measures it has already announced.At the same time the Greek PASOK government is facing mass demonstrations and strikes, which have encouraged resistance to further austerity measures.

It is noteworthy who will not be targeted. Greece has one of the lowest tax takes in the Euro Area. In the 15 years to 2006, Greek total general government revenues, as a percentage of GDP, were 37.9% compared to an average rate across the Euro Area of 45.3%.[1] This low level of taxation was, in the Greek case, the source of long-standing budget deficits which were hidden from a gullible or complicit EU (or Eurostat) inspectorate over a number of years.

Greek absence of taxation is also a long-standing burden borne by the poor in the country. The Financial Times reports that, according to the official tax returns, there are literally only a handful of Greek citizens who earn more than €1mn per annum registered for tax purposes, and that the Greek shipping magnates and the other rich are registered as 'non-domiciles' in Britain, and consequently pay tax nowhere.

Greece is not in the financial firing line because of a particularly severe recession or an especially blighted banking sector. The latest estimates from Eurostat show that Greece's GDP fell 2% in 2009, but this compares to -4% for the Euro Area and -4.1% for the EU as a whole. This is shown in Figure 1. At the same time, Greece has committed funds to its banking sector equivalent to 11.4% of GDP - far less than the 31.2% EU average (and 232% for Ireland).[2]

Figure 1

The cause of the turmoil in Greece is its high level of government debt, which existed long before the current crisis, combined with a sharply rising budget deficit. Greek government debt as a percentage of GDP has been hovering close to 100% of GDP in all years this century, and is forecast by the EU to rise to 125% of GDP. Greek bond yields were already rising, but were pushed sharply higher by the decision of the European Central Bank, in effect, to remove Greek government bonds from the list of assets it would hold at the end of this year. A reversal of that announcement alone would transform the attitude to Greek government debt, but has not been forthcoming. Likewise, a genuine transformation of the tax system in Greece, as well as rigorous clampdown on tax evasion by the wealthy, would have a dramatic impact on the deficit.

Instead, it seems as the European institutions are trying to get their act together to act as a quasi-IMF, with any support conditional on a deepening of current austerity measures. This is no more likely to be successful in Greece than it has been in Ireland’s case, where deficit projections continue to rise.

As in other countries the rise in the Greek deficit is caused by a slump in taxation receipts, which have fallen by 8.1% in 2009 and which are forecast to fall by over 10% in 2010 [3]. This hole in government finances is itself linked to plummeting levels of investment in the economy. The recession in investment began a year earlier, in 2008, and has already fallen in total by 22.5%, with further falls expected this year [4]. By contrast, the recession-related rise in government spending over the same two years has been just 3.5% [5]. This is shown in the Figure 2 below.

Figure 2

Greece has a narrow tax base, with an unusually wide range of tax-exempt activities. The tax exemptions are revealing as to whose interests are being protected. Among the tax exempt activities:

• Proceeds from the sale of shares that are traded on the Athens Stock Exchange.
• Income from ships and shipping.
• Any dividend received from a Greek company.
• Capital gain from sale of a business between family members.

As a result, any decline in taxable activity leads to a disproportionate decline in tax receipts. This appears to be the case in Greece, where the slump in investment, which is taxable through a variety of levies on goods and services, has led to the decline in aggregate tax receipts and rising public deficits.

Further, the concealment of the actual size of the public deficits appears to have gone unchecked by the EU Commission - as its own 2004 Report into false public accounting in Greece provided no more than a public admonishment, and no programme for change. The new EU investigation however shows that in the years 2000 to 2003, the public deficit was understated by 10.6% of GDP. And, in a tell-tale sign of the unreformed nature of Greek society since the 1970s, more than half of that, 5.5% of GDP, was on military spending.

There is no economic logic behind spending cuts to close the deficit. Higher spending was not the cause of the budget deficit, lower tax receipts are. Worse, since tax evasion is endemic among Greek businesses and the rich, cutting the income of the one section of society that does pay tax, the poor and salaried workers, will reduce taxation revenues further.

The austerity measures now foisted on Greece stand in sharp contrast to the reflationary measures adopted by the major countries across nearly the entire the Euro Area -a policy led by Germany. German has adopted a reflation/stimulus package amounting to 4% of GDP. Germany's measures could have been better targeted. But despite a stagnant 4th quarter of 2009, forecasts for Germany's growth and its deficit are both on an improving trend.

The question is therefore posed, why is a reflationary recipe that clearly works for 'core' Europe deemed unsuitable for Greece? Why can government investment work for Germany, France, Belgium, and so on, but is ruled out in the case of Greece?

The answer may lie elsewhere, in the countries of Eastern Europe. There a number of countries had been hoping to benefit from further EU enlargement, which now seems postponed. Prior to enlargement, the EU demanded continual reform of the Eastern European economies – including further privatisations, liberalisation of the labour markets and a reduction of social spending.

These privatisations facilitated the arrival of Western European and US telecomms, agribusiness and other firms, but above all banks and financial firms. The drive to lower wages and social spending allowed a cheapening of labour, which could be exploited by Western firms, and led to widespread emigration. The removal of local producers in turn expanded the market for Western goods.

This sounds like the package of 'reform measures' to be demanded of Greece in return for any loans. The Greek population is finding that, while all members of the EU are equal, some are more equal than others.

Sources

1.EU Commission, EcoFin, Europea Economic Forecast Autumn 2009, Statistical Annex, Table 36.

2. EU Commission, Euro Area Report, Winter 2009, Table 2.1.

3. Table 36

4. Table 9

5. Table 35

The myth of the decline of the US consumer - by John Ross

A widespread myth about the international financial crisis is that what is taking place is a serious reduction of consumption in the US, with the knock on consequences that would flow from this for the world economy. The present article shows that this myth is factually untrue. No major downturn of US consumption has taken place. Therefore such a non-existent downturn in US consumption cannot be the driving force of either the US or international ‘Great Recession’.

* * *

The claim that a key driving force of the present international 'Great Recession' is a major downturn of US consumption is a frequent one. We will take as an example of this argument Stephen Roach’s book The Next Asia - all page references therefore refer to this work. Roach, president of Morgan Stanley Asia, is chosen because he is a coherent economist who spells out this mistaken claim more lucidly than many far less serious economists who make it.

According to Stephen Roach what is taking placed is the 'capitulation' of the US consumer. Thus Roach refers to, ‘America’s postbubble compression of consumer demand.’ (p378).

This alleged reduction in US consumption is then cited as the driving force of the economic downturn. As Stephen Roach put it:‘The current recession is all about the coming capitulation of the American consumer.’(p20) Therefore: ‘The main event… is the likely capitulation of the overextended, savings-short, overly indebted American consumer.’(p42). Roach concludes that: ‘After a dozen years of excess, the overextended American consumer is finally tapped out… Hit by the triple whammy of collapsing property values, equity wealth destruction, and an ongoing unemployment shock.’(p325)

As a result of this situation a major reduction in the share of consumer spending in the US economy is foreseen. Stephen Roach concludes: ‘the US consumption share of real GDP, which hit a new record of 72.4% in the first quarter of 2009, needs, at a minimum, to return to its prebubble norm of 67% ... the die is cast for a protracted weakening of the world’s biggest spender.’(p32) The situation is therefore that: ‘the US consumer [is] most likely in the early stages of a multi-year contraction’ (p79) Indeed: ‘Despite the unprecedented contraction of consumption in late 2008, there is good reason to believe the capitulation of the US consumer has only just begun.’ (p385)

It is this alleged reduction of US consumption which, it is asserted, will cause the slowdown in the world economy: ‘The postbubble shakeout stands to be dominated by a protracted adjustment of the US consumer – providing powerful and lasting headwinds on the demand side of the global economy for years to come.' (p396)

The problem for this thesis is that it is factually incorrect. No such major reduction of US consumption has taken place. The share of consumption in US GDP has expanded and not contracted. And, as no significant reduction of US consumption has taken place, it therefore cannot explain any of the current trends in the world economy

To show the factual situation Figure 1 graphs the percentage change in the major components of US GDP between the 2nd quarter of 2008, the last before the US recession began, and the most recent available data - that for the 4th quarter of 2009. During this period US GDP contracted by -1.9%. However the reduction in US personal consumption was only -0.6%. Government expenditure, consumption and investment taken together, increased by 3.1%.

Compared to the relatively small fall in US personal consumption the really large declines were in US residential fixed investment, which dropped by -21.2%, and in US non-residential fixed investment, which declined by -20.3%, In other words, as regards the US domestic economy, what occurred was not a consumer decline but a large investment fall.

As regards the external relations of the US economy there were also declines in exports, down -7.7%, and a major drop in imports - by -12.3%.

Compared to these major shifts in investment and trade the decline in US consumption was extremely small and played almost no role in the economic contraction.

Figure 1

To show the real shifts in the US economy even more starkly, and illustrate further that the 'decline of US consumption' is a myth, Figure 2 shows the shifts in the major components of US GDP from the 2nd quarter of 2008 to the 4th quarter of 2009 in monetary terms - i.e. in current prices.

In this period US GDP fell by -$34 billion. However US personal consumption actually rose by $56 billion. In contrast US residential fixed investment fell by -$129 billion and US non-residential investment dropped by -$362 billion. The total decline in US fixed investment was -$490 billion. The breakdown of these figures is important as it shows that the downturn in investment was concentrated in non-residential, and not simply residential, sectors.

Over the same period inventories rose by $9 billion. Net trade, that is the trade balance, improved by $298 billion. US government expenditure, consumption and investment combined, increased by $92 billion.

In current price terms, therefore, there has been no fall at all in US consumption, indeed it has increased. It is US fixed investment that has fallen sharply.

Figure 2

What has made possible these shifts is that the proportion of the US economy devoted to personal consumption has not fallen, as Stephen Roach and others believed it would, but it has on the contrary increased. This is shown in Figure 3. US personal consumption was 70.3% of GDP in the 2nd quarter of 2008, immediately before the recession started, and it had risen to 70.9% of GDP by the 4th quarter of 2009.

Figure 3

In summary, the claim that the 'Great Recession' is rooted in a decline of the US consumer, and of US consumption, is a myth. No such decline has taken place. The economic decline in the US is a fall in investment, not in consumption.

Theories that the present situation in the world economy is driven by a decline in the US consumer and US consumption are therefore equally false. A process cannot be driven by something which has factually not occurred.

A myth is not made truer by repeating it. Therefore the claim that the 'Great Recession' is rooted in a decline of the US consumer, and US consumption, should be abandoned as factually unfounded.

* * *

This article originally appeared on the blog Key Trends in Globalisation.

Goldman Sachs rightly stress capacity constraints and not overcapacity are dominant in China

Relatively widespread coverage in economic media has been given to an important new analysis published by Goldman Sachs pointing to the inflationary consequences of major capacity constraints emerging in the Chinese economy. As Geoff Dyer noted in the Financial Times on 22 January: 'According to Yu Song and Helen Qiao... the most extreme example is in the auto sector, where extra shifts mean factories are running at above capacity. They also see emerging bottlenecks in electricity, coal and even in aluminium and steel which only a few months back seemed to be suffering from chronic overcapacity.

'"The capacity overhang has been quickly whittled down in major industrial sectors," they wrote... The apparent rebound in Chinese exports, which grew 17 per cent in December compared to the year before, has reinforced the impression that the output gap is shrinking.

'Inflationary pressures could also come from the labour market. Before the crisis, which led to millions of migrant workers losing jobs, wages were rising quickly as the labour supply started to slow. Surveys of job centres suggest employment is returning to pre-crisis levels.'

This analysis, which is confirmed not simply by the individual sectoral studies carried out by Yu Song and Helen Qiao but by macro-economic analysis, is intrinsically important for analysing China's current economic situation. But it also refutes the bad, and inaccurate, piece of economics produced last year by the European Chamber of Commerce in China which suggested overcapacity was the key issue in this regard in China - unfortunately this report was picked up in an editorial the Financial Times. To show the report's errors were evident not only after the event I cite my letter in the Financial Times in reply:

'The basis of the report is an alleged clash between a "rising savings rate in the United States", supposed to account for a decline in the US trade deficit, and China's economic policy. Factually no "rising savings rate" in the US savings rate has occurred. Since the second quarter of 2008 US savings have declined from 12.7 per cent of GDP to 10.4 per cent of GDP.

'In any country, including China, it is evidently possible to point to individual industries suffering from overcapacity, as well as those with insufficient capacity – a statistical measure necessarily means cases below and above average.

'Simply citing particular cases, as the report does, therefore establishes no general case of "overcapacity" as regards China's economy. This same mistake applies within individual industries. For example, in the Chinese chemical sector the report notes 50 per cent of the industry is in a balanced state of supply and demand, 30 per cent of products are in short supply, and 20 per cent have overcapacity problems – a normal market situation.'

Hopefully this new analysis by Goldman Sachs will put an end to erroneous claims overcapacity is the key issue in China. On the contrary it confirms clearly that capacity constraints, that is undercapacity and not overcapacity, is the dominant issue facing the Chinese economy in this field.

* * *

This article originally appeared on the blog Key Trends in Globalisation.

China's dramatic surge in domestic demand

China has achieved a dramatic expansion of its domestic demand in 2009. It is likely that GDP figures will show that China's domestic demand rose by around 11% last year while China's trade surplus fell by over thirty percent. These estimates are made using conservative assumptions and it is probable the eventual out turns will be even higher - although they will not alter the essential picture, This article looks at this remaking of the pattern of China's demand.

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The full data for China's trade in 2009 will be published next week. Data for GDP will be published later. These will give a more fine grained picture of China's economic development in 2009. However data for the first 11 months of China's trade this year have already been issued and there is no doubt that the official 8.0% target for GDP growth will be met and exceeded. These already published figures therefore allow a clear picture to be formed.

To take first the ballpark numbers, and using conservative assumptions, China's trade surplus, that is its net exports, will have declined in 2009 by around or slightly over $100 billion - over thirty percent. China's GDP will have increased by over $350 billion if growth in 2009 was 8.0% and by approaching $400 billion on the assumption that growth was 8.5%. Detailed figures are given in Table 1. Assumptions used to calculate these are given in Note 1.

Taking first trade, in 2008 China's exports were $1.431 trillion and imports $1.333 trillion. China's trade surplus was $298 billion. In the first 11 months of 2009 China's exports were $1.071 trillion - a fall of $248 billion, or 18.8% compared to the same period in 2008. China's imports in the same period were $0.891 trillion - a fall of $167 billion, or 15.8%. China's trade surplus dropped from $261 billion in the first 11 months of 2008 to $180 billion in the same period of 2009 - a decline of 31%.

To give a projection for 2009 as a whole, if the 31% fall in the trade surplus was maintained for the entire year then China's trade surplus in 2009 would be $206 billion - a decline of $92 billion. In reality the drop is likely to be greater as China's trade surplus in December 2008 was an exceptionally high $39 billion. The actual decline in China's trade surplus for 2009 is therefore likely to be at least $100 billion - another way of stating that China in 2009 added a net $100 billion to international demand. The excellent export figures in the rest of Asia at the end of 2009 in significant part reflect this boost in demand from China.

In order to estimate the effect of the decline in the trade surplus on the structure of China's demand it is useful to translate trade figures into GDP percentages. This involves taking into account service sector trade, and various relatively small statistical adjustments, which lead to China's total surplus of exports over imports in 2008 being $353 billion in national accounting terms. As China's net export situation is dominated by trade in goods it is assume for simplicity below that the national account trade position also falls by 31%.

China's GDP in 2008 was recently revised upwards to 31.405 trillion yuan or $4.6 trillion at the official exchange rate. No change in the figure for net exports has however been published. As the trade position is easier to measure than GDP, where the upward shift was accounted for primarily by a previous underestimate of output in the small service sector, the figure for China's net exports is unlikely to change greatly. This upward GDP revision changes downwards slightly China's export surplus in 2008 as a percentage of GDP - from the previously publishes 7.9% of GDP to 7.7%. This figure is used in Table 1.

Turning to 2009, the official GDP growth projection for the year was 8.0%. However it is clear from the first three quarters results that the eventual figure for growth will not only be achieved but almost certainly exceeded. As the aim in this article is to use conservative assumptions, and therefore take figures which are least favourable for the position presented, it will be assumed for calculation that GDP growth in 2009 was 8.0%. A higher GDP growth rate, given that trade figures are unlikely to change greatly, would imply a higher growth of domestic demand than that indicated in Table 1 below.

Assuming an 8.0% growth rate, the increase in China's GDP in 2009 would imply an increase in GDP of approximately $368 billion - the exact figure depending primarily on the assumption made on the inflation rate to translate an 8.0% increase in constant price terms into current prices.

Taking the assumption of a $109 billion decline in the export surplus, that is 31%, and a $368 billion increase in GDP implies that China's domestic demand in 2009 rose by $477 billion, or 11.2%. This would be one of the highest increases in domestic demand in a single year ever achieved by any country in history.

On this data China's export surplus will have fallen from 7.7% of GDP in 2008 to 4.9% of GDP in 2009, or by 2.8% of GDP. China's domestic demand, conversely, will have risen from 92.3% of GDP to 95.1%. Detailed revision of these figures will be given as final trade and GDP data for 2009 is published. They will, however, not alter the fundamental picture.

Table 1

The implications of such data are clear. China did not require a surge in its trade surplus for its economy to undergo rapid growth in 2009 - as some argued. China successfully shifted demand into its domestic economy. An approximately $100 billion decline in net external demand was more than cancelled by a more than $450 billion increase in domestic demand. This must be counted, in light of the extremely negative external economic situation, as one of history's most successful and skilful pieces of macro-economic management. Simultaneously with rapid domestic economic China's trade surplus declined - easing global imbalances and particularly boosting exports from other Asian economies.

Given this dramatic increase in China's domestic demand why did a number of commentators fail to foresee this and therefore greatly underestimate the potential for China's economic performance in 2009? In a number of cases it was because they committed an elementary economic error. They reduced the potential for China's growth in domestic demand to its increase in domestic consumption. However domestic demand is composed not simply of domestic consumption but also of domestic investment. China's domestic investment rose rapidly in 2009 as well as its domestic consumption - the combination of the two producing the rapid increase in domestic demand.(2)

In conclusion the fundamental trend is clear. China succeeded in 2009 in achieving an extremely high rate of increase of both domestic investment and domestic consumption - enabling it to overcome, in terms of GDP growth, the negative shock of the fall in exports and the decline in the trade surplus. Sceptics on the ability of China to raise domestic demand were shown to be wrong. China's stimulus package, which produced the results, was shown to be an extremely impressive piece of macro-economic management.

Addition 10 January

The publication of China's trade data for 2009 confirms the points made above. The new data shows China's trade surplus in 2009, on a foreign trade and not a national accounts basis, was $196 billion compared to $298 billion in 2008 - a fall of $102 billion or 34%. An equivalent percentage decline in China's net exports on a national accounts basis would mean a decline in its surplus of $120 billion compared to the $109 billion projected in this article for calculating the increase in China's domestic demand. This reaffirms that the trade assumptions made for calculations in the article above were conservative.

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This article originally appeared on the blog Key Trends in Globalisation.

Notes

1. All data, unless otherwise stated, is taken from China Statistical Yearbook 2009. The assumption made for China's export surplus in 2009 is set out in the body of the article. To calculate the changes in GDP in current prices it is necessary to make an assumption on inflation/deflation rates. In 2009 these will be relatively minor, therefore for simplicity they have been assumed to be zero. There is likely to be net deflation in 2009, which would revise the figure for the current price increase in GDP given in Table 1 downwards, however it is also likely that GDP growth will exceed 8.0% which would revise the figure upwards.Therefore Table 1 is given as a qualitative initial projection. Revisions will be given as detailed figures are published.

2. Kieran Latty has a clear numerical explanation of this in a comment on Key Trends in the World Economy.

Decline of the Rupee's exchange rate - India moves further towards the 'Asian growth model'

India was one of a number of countries that experienced major currency devaluation against the dollar during and after the international currency crisis. As the comparison to China, which pursued a policy of stabilising the RMB's exchange rate against the dollar after the outbreak of the financial crisis, is particularly interesting the movements of the RMB and the Indian Rupee against the dollar since 2000 are shown in Figure 1.

Figure 1

As may be seen the Rupee from 2000 up to September 2007 had a tendency to a weaker exchange rate than the RMB. But the difference was not extreme and in September 2007 the two currencies were essentially at parity in terms of exchange rate shifts with a roughly ten percent upward movement in exchange rate against the dollar compared to 2000.

After September 2007, however, a marked divergence between the exchange rate of the RMB and the Rupee began. The RMB first continued to rise and then stabilised, without falling, when the financial crisis began. The exchange rate of the Rupee, in contrast, start falling from September 2007 onwards and this accelerated as the financial crisis developed. The specific trends since the start of the financial crisis are shown in Figure 2.

Figure 2

Taking these movements together, between September 2007 and January 2010 the RMB rose by over 10% against the dollar while the Rupee fell by over 20% between September 2007 and its low point in March 2009. Even after recovery of the Rupee, at the beginning of January 2010 it was still more than 12% below its September 2007 level. As the RMB went up against the dollar in the same period this means that the Rupee has carried out an effective twenty per cent devaluation against the RMB since September 2007.

Given that India runs, relative to the size of its economy, a containable balance of payments deficit, which in 2008 was 2.7% of GDP, no substantive internationally destabilising consequences flow from the devaluation of the Rupee against either the dollar or the RMB. What will be significant however will be to see whether this clear devaluation of the Rupee against the RMB alters the relative dynamics of India's and China's economies.

As this blog has noted on a number of occasions the long term effect of India's economic reforms has been to shift it decisively towards the 'Asian growth model' - that is to a very strong increase in savings and investment rates. Indian Prime Minister Manmohan Singh has consciously supported this policy.

The decline of the exchange rate of the Rupee moves India further towards adoption of the 'Asian growth model'. This is because for countries such as South Korea and China a second component of their economic strategy, alongside high rates of savings and investment, was to maintain a low exchange rate in order to boost exports.

Contrary to accusations to the contrary this did not necessarily mean running a large trade surplus, as this depended on developments such as the rate of growth of the economy which helped determine whether imports rose equally - for example China's large trade surplus appeared only in 2005 and is now declining, while South Korea at various times has run large trade deficits. The low exchange rate policy, however, did ensure a rapid development of the share of exports in the economy, allowing economies of scale from production for the international market and other benefits to be achieved. The fact that India was more cut off from the international division of labour compared to is east Asian competitors, that is its share of exports and imports in the economy was relatively low, was an achilles heel.

Having achieved a level of savings and investment which is currently higher than South Korea and the other former East Asian tigers, and is not far behind China, the logical next step for India is to adopt a low exchange rate policy to stimulate exports still further. The changes in the Rupees exchange rate in the last period give the opportunity to achieve this. It remains to be seen whether they will be consolidated.

In addition to the importance for India itself there is an international significance of India's further shift towards a policy of a high savings and high investment coupled with a low exchange rate to stimulate exports. For this, as noted, is precisely the 'Asian growth model'. The fact that the world's second most populous country, soon to become its first, is moving with success further towards such a model has clear implications. Far from the 'Asian growth model' moving to its end after the financial crisis, as some commentators have claimed, it is spreading further.

Watching the exchange rate of the Rupee, and its effect on India's economic performance, is becoming a highly important international issue.

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This article originally appeared on the blog Key Trends in Globalisation.

The real reason global imbalances have declined - factual economic trends in the US and China

One of the most publicised theories regarding the current state of the world economy, and the causes of the international financial crisis, is that regarding 'global imbalances'. This thesis has been presented at book length by Martin Wolf in Fixing Global Finance, as well as in numerous articles in his position as the Financial Times chief economics commentator, by Stephen Green of Standard Chartered, by David Cohen of Action Economics, by Brad Setser, by Michael Pettis, Professor of Finance in Peking University, and numerous other authors.[1]

This theory has however been described as erroneous by Asian leaders. That they are right in this opinion will be shown below. Specifically there is a logical incoherence in the theory in that its policy prescriptions are not entailed by its analysis. This in turn leads to it not being in accord with the facts of the world economy as the global imbalances it describes are shrinking by quite other mechanisms than the ones it outlines. As a result it is wrong in its policy proposals - as shown by the fact that the most rapid economic growth is being enjoyed by an economy, China, which is pursuing policies which are the opposite of those prescribed by this theory.

A theory which is deficient in coherence, and which fails to foresee the possibility of reducing global imbalances by mechanisms which are actually occurring, is evidently a theory which is erroneous.

Given the wide range of those supporting variants of what will be termed the 'global imbalances hypothesis' this theory naturally has a number of secondary variations. But they have a common core consisting of an analysis coupled with a policy conclusion which it is alleged is entailed by it.

On this theory, the well known problems of the US financial system are outward signs of a much more fundamental malaise of imbalances in the world economy. In the words of Martin Wolf: 'Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter…. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn.'

The core analysis of this theory is that the world economy has been characterised by two global imbalances, the first being the US balance of payments deficit – ascribed to US lack of saving/over consuming, the second being China's balance of payments surplus – allegedly caused by China 'over saving'. The policy conclusion which allegedly follows from this is that the US save more and China save less.

As Brad Setser put it: 'the global economy prior to the crisis was characterized both by high levels of both savings and investment in Asia and the oil exporters and by high levels of consumption and low levels of savings in the US. 'Therefore, as Robert Skidelsky phrased it: 'emerging market economies need to spend more and save less, and mature market economies need to spend less and save more.'. As Martin Wolf put it specifically regarding China: ''does it make sense for China to save so much or, for that matter, to invest so much?... Higher consumption today would surely be desirable.'

It is unclear in some variants whether this theory is being put forward merely prescriptively or whether it is stated that the trends it proposes as desirable are actually occurring – or a combination of the two. However it is clear that a number of its supporters believe that the proposed policy prescriptions of this theory are actually occurring. Thus for example Robert Skidelsky argued in July: 'In fact the present financial meltdown is producing the market-led adjustment that has eluded policy makers. Willy-nilly Americans are having to spend less and save more.'

The 'global imbalances hypothesis' has become so prevalent it may be described, in the phrase popularised by JK Galbraith, as a 'conventional wisdom'. Unfortunately, like many other previous conventional wisdoms it is not true. There are a number of further aspects of the 'global imbalances hypothesis' which are wrong, and which have earlier been analysed on this blog. But if a theory, as will be shown, is inconsistent and factually wrong that constitutes adequate grounds why it should not be maintained. A new, more correct, conventional wisdom is required.

Inconsistency of the theory

The economic inconsistency of the 'global imbalance hypothesis', that is that the policy prescription does not logically follow from the analysis, is easily demonstrated. A country's balance of payments is, by basic accounting identity, equal to the difference between its domestic savings and its domestic investment - the US deficit is exactly equivalent to the degree that US savings are lower than its domestic investment, China's surplus is exactly equivalent to the degree that its savings are higher than its domestic investment.

It immediately follows from this identity that the only way to correct such imbalances, if that is set as the overriding goal of policy, is not at all, as the 'global imbalances hypothesis' suggests, for the US to save more and China to save less. It is equally possible to solve these imbalances, again if this is set as the policy goal , by the US investing less and China investing more. Furthermore it is this latter process affecting investment, not the ones foreseen by the 'global imbalances hypothesis', that is actually occurring and leading to the lessening of the global imbalances.

To take this in detail, factually global imbalances are indeed rapidly declining – the US balance of payments deficit is shrinking and China's balance of payments surplus is declining. But they are doing so for reasons that are the the opposite to those outlined in the theory above.

Far from US saving rising it is declining. The US balance of payments deficit is therefore not shrinking because US saving is rising but because US investment is falling even more rapidly than US saving. China's balance of payments deficit is not declining primarily because it is consuming more but because it is investing more – that is, because China is moving its investment level up to its savings level, and in so doing generating the most rapid rate of growth in the world.

These factual trends have previously been outlined both regarding the US and China on this blog. The latest data which allows a major testing of the different theories is the publication of the second quarter US GDP figures together with data for the equivalent period for China's trade and GDP. All US data below therefore, unless specifically stated otherwise, is calculated from the tables accompanying the US second quarter 2009 GDP figures published by the US Bureau of Economic Analysis. The data shows clearly that the trends taking place in the world's two largest economies are not those in the 'global imbalances hypothesis'.

The rise in US consumption

Taking first the fundamental trend in US consumption, it is clear that under the impact of the international financial crisis US consumption has not fallen but risen further as a percentage of GDP. This is shown in Figure 1.

As may be seen total US consumption, the sum of personal and government consumption, rose rapidly as a proportion of GDP from 1997 until the end of 2003, then stabilised until the end of 2007, and then began to rise sharply again from the beginning of 2008 under the impact of the developing financial crisis.

Figure 1

Taking precise figures, between the last quarter of 2007 and the second quarter of 2009 US consumption rose from 85.8% of GDP to 87.6% - an increase of 1.8% of GDP. Between the second quarter of 2008, the last before the opening of the entirely open financial crisis with the collapse of Lehman's, and the second quarter of 2009 US consumption rose from 87.0% to 87.6% of GDP. Between the first and second quarters of 2009 US total consumption rose from 87.2% to 87.6% of GDP. The trend of rising US consumption under the impact of the financial crisis is therefore clear. More detailed breakdown of this rising share of consumption in US GDP may be found in the footnote. [2]

If US consumption has risen as proportion of GDP why, therefore, has the US balance of payments deficit been shrinking? By accounting identity this deficit is necessarily equal to the shortfall of US savings compared to domestic investment. Therefore shrinkage of the deficit means the gap between saving and investment is narrowing despite consumption rising. The explanation is that US savings are not increasing but falling, but US investment is falling even more rapidly than US saving.

The decline in US investment and saving

Analysing first investment, for which the necessary detailed data is available in the US second quarter GDP figures, these show that US total investment fell between the fourth quarter of 2007 and the second quarter of 2009 from 19.1% of GDP to 14.8% - a decline of 4.3% of GDP.[3] In the period between the second quarter of 2008 and the second quarter of 2009 US investment fell from 18.3% to 14.8% of GDP.

Turning to savings, ideally one would wish to have direct measurement of total savings for the second quarter of 2009, which were not published with the GDP figures, and figures for the US balance of payments for the same period – which are also not yet published. Fortunately, however, the shifts in the US trade balance are so large that it is relatively easy to work out the trends.

Savings equal the sum of total investment, for which full US figures are available, minus the balance of payments deficit – for which second quarter figures are not yet available. But shifts in the US balance of payments are dominated by changes in the trade balance. Provided, therefore, that it is being used to establish a qualitative direction of change, and is not projected as an exact statistical calculation, it is perfectly possible to use the major shift in the US trade balance to show the change in the direction of US savings.

If 2008 is taken as the year in which the financial crisis unfolded then the US balance on trade in goods and services fell between the last quarter of 2007 and the second quarter of 2009 from 4.9% of GDP to 2.5% - an improvement of 2.4% of GDP (see Figure 2).

Figure 2

It follows from the data above that US investment has fallen by 4.3% of GDP since the beginning of the financial crisis while the US balance of trade has improved by only 2.4% of GDP - a difference of 1.9% of GDP. If all other components of the balance of payments had remained the same then this would necessarily mean that US savings had also declined by 1.9% of GDP – if savings had remained static, and other components of the US balance of payments had remained constant, then a 4.3% of GDP fall in investment would have translated into a an equivalent 4.3% improvement in the balance of payments figures. The 1.9% of GDP gap between the 4.3% decline in investment and a 2.4% fall in the balance of payments would necessarily mean that US savings had fallen by 1.9% of GDP.

Evidently no such precise quantitative assertion can be made as what is being calculated above is the trade balance and not the overall balance of payments. But it means that for US savings not to have fallen components of the US balance of payments other than trade would have had to improved by 1.9% of GDP or $269 billion. This is completely implausible and it is therefore evident that US savings have been falling.

This is confirmed by taking the latest figures for which there is measured data on total savings, that is for the first quarter of 2009. Between the fourth quarter of 2007 and the first quarter of 2009, US total savings fell from 13.9% of GDP to 11.5% of GDP. These trends of falling US savings are shown in Figure 3.

Figure 3

The reason some media commentators have claimed US saving is rising, when it is actually falling, is because they confuse household saving (which rose from 1.1% of GDP to 4.0% of GDP between the last quarter of 2007 and the second quarter of 2009) with total saving (the sum of household, company and government saving). The rise in US personal saving is however being more than offset by the decline in company and government saving – hardly surprising given the scale of the US budget deficit. Robert Skidelsky's statement, cited above, that US saving is rising is therefore inaccurate - it appears he may be making an incorrect generalisation from personal saving to total saving.

Michael Pettis claims that US consumption is falling more rapidly than GDP, which would imply saving is rising, but unfortunately makes two errors – first he confuses personal consumption with total consumption, and second he fails to note that shifts in relative prices mean that although in volume terms US personal consumption fell more rapidly than GDP in the second quarter of 2009 it increased as a percentage of GDP. From the point of view of global imbalances, that is the US balance of payments deficit, it is the proportion of GDP devoted to consumption which is determining and not movements in volume.

It is therefore clear that the first part of the 'global imbalances hypothesis' regarding the US is wrong. The imbalance of the US balance of payments deficit is not falling because US saving is rising but because US investment is falling even more rapidly than US saving is falling. Now consider China.

China's rising investment and declining trade surplus

While the macro-economic data available for China for the second quarter of 2009 is not as detailed as for the US nevertheless, again, the shifts are so large it is relatively easy to ascertain the trends.

The first trend is that China's investment is rising as a percentage of GDP. Second China's balance of payments deficit is declining. These will be considered in that order.

First, taking the rise in China's investment as a percentage of GDP, the components of the 7.1% rise in GDP in the first half of 2009 were 6.2% rise in investment, 3.8% rise in consumption, and minus 2.9% fall in net exports. Unless China's savings were increasing equivalently such a rise in the percentage of investment in the economy necessarily means that China's balance of payments surplus must fall.

As with the US balance of payments figures for China for the second quarter of 2009 are not yet available. But the drop in the trade surplus, which dominates China's balance of payments position, is of sufficient magnitude that it is clear that China's balance of payment surplus is falling.

Figure 4 shows China’s monthly trade surplus since 1992 up to June 2009. Figure 5 shows the same data calculated as a three monthly moving average in order to avoid any purely short term distortions.

Figure 4

Figure 5

The trend is clear. China#s trade surplus rose steadily from 2005 onwards and then temporarily rose even further under the impact of the onset of the international financial crisis in September 2008. The peak was reached in January 2009 with a monthly surplus of $42.1 billion. Since then China's surplus has fallen steadily. The surplus for June was $8.25 billion.

Expressed in terms of three monthly moving averages China’s monthly trade surplus was $22.5 in August 2008, immediately before the collapse of Lehman brothers, rose to $38.1 billion in January 2009, and has since dropped to $12.5 billion.

Shifts in other components of China's balance of payments sufficient to offset the rapid decline in the trade surplus are not credible so it is clear that China's overall balance of payments surplus has shrunk - meaning the gap between China's savings and investment has narrowed.

While savings figures are not available for China at present it is clear from the data above that they have not risen to match China's rise in investment. There are reasons to believe China's savings may have declined somewhat – China's budget is projected to move into a 3% of GDP deficit, profitability of export and other industries is under pressure from the international financial crisis, and given a 15% rise in retail sales there is no reason to believe household saving has risen significantly (if at all).But it is clear that China is fundamentally responding to the financial crisis by raising its rate of investment. The result has been the most rapid rate of growth in the world.

The logical lacunae in the global imbalances hypotheses, that it did not point out that China could just as much reduce its balance of payments surplus by increasing investment as by reducing saving, is therefore the actual course of China's economic policy - with the most successful results of any country in the world.

Indeed it is quite probable that this year, in net terms,the whole of world growth will be accounted for by the expansion of China's economy. Compared to this level of economic success all discussion of 'green shoots' in other economies is insignificant.

The errors of the 'global imbalances hypothesis'

For the reasons set out above it is therefore not material that the 'global imbalances hypothesis' is conventional wisdom - many things that are conventional wisdom turn out to be false, nor that a number of those supporting it are outstanding economists, nor that Martin Wolf is one of the world's outstanding economic journalists with a deep knowledge of economic statistics etc. A theory which lacks internal coherence, which is factually wrong, and which leads to wrong policy prescriptions is a theory that does not meet the test of scientific rationality. It should therefore be set aside.

Instead the realities of the world economy should be recognised. The US balance of payments deficit has been shrinking not because US saving has been rising but because US investment has been declining more rapidly than US saving has been falling. China's balance of payments surplus has been declining primarily because its investment level has been rising. That is, the logical gap which existed in the 'global imbalances hypothesis' corresponds to the actual course taken by the world economy. As always when the facts and a theory do no coincide it is the theory which should give way.

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This article by John Ross originally appeared on the blog Key Trends in Globalisation.

Notes

[1] The wide circulation of this analysis may be traced to a speech by Ben Bernanke, now Chairman of the Federal Reserve,

[2] Breaking these figures down into their detailed components US personal consumption rose from 69,9% of GDP to 70.6% between the fourth quarter of 2007 and the second quarter of 2009. In the period from the second quarter of 2008 to the second quarter of 2009 US personal consumption rose from 70.3% of GDP to 70.6%. US personal consumption increased between the first and second quarters of 2009 from 70.4% of GDP to 70.6%.

To calculate precisely how much US government consumption has risen it is necessary to note that the US is unusual in that in its main aggregate GDP statistics it groups together government consumption and government investment – most countries statistically treat government investment simply under overall investment. If the two components (consumption and investment) of US government expenditure are taken together they increased from 19.2% of GDP in the last quarter of 2007 to 20.7% of GDP in the second quarter of 2009. It is necessary to eliminate from this the rise of government investment from 3.3% of GDP to 3.6% of GDP in the same period. Government consumption rose from 15.9% of GDP to 17.0% of GDP. In the period since the second quarter of 2008 US government consumption has risen from 16.4% to 17.0% of GDP.Government consumption rose from 20.3% to 20.7% of US GDP between the first and second quarters of 2009.

Considering, therefore, both total consumption and its breakdown the rising proportion of consumption in US GDP since the beginning of the financial crisis is clear – indeed consumption has risen as a proportion of US GDP both as regards personal consumption and government consumption.

[3] Private fixed investment declined from 15.8% to 12.3% of GDP, inventories fell from plus 0.1% of GDP to minus 1.1.% of GDP, and government investment rose from 3.3% to 3.6% of GDP.

Ireland - the scale of economic downturn in the 'Celtic Tiger'

Most attention in the international financial crisis has naturally been focussed first on the situation in the largest economies (US, China, Japan, Germany, India) and, after that, on the extremely severe problems in a number of developing countries and in parts of Eastern and South Eastern Europe – with, for example, a decline of GDP in the Slovak Republic of 11.4% up to the end of the first quarter of 2009 and a decline of GDP in Turkey of 13.7% to the same period. Insufficient international attention has therefore been given to the situation in Ireland – that is the southern 26-county state - for many years referred to as the ‘Celtic Tiger’ on the basis of its rapid growth.

The economic crisis in Ireland has been referred to as similar to that of Iceland with the difference of one letter and six months. This comparison, however, actually understates the scale of downturn in Ireland’s overall productive economy. The fall in Ireland’s GDP, 9.6% by the first quarter of 2009 compared to its peak level, is significantly worse than Iceland’s – where GDP has only dropped by 4.4% since its peak. Indeed, apart from the Slovak Republic and Turkey, the decline in Ireland’s economy is the worst for any OECD country.

There are also very specific features of the economic crisis in Ireland. First, the economic downturn in Ireland started much earlier than in other countries. The European Union’s GDP peaked in the first quarter of 2008 – that is before the international financial crisis commenced. But Ireland’s GDP peaked in the first quarter of 2007 and then started to decline. Ireland’s economy has therefore been shrinking for two years. The international financial crisis therefore clearly did not cause Ireland’s recession, although of course it greatly worsened it. In Ireland the international financial crisis affected an economy that was already moving downwards.

Second, unlike most other countries, the financial crisis has scarcely affected Ireland’s trade. The decline in Ireland’s exports of goods of services, up to the most recent figures for the first quarter of 2009, is 4.5% - evidently extremely mild compared to the comparable figures for the US of minus 14.7%, the UK of minus 17.3%, Germany minus 17.5% or Italy minus 22.1%.

Instead the downturn in Ireland has been concentrated in an extremely severe collapse in investment. Ireland’s gross domestic fixed capital formation, by the first quarter of 2009, had fallen by a 42.9% compared to its peak in the first quarter of 2007. To give a scale of comparison the equivalent fall in Germany from the peak level has been 11.4%, in the UK 14.7%, and in the US by 14.7%.

The decline in investment in Ireland has been by far the worst in any OECD country except for Iceland (where, due to the disintegration of the financial system, investment had fallen by over sixty per cent).

These trends in Ireland's economy are shown in Figure 1.

Figure 1

In order to give an indication of the scope of the fall in Ireland's investment Figure 2 shows the percentage decline of investment in the G7 as a whole since its peak in the first quarter of 2007, the decline in investment in Ireland in the same period, and, for comparison, the decline in investment in the US at the beginning of the Great Depression in 1929 - as there are no quarterly GDP figures for the US in 1929 it has been assumed for illustration that the annual decline in that period was spread evenly throughout the year.

It may be seen that the scale of investment decline in Ireland is far closer to the US in 1929 than it is to the decline in the G7 in the current recession - the fall in fixed investment in the US in 1929-31 was -47.6% compared to the fall in a similar two year period in Ireland in this downturn of 42.9%. For comparison the fall in investment in the G7 in this recession in the same period was 13.4%.

The decline in investment in Ireland is, therefore, without exaggeration, of 1929 proportions.

Figure 2

The result of this, as may be seen in Figure 3, is that the proportion of investment in Ireland's GDP has fallen precipitately from a peak of 28.5% of GDP in the fourth quarter of 2005 to only 15.3% of GDP in the first quarter of 2009.

Figure 3

China’s investment surge aids its own and the world economy - by John Ross

The publication of data for April paints a graphic picture of the present interplay of forces within China’s economy. They also show, so far, the broad correctness of the policies undertaken by China’s government in meeting the international financial crisis and, simultaneously, illuminate the very serious errors of writers such as Martin Wolf, chief economics commentator of the Financial Times, who advocated an entirely different course.

Externally China’s economy continues to be struck with great force by the current collapse in world trade produced by the international financial crisis. China’s April exports were down 22.6% compared to a year earlier. This is a lesser fall than for most countries but necessarily applies severe contractionary pressure to China’s economy.

Internally the Chinese government’s stimulus programme has led to a 30.5% rise in investment in fixed assets in the first four months of 2009 – an increase from the 28.6% year on year increase in the first quarter. Simultaneously China's retail sales in the year to April grew by 14.8%.

The result of the contradictory impact of the negative pressure from the decline in export, and the positive one from internal economic expansion, was the 7.3% year on year increase in industrial output to April. This is relatively low by China’s recent standards but stellar by those of almost all other countries which are suffering major declines in industrial production.

As China’s investment is rising more rapidly than consumption the share of investment in China’s GDP is necessarily rising. While precise quantitative data on the composition of GDP will not be available for some time nevertheless it is possible to judge orders of magnitude.

If it is assumed that China’s overall consumption rises at the same rate as retail sales (which is probably on the high side but no alternative objective measure is available at present),and that retail sales and investment continue to rise for the rest of the year at the same rate as in the first four months, while it is simultaneously assumed the balance of payments surplus declines by 30%, then this implies fixed investment would rise from 43% of China’s GDP in 2007 to approximately 46% in 2009. Evidently there are a considerable number of assumptions in such an estimate regarding trends in the rest of the year but it gives a rough yardstick.

Calculations done by Jing Ulrich, chairwoman of China equities at JP Morgan in Beijing, give a slightly lower estimate - that at present rates of growth investment will account for 45% of China’s GDP this year. Whatever the exact final outcome, therefore, it is clear that the share of investment in China’s GDP is rising.

In the present circumstances this has necessary consequences for China’s balance of payments surplus – given that such a surplus is necessarily equal to the surplus of domestic savings over domestic investment.

It is wholly unlikely that China's total savings level is rising at present given that the state budget is projected to move from balance to a 3% deficit this year, and company profits, the main source of China’s high savings level, are falling as a proportion of GDP under the impact of the financial crisis. China this year will at best have the same savings level as last year, or more probably its savings rate will decline somewhat.

As China’s savings rate is static or falling, and investment is rising, this implies a fall in China’s balance of payments surplus during 2009. China’s broader balance of payments figures will not be available for some time but balance of trade figures are available to April - and the trade balance dominates China’s overall balance of payments position.

The trade figures indicate that China’s monthly trade surplus fell from a peak of $40.1 billion in December to $13.1 billion in April. This figure, however, does not take into account seasonal fluctuations and a comparison with April last year shows a smaller reduction from $16.7 billion to $13.1 billion. The trend in the balance of payments surplus at present, however, is downwards. China’s balance of payments surplus, in short, is likely to fall as domestic investment rises.

This development may be sharply contrasted to the course advocated by Martin Wolf, and others, that China should close the gap between its savings and investment levels primarily by cutting its savings level rather than increasing its investment rate. As has been frequently pointed out on this blog there is a clear factual, as well as theoretical, positive correlation between a high rate of investment and a high rate of growth. China’s economy would slow if it were to reduce its investment rate – something which is not merely undesirable from the point of view of China but, particularly given the present international financial circumstances, is also highly undesirable from the point of view of the world economy. The present course of the Chinese government, which is increasing China’s investment rate, is therefore far preferable to the course advocated by Wolf not only from the point of view of China but from the point of view of the world economy.

Regarding China’s balance of payments surplus itself, while China requires a high rate of investment for a high rate of economic growth there is no reason to be found in economic theory, nor is there any evidence to suggest, that a high balance of payments surplus is any sense a precondition for rapid economic growth. Indeed, as a balance of payment surplus necessarily means that resources are not being productively invested in China, but are being invested in US Treasury bonds, it would be preferable, and secure a higher rate of return, for China to productively use a larger proportion of its assets within China – or put in other terms, the preferable way for China to use its high savings rate would be to increase its domestic investment rate from its previous level.

The argument that has appeared in sections of the foreign language media that China should not increase investment because this will increase ‘overcapacity’ is entirely fallacious theoretically. A high level of investment does not consist in creating more production capacity of the same type at the same levels of technology, efficiency, or productivity – the proposal that China should create more low value added production capacity is evidently false. The issue is high investment to upgrade China’s economy technologically and in terms of productivity and efficiency. Moreover, factually, China is at the beginning of this upgrading of its investment capacity. Capital stock per US worker or per West European worker is very much higher than per Chinese employee. To overcome this lag requires that the investment stock per Chinese worker rise more rapidly than in the US or Europe for a prolonged period.

In addition to direct investment in the workplace the efficiency of any economy, its level of productivity, does not rely only on extra machinery but on the efficiency of a country’s entire productive system including transport, communications, education etc. China has many decades of rapid investment to go through not only in machinery but in infrastructure before its level of capital stock, and therefore overall economic efficiency, even remotely approaches that of the US or Europe. This is merely another way of stating that, in order to achieve the technological and productivity level of the US and Europe, China must go through many decades in which its rate of growth of investment must exceed that of the US and Europe.

Nor, contrary to what is sometimes argued, is a high rate of investment contrary to the environmental needs of China – the exact opposite is true. Environmentally protective policies, for example low carbon emission power generation, is likely to be more expensive than environmentally damaging technology in the short term - although not necessarily in the longer one. To maintain a high level of economic growth in an environmentally protective fashion will therefore require a higher level of investment in China to maintain the same rate of growth – although such investment, of course, will not be in the same technologies as at present.

Increasing its level of investment, therefore, means the technological and productivity upgrading of China – both in terms of immediate productive capacity and the other indirect forms of investment supporting it, and not a merely quantitative expansion of existing technological and productivity levels. In short the argument that extra investment is wrong because it will create ‘overcapacity’ is entirely economically fallacious.

Purely abstractly, from a financial point of view, the highest possible utilisation of China’s savings for a still higher investment within China itself is desirable – which of course, as a by-product, would eliminate the balance of payments surplus. However such abstract financial considerations are subordinate to more practical constraints.

First, in the medium and long run the population of China will gain most from a high rate of economic growth, which requires a high level of investment. That is, the gain in sustainable consumption, both individual and social, which flows from a high growth rate and high investment level exceeds that which would be gained from increasing the share of consumption in GDP. Nevertheless such medium and short term gains must be balanced against short term consumption – with the key criteria being the welfare of the population and therefore its support for the economic system which has brought such success.

Second the rate of investment must be used to upgrade environmentally protective technologies and to replace, not expand, environmentally damaging ones.

Third handling very large investment programmes is not merely a question of allocation of finance but involves material organisation of the economy. As the author is aware of not only from theory but from experience of dealing with large infrastructure projects in London it is considerably easier to make allocations of finance than it is to ensure the efficient delivery of very large scale investment programmes. Whether China possesses the capacity to achieve the latter on any specified scale is a concrete issue that only those in the centre of the relevant economic decisions making have the information to take. Furthermore social, as well as strategic economic growth decisions, must be taken into account.

From an overall financial point of view under the conditions that prevailed in the first half of 2008 prior to the financial crisis, when the Chinese economy faced over- heating and rising inflation, it would, of course, have been dangerous and irresponsible to increase investment further. But now China’s economy is faced not with overheating but an international economic downturn and a potential, if not yet extremely serious, threat of domestic deflation rather than inflation – China’s consumer price index fell by 1.5% in the year to April and its producer price index fell by 6.6% in the same period. Under those circumstances an increase in the rate of investment does not pose the threat of overheating.

China’s investment surge is therefore not only good for its own economy but good for the world economy. Those, such as Martin Wolf, who proposed an alternative course that China should reduce its savings and investment rates were dangerously wrong.