“China is making all of us poorer” writes Paul Krugman in his blog at the New York Times (Krugman 2010). He is referring to the current account surplus of the Chinese economy draining aggregate demand from the rest of the world and leading to lower employment and income. Krugman is not alone in attributing extraordinary importance to economic developments in the Middle Kingdom. The savings glut hypothesis – the idea that high saving in China depressed world’s benchmark real long-term interest rates in 2006-07, thus contributing to a housing boom in the US and investors' purchases of securities backed by subprime mortgages in their "search for yield" – is another example of the view that developments in China have large macroeconomic impacts on the rest of the world.
The economic logic behind these arguments is not at issue.[i] High savings, whatever the source, do reduce demand and will therefore have a dampening effect on economic activity in the short and medium term. They also increase the supply of loanable funds and hence reduce real interest rates.
Putting the two arguments together does lead to a dilemma, however. Suppose the Chinese authorities were able to steer the economy towards more "domestic-demand-driven economic growth" by encouraging domestic consumption. What would be the consequences for the rest of the world? Greater consumption in China would mean greater imports as some of the expenditures would surely fall on goods produced abroad. Exports of the rest of the world would increase leading to greater employment and incomes, as Krugman’s argument would have it. Another way of saying the same thing is that a reduction in saving in China, which is simply the flip side to the increase in consumption, would reduce the surplus in its balance of trade and hence represent an improvement in the trade balance of the rest of the world. The improved balance of trade would add to aggregate demand. But if the savings glut hypothesis is correct, then the reduced saving in China will lead to an increase in real interest rates in the world, potentially reducing investment and growth and making it more costly for governments to service their debt. With anaemic growth and growing fiscal deficits in many economies, these would not be a welcome development at present. In other circumstances, however, higher real interest rates might be desirable.
Is China big enough for its policies to make us poorer?
To get a sense of the quantitative importance of policy changes in China on the rest of the world let us contemplate the consequences of China reducing its external saving/investment gap, i.e. its current account balance, by, say, 5% of Chinese GDP.[ii] As China’s GDP represents about 10% of the rest of the world’s GDP, the improvement in the current account balance for all other countries taken together would be 0.5% of GDP. Let us assume that each economy in the rest of the world will get an equal improvement in its current account balance (as a percentage of its GDP) as a result of the increased imports of China.[iii]
This improvement can be thought of as an autonomous increase in demand. How large will be the impact on GDP? Assuming a multiplier of 1.5 we would get an increase in US GDP by 0.75%.[iv] Although it obviously is helpful, it is hardly a change that will qualify as a major source of a recovery, especially since the improvement in the US current account would be phased in over several years. If we use Okun’s Law to calculate the effect on employment we would conclude that the unemployment rate in the US would decline by about 0.25% (0.75/3), not much bigger than a rounding error.
What about the offsetting effect of higher interest rates that would be the consequence of reduced savings in China? Similar arguments to those just made suggest that the offset is likely to be small because China is not yet big enough, relative to the world economy as a whole, for a plausible change in its savings to have a quantitatively important impact.[v]
The conclusion of this discussion is that a rebalancing of demand in the Chinese economy large enough to virtually eliminate its current account surplus would not make the rest of the world wealthy. The flip side of course is that the current deficit is not making us materially poorer.
A more sophisticated estimate
It may be objected that the quantitative aspect of above analysis is too simple-minded, as it is based on an "Econ 101" Keynesian multiplier framework. So let us ask what a more sophisticated model would tell us. The model proposed in N’Diaye, Zhang, and Zhang (2010) is a multi-country model used by the IMF, among others, to study interactions between countries and regions of the world economy. What makes it particularly useful for our purposes is that it contains the US, the Eurozone, and China among the building blocks, the relative sizes of all economies are calibrated to actual data, and production and trade patterns (both in final and intermediate goods) reflect those found in the data.
Zhang, Zhang, and Han (2010) provide a simulation of this model that can be used to address the question raised here. The simulation shows the effects of a hypothetical change in saving behaviour in China on the pattern of current account balances around the world as well as on outputs, employment, and other macroeconomic variables. Specifically, the simulation entails a ten-percentage-point reduction in saving as a share of GDP phased in over ten years. Figure 1 confirms the back-of-the-envelope calculations discussed above.[vi] It shows that while the decline in saving in China will have a large impact on China’s own current account balance, the spillover effects on the other regions in the model are very small. In particular, the improvement in the current account balances of the Eurozone and US are each on the order of 0.1% of the corresponding GDP levels.
Figure 1. Effect of a declining Chinese saving rate on current-account balances after five years
Source: Zhang, Zhang, and Han (2010).
Given the small spillover effects on current account balances, it should come as no surprise that the impact on GDP and employment are equally tiny. For example, the employment rate in the Eurozone increases by 0.33 percentage points and in the US by 0.11 percentage points. Similarly, the impact on real interest rates is negligible.
The conclusion we should draw from this analysis is that policies in China will not solve the income and employment problems in the Eurozone and the US. These problems have to be tackled principally by measures internal to these economies.
Of course, Chinese authorities do have good reasons to take actions that increase incomes and consumption of Chinese households, thereby improving their standard of living. Indeed these are explicit policy objectives of the Chinese government. To the extent that such actions also contribute, even modestly, to reducing global current account imbalances, they will be welcome by the rest of the world as well.
Cogan, John F., Tobias Cwik, John B. Taylor, and Volker Wieland (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers ”, mimeo, February.
Krugman, Paul (2010), “Capital Export, Elasticity Pessimism, and the Renminbi (Wonkish)”, New York Times blogs, 16 March.
Mollerstrom, Johanna (2010), “The source of global trade imbalances”, VoxEU.org, 27 March.
N’Diaye, Papa, Ping Zhang, and Wenlang Zhang (2010), “Structural Reform, Intra-Regional Trade, and Medium-Term Growth Prospects of East Asia and the Pacific ---Perspectives from a new multi-region model”, Journal of Asian Economics, Vol. (21), p.20-36.
Romer, Christina and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan”, 8 January.
Zhang, Wenlang, Zhiwei Zhang, and Gaofeng Han (2010), “How does the US Credit Crisis Affect the Asia-Pacific Economies? – Analysis based on a general equilibrium model”, Journal of Asian Economics, Vol. (21), p.280-292.
[i] The quantitative relevance, however, has been questioned (Mollerstrom 2010).
[ii] This would be a large adjustment and it would virtually eliminate the existing imbalance. Suppose it did so by boosting domestic consumption. Assuming that each extra yuan of expenditures leads to a 0.4 yuan increase in imports and assuming a savings propensity of 50%, autonomous consumption would have to increase by 17.5% of GDP. Under the same assumptions, GDP itself would increase by 25% compared to a case without the change in consumption. Clearly such changes could only be contemplated over a medium-term adjustment period.
[iii] It is sometimes assumed that a reduction in China’s current account will lead to an almost equivalent reduction in the deficit of the United States. There is no reason why this would have to be the case. Increased consumption in China is likely to increase imports of many types of goods and commodities which are not necessarily produced in the United States. Of course, the economies that benefit from the increased imports by China are in turn likely to increase their imports, some of which will come from the United States. So, barring a more detailed analysis based on a multilateral trade model, our assumption of an equal distribution across countries of the increase in Chinese imports is a reasonable starting point for the analysis.
[iv] Romer and Bernstein (2009) argue that a multiplier of 1.5 is representative for the US. This has been challenged. A recent study by Cogan, Cwik, Taylor and Wieland (2009) argues that the multiplier is more likely to be on the order of 0.5. That would of course make the impact on US GDP very minimal.
[v] In a model of interest rate determination which emphasizes the supply and demand of stocks of dollar-denominated assets rather than savings and investment flows, the persistence of dollar-denominated reserve accumulation would increase the interest rate effects over time.
[vi] AU&NZ refers to Australia and New Zealand, EMEAP6 refers to Hong Kong, Indonesia, Malaysia, the Philippines, Singapore and Thailand combined, and EA denotes the Eurozone.