It is a discomfiting historical fact that great power shifts in the global economy are dangerous. They have tended to coincide with extreme financial dislocation, currency turbulence and trade friction. This is because the aspiring new boy on the block is usually a protectionist-inclined creditor country that is reluctant to shoulder international responsibility commensurate with its economic strength.
Consider the transition from British to US hegemony after the first world war. From 1918 the US rejected the Versailles treaty, opted out of the League of Nations and had nothing to do with German reparations, although it collected war debts from the allies. Britains liberal attitude to trade allowed the US to run a big trade surplus. Meantime, the young and inexperienced Federal Reserve pursued lax monetary policies in the Roaring Twenties while unwisely trying to prop up the ailing pound.
When the Fed belatedly pricked the resulting bubble in 1929, the Jazz Age came to an abrupt end, banks collapsed and the depression ensued. As the US exported its problem of deficient demand to the rest of the world, it failed to provide leadership to prevent an outbreak of disastrous competitive devaluations and was unwilling to act as a global lender of last resort to collapsing banks.
The next case in point is postwar Japan. Japanese economic growth was export-led, fuelled by an undervalued yen and subsidies for exporters. It was a model that worked as long as Japan was not a significant economic power. Yet by the late 1960s Japan was the second largest economy in the world. It was also running a huge trade surplus with the US.
International efforts to address imbalances and stabilise an overvalued dollar in the Reagan era had unintended consequences not least that Japanese intervention in the yen-dollar rate had the same bubble-inducing outcome as the Feds efforts to prop up sterling in 1927. The pricking of the bubble led to 20 years of economic stagnation.
Chinas challenge to the US is similarly export-led and its current account surplus is the biggest contributor to the Eurasian savings glut that led to the credit bubble and the global imbalances behind the financial crisis. Yet despite its success, Chinas economic model generates wasteful over-investment and under-delivers to ordinary people, who have the lowest share of private consumption in GDP in Asia. In a country that enjoys double-digit growth rates, employment growth has been running at a paltry 1 per cent a year, while real returns on savings are negative. As with Japan at its peak, the economy delivers a poorer quality of life than the per capita income figures suggest, with pollution, adulterated food and bad employment conditions posing threats to health.
Chinas export-led growth, fuelled by an undervalued renminbi, has been possible only because the US and other deficit countries have been willing to run up large debts to finance household consumption and now government spending. The snag is that the resulting imbalances are not sustainable because the point of debt exhaustion is close. Yet as Charles Dumas of Lombard Street Research argues in Globalisation Fractures, a new book on the incompatibility of the policies of the leading industrial countries, the policy response to the crisis has been too narrowly focused on financial issues rather than global imbalances.What is needed globally is for both debtor and creditor countries to rebalance their economies. The debtors need to tidy their balance sheets, while the creditors need to bump up domestic consumption, let currencies float and reduce export dependence. This would also be in Chinas own interest because its economy is in disequilibrium. It cannot, among other things, prevent inflation and asset-price bubbles while running an artificially low exchange rate. Yet the obstacles to change are formidable. The key to rebalancing towards consumption, says Mr Dumas, may be relaxation of government control over its citizens, which is unlikely to happen. There are also powerful lobbies against change, not least the inefficient producers who have been featherbedded by a cheap currency and whose economic survival depends on continuing undervaluation.
There is, then, a Chinese policy impasse. How does the world escape from its dire potential economic consequences? One scenario might be muddle-through: the US responds to an impending economic slowdown with looser fiscal and monetary policy, at the cost of racking up more debt and a crunch later on. Another would see US fiscal conservatives prevent budgetary loosening, while monetary policy remains lax. This would cause the US current account deficit to shrink sooner rather than later.
Either way, the risks of a protectionist backlash against China would rise. Under either scenario, the worlds creditor countries would ultimately see their chief market dry up. The main difference is in the timing. When, you might well ask, will the creditors wake up?