China is to blame – freedom and current accounts

“The freer the market the freer the people”. This is one of the questions that you are asked to assess in the the questionnaire designed by the Political Compass to determine where you stand on the economic continuum (left/right) and the social values (authoritarian/libertarian) continuum. I was reminded of this proposition when I read the latest Bloomberg opinion piece (December 7, 2010) – China Needs a U.S. Lesson – written by Alberto Alesina (Harvard) and Luigi Zingales (Chicago). They claim that the lack of freedom in China is to blame for the world crisis. They ignore the failure of the capitalist bosses and the bankers to behave honestly and competently. They ignore the wilful neglect of “free” governments who became captive of the self-regulation is good mantra proposed by the “free market” supporters. No, China is to blame because it is communist. The evidence would suggest otherwise. That is what this blog is about.

I have considered the offerings of Alesina before and found them wanting. Please read my blog – The deficit terrorists have found a new hero. Not! – for a thorough critique of Alesina’s propositions that fiscal austerity will generate growth.

In all his work he assumes that households are alleged to have an advanced understanding of the way the economy works and the future fiscal policy settings. All the evidence from behavioural economics tells us they do not have that understanding nor behave in the “rational” way that is alleged in the the mainstream textbooks.

I provide the background to my critique of Alesina in the following blogs – Defunct but still dominant and dangerous and The myth of rational expectations.

Anyway, now he and Zingales are entering the political fray and claiming that the main problem with the world economy is because there is a “lack of freedom in China”. When mainstream macroeconomic theory is bereft of anything to offer by way of predicting the crisis were are enduring and providing coherent solutions to it, then they have to cast wider to appear relevant to the modern debate.

If I was Harvard I would sack Alesina and save a bundle – given they are not in very good financial shape. One of the cleaners at Harvard is more productive than our erstwhile professor yet that university has been laying off their low-paid staff.

Anyway, these characters claim that:

In his famous 1987 speech in Berlin, U.S. President Ronald Reagan delivered the exhortation to Soviet leader Mikhail Gorbachev: “Tear down this wall.” Contrary to everybody’s expectation, the wall started to come down only two years later.

It is about time to give the same directive to communist China. The Chinese wall is metaphorical, but equally hideous: It limits freedom of expression, assembly and movement. It prevents the Chinese from pursuing their happiness and choices freely. If there weren’t enough moral and humanitarian reasons to make that exhortation, here is an economic one: The lack of freedom in China is the main cause of imbalances in the world.

Now, before some of you have your own McCarthyist purge on me let it be known categorically that I am not a supporter of the Chinese regime. If you want a guide to my political leanings here is my Political Compass score. I am pretty much a social libertarian who hates government dictates but understands that in a modern monetary system there is a government which has important capacities by dint of its currency monopoly and should use those capacities and its regulative powers to ensure the economy delivers outcomes that benefit all of us rather than a selective few.

I am clearly not a Stalinist or a supporter of authoritarian regimes. Is that clear? (Ray!).

As an aside, the following graphic shows the Political Compass assessment of different positions taken by the major political parties in the last Australian Federal election held in August 2010, which resulted in a hung parliament. I have superimposed my score on the graph. The narrative provided by Political Compass about the Australian political scene is interesting (depressing though it is).

But when I read the Bloomberg article I invoked the old “I smell a rat” filtering system. I thought – Alesina lecturing anyone about freedom? Here is an economist who advocates economic policies which deliberately entrench unemployment and all the poverty and restrictions that accompany it lecturing us about freedom.

Unemployment is 9.8 per cent in the US and the US Bureau of Labor Statistics measures of broader labour underutilisation is over 16 per cent at present. Long-term unemployment is rising. The same can be said about most advanced western nations.

Yet Alesina and co say that:

… what’s best in America: freedom.

Are all those workers denied a job and a livelihood because the US government is too wilful and/or incompetent to ensure there is enough aggregate demand to support higher employment growth free? I don’t consider being deliberately held in a socially alienated situation by the state to be a nation that is free.

Anyway, the bias in the article is obvious. Once we define the US as the exemplar of freedom then the term loses meaning in most nearly any way that matters. I will come back to that in a moment.

Their argument is as follows. First, China has a huge trade surplus which “is the counterpart of too much saving, which leads to unfair advantages and possibly deflationary pressure on a global scale.”

Yes, except what exactly are these “unfair advantages” when the trade with the rest of the world is “free”.

Second, they say that most economists think the problem is “due to China’s undervalued currency” which allows China to dump “underpriced products on Western markets, wiping out the competition unfairly”. Thus China should “stop manipulating its currency and let it strengthen”.

They reject this argument because China’s “cost advantage in the products they export exceeds … the difference that a stronger Yuan could achieve” which means that even if the Yuan appreciated it would not help. They note (correctly) that a revalued Yuan would just mean that “Americans will pay more for Chinese imports, without reducing the amount imported by very much”.

They then ask:

Why then does China export so much more than it imports? The answer comes from simple accounting. For every country, the current account is equal to the difference between the income produced and the sum of domestic investment and consumption. When a country consumes and invests less than it produces, it is bound to have a current-account surplus.

In the case of China, a country that grows 9 percent a year and invests 43 percent of its gross domestic product, it is hard to argue that it invests too little. But it is very easy to argue that it saves too much: 54 percent of GDP versus an average of 33 percent among developing countries and 17 percent among Organization for Economic Cooperation and Development economies. So China’s surplus is due to its excessive saving, not to its undervalued currency.

I have no real disagreement with this view of the national accounting although terms like “saves too much” are loaded. It is difficult to compare a developing country like China with a huge land-mass and a huge population to support (with requisite physical infrastructure needs to support the development process) with a smaller, less populated developing country.

China is clearly in a nation-building phase at present and is developing world class transport, education and other public institutions. It is no surprise that their investment and saving rates are so high. This is a typical situation in a nation in the early stages of development.

So these facts alone do not signal an issue except that the Chinese, like any net exporting nation are foregoing the benefits that using their own resources might bring and shipping more to the rest of the world in return for bits of paper than they are getting back in terms of real goods and services.

Modern Monetary Theory (MMT) which stresses that exports are a cost and imports are a benefit. That insight is contrary to the way the traded-goods sector is viewed by most mainstream textbooks which stress that trade surpluses provide the way to underpin economic growth.

Please read my blog – Modern monetary theory in an open economy – for more discussion on this point.

As an aside, there is an interesting interview with former German Chancellor Helmut Schmidt in the Monthly Bulletin of the Official Monetary and Financial Institutions Forum (OMFIF). You need a subscription to read it but here is an interesting excerpt in English. The interview was conducted by Dave Marsh (co-chairman of OMFIF) on behalf of the Handelsblatt:

Handelsblatt: I remember you saying many times, if the Germans keep the D-Mark we will make ourselves unpopular with the rest of the world; our banks and our currency would be the Number 1, all the other countries would be against us and that was why we should have the euro to embed us in a larger European undertaking. It’s all rather ironic, because people are saying that Germany has profited a great deal from the euro because the D-Mark has been kept down and this helps German exports …

Schmidt: I ask myself whether this profit really is a profit? I wonder whether running perpetual current account surpluses really amounts to a profit. In the long run it is not a profit.

Handelsblatt: Because in the long run these assets will have to be written down because people won’t pay them back …

Schmidt: Yes – it means that you sell goods and what you get back is just paper money and later on it will be devalued and you will have to write it off. So you are withholding from your own nation goods that otherwise they would like to consume.

So the typical mainstream economics view is that policy should be focused on eliminating CADs. Alesina and co seem to be arguing the opposite which is interesting in itself.

MMT emphasises that external deficits provide material benefits to a nation while external surpluses are typically not to be encouraged.

First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.

Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).

Second, external deficits reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.

An external deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.

As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.

However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.

Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.

The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.

Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.

Alesina and co then suggest that there is a simple way to tell whether Chinese savings are excessive:

How can we deem Chinese savings excessive? In a free country, the aggregate consumption-saving decision is the result of individual choices, which reflect the preferences of its citizens. It would be very paternalistic of us to argue that savings are excessive.

The point, though, is that China isn’t a free country and the economic decisions of Chinese aren’t driven by market forces. They are influenced by political decisions made by a small self-appointed elite. This group has decided that the accumulation of claims on the rest of the world is more important than the standard of living of the current generation.

Reflect on the points I made above. I do not support any strategy that promotes external surpluses. But then how does Alesina’s perspective square with the overwhelming IMF bias towards export-led growth – which is an ideology that they have imposed on nations for years now as part of their agenda to restrict fiscal policy activism aimed at expanding domestic activity?

Please read my blog – Export-led growth strategies will fail – for more discussion on this point.

Alesina’s current argument is at odds with the prevailing neo-liberal ideology although in all his other work he advances this ideology. The gross inconsistency of their position tells me that there is another agenda operating, which is to attack the political nature of China.

I agree that the “Chinese wages are kept low by preventing labor from organizing and limiting the flow of information” but that is a common situation in the early stages of development. America hasn’t got a great tradition in paying high wages to its lowest-paid workers and also has been union busting itself.

I also agree that:

… some more generous social-security system — now almost non-existent — for Chinese families would lower their precautionary savings.

Again that is a common issue in a developing nation whether “free” or not. It is also a problem in “free” countries like Japan where private provision of retirement income is culturally ingrained and means that private saving is high.

This necessitates rising budget deficits if you want to have lower external surpluses. The problem with the US is a lack of political will to introduce appropriate levels of fiscal stimulus. The problem in the Eurozone is their failure to organise a monetary system that can withstand external demand shocks. And what about German trade surpluses?

Anyway, Alesina’s message is clear:

… the U.S. should regain the high ground and lecture them on what’s best in America: freedom. Accusing communist China of keeping workers’ salaries artificially low and not being pro-workers would embarrass the nation’s government. Learning from Reagan, we can stand on our beliefs. If we do, the Chinese wall will come down sooner than we expect.

You might like to read this blog – China is not the problem – where I explain why the focus on China’s external accounts is an unproductive diversion. It diverts attention away from the failure of other governments to use their fiscal capacity appropriately to advance the interests of their population.

The US benefits from China’s willingness to deprive its citizens of material wealth and net ship its “labour” and other real resources embodied in the exports to other nations. What is the problem for the US? Answer: its poor system of government. That has nothing to do with China or its repressive system.

But with all that said, I then wondered about the veracity of Alesina and co’s proposition – that “freedom” implies lower or non-existent external surpluses. What about Norway? What about Taiwan? What about Trinidad and Tobago? What about Latvia, Switzerland, Sweden, Luxembourg, Netherlands, South Korea, Germany, Estonia, Lithuania, Denmark, Israel, Japan, Chile, Austria, Argentina, Indonesia, Finland, Uruguay, Belgium, Peru, and Hungary?

Why mention these nations (and in that order)? According to the IMF World Economic Outlook database, these nations ran current account surpluses (magnitude in the order above) in 2009.

These nations are all classified by Freedom House as being free! Using information obtained from a survey instrument, Freedom House publish indicators of political rights (PR) and civil liberties (CL) where a score of 1 represents the most free and 7 the least free rating. The ratings reflect an overall judgement based on survey results.

Their indexes are widely used but that doesn’t mean I support the implicit methodology or biases. But for the sake of correspondence let’s use the indexes because Alesina and co would probably agree with the Freedom House approach given they think the US is the exemplar of freedom. I actually think the US is the worst of all terrorist nations but we could debate that another time.

So around 50 per cent of the nations classified by political rights and/or civil liberties as being free run current account surpluses. Not a good start for the Alesina thesis that political oppression translates into lower net exports.

If you add in those nations classified as Partly Free then the percentage of total current account surplus nations that are Free or Partly Free is 72 per cent. Again not encouraging for Alberto.

But then we can do some further statistical analysis. The following graphs shows the relationship between the Freedom House political rights score (horizontal axis) and the current account balance for 2009 as a percentage of GDP. The sample includes 177 nations drawn from the IMF WEO database. External deficits are negative and surpluses positive.

I took out the observation for the Democratic Republic of Timor-Leste which recorded a current account surplus of 245.3 per cent and had a PR score of 3 and a CL score of 4. It doesn’t alter the analysis at all.

The left-panel shows the scatter plot for political rights (PR) score on the horizontal axis and the current account balance as a % of GDP on the vertical axis, while the right-panel uses the civil liberties (CL) score on the horizontal axis and the current account balance as a % of GDP on the vertical axis. You will readily appreciate that there is no relationship between these pairings.

Some “free” nations run current account deficits while others run surpluses. The same holds right through the “freedom” spectrum.

I also ran some regressions to calibrate the relationships. For non-econometricians don’t worry – nothing much is added by the following table. I fitted models for the Current Account balance as a percent of GDP in 2009 for the 176 countries regressed on PR and CL and then both together. The regressions could be made more complicated but you will never find a statistically significant relationship. None of the explanatory variables (PR and CL) were remotely significant in the regressions.

In other words, there is no inevitable relationship between “freedom” and the external balance.

Conclusion

It is more likely that the Chinese have been reading too many IMF and World Bank articles juxtaposed with some OECD diatribes on the advantages of export-led growth and this has led them to pursue this stupid growth strategy.

It is more likely they have been following the German or Japanese example than it is that their repressive system is driving this external outcome.

Alesina and co’s contribution appears to be more motivated by blind ideology and doesn’t stack up with the empirical evidence. Why should I be surprised about that? After all Alesina thinks households and firms are Ricardian and are not spending at present because they think the deficits have to be paid back. If you believe that you will believe anything.

The best thing the US could do is to stop hectoring other nations and look at its own dysfunctional system of governance. It should immediately announce another fiscal stimulus aimed at increasing employment (that is, direct public sector job creation). That would be a far better way to advance the interests of Americans than worrying about whether China’s citizens are being repressed or not.

The latter issue is not unimportant but when you deliberately impose important and idleness on around 16 per cent of your available labour then you are hardly in a position to give lectures on freedom to another “repressive” regime.

Somewhere out in the middle of the Atlantic …

Here is my laugh for today – In Latest Compromise with GOP, Obama Agrees He is a Muslim – which is pretty much the state of US politics from an outside-looking-in perspective.

Tomorrow …

The ABS release the November Labour Force survey tomorrow – keenly anticipated!

That is enough for today!