My Blog

January 30, 2008

WED 30 JAN 2008

The new China-Europe-US world order By Michael Pettis

There is a longish and much-discussed article in this Sunday’s New York Times (“Waving goodbye to hegemony”) by Parag Khanna, a senior research fellow in the American Strategy Program of the New America Foundation, which strikes me as a sort of compendium of a lot of fashionable and muddled thinking about the evolving geopolitical order.  The main thesis is that we are moving away from US hegemony (what? again?) towards a new world order to be dominated by China, Europe and the US.

 

After stating this thesis Khanna then makes a number of suggestions about how the US should prepare itself for this new world – some commonsense, some irrelevant.  Most of his evidence in favor of his thesis is not based on aggregate numbers but rather on the sort of anecdotal and often meaningless examples with which journalists love to exemplify an assertion (“But there are statistics, and there are trends,” he says in explaining why he prefers symbolic anecdotes to data). For example, he points out that Tata is trying to buy Jaguar, London has (had actually) more IPOs than New York, developing countries have more reserves than the US, etc.  But the examples are purely symbolic and contain no substance, especially the point about reserves – regular readers of my blog know how much it irks me when people confuse reserves with wealth, especially when dealing with China, where growing reserves are a symptom of serious domestic problems, not rude good health.  Anyway when it comes to the hugely symbolic acts of rising powers, I think Japan in the 1980s blows out all of the current contenders – although perhaps Khanna is not old enough to remember.

 

Khanna supports his analysis by pointing out that in the past two years he has visited forty countries around the world, but at the risk of sounding like a world-weary snob, this does not impress me much – in fact I am a little worried by the Starbucks school of comparative politics.  It reminds me of something a Canadian China scholar once told me – for him the biggest difference between China experts who have never visited China and those that visit twice a year is that it is sometimes possible to convince the former when they are mistaken.  I would be much more impressed with Khanna’s article if he had a little more sense of history.  His comments about Hugo Chavez, for example, suggest he knows little about a very common thread in Latin American history – the very difficult history of what my Latin American friends call fiscal-surplus populism.  His claim that Russia will eventually choose to be swallowed up either by Europe or by China, as what he calls a petro-vassal, certainly violates everything I thought I knew about Russian history.

 

But I have a more fundamental problem with his thesis.  I know this is a very contrarian position, but not only do I personally not think we are moving towards a China-Europe-US great power world in my lifetime, I think a very plausible case can be made that the US will be even more dominant by the middle of this century than it is today (and that Europe will be far less).  I say this not with pride or glee – I actually think the supremacy the US has enjoyed during the past few decades is bad for the US and may have caused us to undermine some of our strongest values, as President Bush has already demonstrated.  To me an increase in US relative power is almost certainly a bad thing for the US, but nonetheless I think it is more likely than the alternative.

 

With all the recent hype about US decline it may seem a little hard to think otherwise, but breathless predictions of US decline have been made often enough in the past that they have become a little stale.  By some accounts the US has been in a state of permanent decline since at least the end of the 19th Century, when some English wit claimed that the US had already passed directly from youth into senility without having gone through a period of maturity.  Certainly since the first big recession after WW1 (I believe it was 1919-1921) or at least since the beginning of the Great Depression, it has never been hard to find very serious American and foreign scholars announcing the imminent end of relative US power.  More to the point, during my life time the current period of Chinese dominance is only the latest of at least three periods of unstoppable US decline.

 

The first one was during the 1970s, and that seemed to be a very plausible prediction at the time. The US faced a real set of problems unlike any it faces today, combining the geopolitical (the defeat in Vietnam, the humiliation of Iran, widespread anti-Americanism and the seeming collapse of US foreign policy in general), the political (the Watergate scandal), the cultural (hippies!) and the economic (inflation, stagnation, and a collapse in consumer confidence).  At the time you could buy entire blocks of New York City for a few thousand dollars and crime was rising inexorably and shockingly – talk about symbolism.

 

In those days it was pretty clear to any unbiased viewer that the US decline was all but irreversible, and I spent most of my college years learning that this was pretty much a given and we had all better get used to it.  Standing against US decline were the still powerful Soviet Union, which seemed all but impregnable, and the rapid rise of the fabulously wealthy OPEC Arabs (in a world of ever-rising oil prices as far out as the eye could see), who in the popular imagination were rich, secretive economic and political geniuses who were slowly and surely taking over the world with their growing foreign currency reserves.

 

Only a few years later the OPEC Arabs were all but forgotten and the Soviet Union seemed on the point of collapse, but there was a new, even more terrible threat that promised the end of US domination, and that, of course, was Japan.  As well-known as the story is it is still sometimes hard to remember how difficult it was back then for anyone to be taken seriously who doubted the inevitability of Japan’s rise to top-dog status.  Japan was truly a miracle economic and political story whose technological prowess, at the time, seemed likely to pose a real and insurmountable challenge to US supremacy.

 

Today China has replaced Japan, and in spite of the much larger Chinese population, I find the prospect even less likely.  Let me qualify that: There is no question in my mind of China’s relative rise, but the relative rise of China will be slower than many think.  More importantly, its rise would require the relative decline of the US only if there were no more than two countries in the world.  As it is there are more than two, and it is perfectly possible for both China and the US to rise in relative terms at the expense of other countries.  In fact I think this is actually a far more plausible explanation of what is likely to happen.  I would argue that the rise of China (and India) will be more than fully accommodated by the decline of Europe, Japan and Russia.

 

There are several reasons for this but the main reason is demographic.  If we assume that the six great or potential powers of the world are China, Europe, India, Japan, Russia and the US, it seems that all of them with the exception of India and the US have very serious demographic problems that will seriously undermine their future growth.  Take Europe for example.  I don’t have the figures in front of me, but today Europe’s population is, I think, about 15% greater than the US.  By the middle of the century it will be about 15% smaller, and its median age will have risen from a couple of years more than the US to about 12-16 years more.  Projecting the differential per capita growth rates over the past few decades into the future (I know, I know, but what is a more plausible alternative?), Europe’s GDP, which is today larger than that of the US, is likely to be only two-thirds or less than that of the US – and when I ran these projections a few years ago I did them on a per-capita basis, not on a per-worker basis, which would have been much worse..

 

Khanna will argue (and nearly does) that Europe has an almost unlimited supply of countries eager to join and, by adding them to the European stew willy-nilly Europe can keep its population and economy growing for a long time.  This would require that Europe keep adding North African and Asian states to the European Union without domestic opposition, fully integrating them immediately in the Europe political and economic system, and without in any way diluting the cohesiveness and decision-making ability of the European elite.  Khanna may have spent several months of those two Starbucks years visiting European countries, but I was born in Spain of a French mother and grew up primarily in Europe, and I think this is, to put it politely, highly implausible.

 

All the demographic problems facing Europe of course are as true, or even truer, of Japan, with the difference that Japan cannot annex neighboring countries as quickly as Khanna believes Europe can.  So Japan, I guess, is out of the running.  On the other hand my own unsubstantiated claim is that there will be an economic and military resurgence of Japan soon enough, so perhaps I wouldn’t count Japan out too quickly.

 

China also faces a serious demographic problem.  It has reached the limits of its population size while the US population keeps growing, driving the relative size of the two countries down from 4:1 currently to less than 3:1 by 2050 (and maybe substantially less).  More ominously, today China is younger than the US, but by the middle of the century I believe it may be even older than Europe, so the relative change in its working population will be even sharper than that of the overall population.  Since the mid-1970s China has benefited from a dramatic improvement in its dependency ratio as the one-child policy wiped out the bottom end of the dependents, but as China ages, the reverse impact of the one-child policy kicks in, so that beginning in 2010-2011 China’s dependency ration begins deteriorating just as dramatically as it improved. 

 

It is a little difficult to say what an equilibrium growth rate for China would be given current demographic conditions, but when the dependency ratio shifts sharply from improvement to deterioration, the new equilibrium growth rate must be substantially lower.  For comparison’s sake I once saw a World Bank study that argued that 30% of the growth of the Asian Tigers was accounted for by the improvement in their dependency rations (which have not improved as dramatically as China’s).  This suggests to me that nearly all estimates of China’s future growth rates are overly optimistic, even if you believe current levels are sustainable, which I don’t, for a variety of reasons I have discussed elsewhere.  By the way, for the curious, I remember reading that the US dependency ratio has actually improved slightly over the past few decades and is expected to continue doing so through the next few decades – although I don’t remember the actual numbers.

 

The problems China faces are not only demographic, of course.  It faces huge environmental, water, and social challenges that make any prediction very tentative and subject to lots of downward revision.  Most of all its political structure makes any of the current set of predictions extremely dependent on an unlikely set of political developments.

 

There are also geopolitical considerations.  When it comes to geopolitical conflicts the US is in a great neighborhood and largely unchallenged.  However all the rest of the potential powers are neighbors, with long histories of conflict and rivalry, and all with exception of Japan (maybe) nuclear-armed.  This hardly suggests to me an environment conducive to relative rise.  In my own view of the world, in the East China, Japan Russia and India will all conspire to keep any one of them from achieving dominant status, whereas in the West Europe will struggle with the problems of immigration and integration.  None of these predictions can be proven except by time, of course, but I think they are at least as plausible as the alternatives.

 

In another post I will discuss some of the issues facing China’s long term economic growth.  I believe that China will certainly grow relative to the rest of the world – from less than 5% of global GDP today to 15-20% in the next few decades – but I am very skeptical about claims that it will become the world’s largest economy in the next few decades.  The problems facing are huge.  Surprisingly enough this view, which should be seen as astonishingly optimistic, actually makes me in the eyes of much of the world a ferocious pessimist about China, which suggests perhaps how over-hyped China has become.  Still, for those of us who were around in the 1980s and remember the Japan hype, this is not exactly unprecedented.

 

WED 30 JAN 2008

Things have gotten grimmer in China By Michael Pettis

What can the PBoC and the financial authorities do?  Last Thursday Premier Wen Jiabao told the State Council that 2008 was going to be an extremely difficult year – an extraordinary admission by some accounts and indicative of how much pressure he is under.  Rising inflation and energy shortages have been made worse by the huge snowstorm that has hit the country, severely damaged crops, and closed train lines just as Chinese families were gearing up for the all-important Spring Festival, driving food inflation before this all-important family holiday much higher.  Domestic overheating, which in the last few months has become a concern almost to rival rising inflation, had been met for much of last year with rising interest rates and minimum reserve requirements, but the much tougher policies enacted in the past three months have suddenly been thrown into question by worries that a slowdown in the US will lead to a sharp drop in export growth.  Rumors are flying about the possibility of a reversal of the tightening measures announced last October.

 

Should the authorities continue tightening or should they backtrack?  Some analysts are now arguing that they cannot continue tightening and should actually reverse policies.  There is a real risk, they claim, that the previous domestic tightening measures will cause investments to slow sharply just as a US economic slowdown kicks in and drives down Chinese export growth.  These were the twin pillars of the Chinese economy, and for both of them to decline sharply at the same time might be more than the economy could bear, although one bit of good news in this almost unbearable gloomy environment was released by the National Bureau of Statistics today.  It turns out that private consumption contributed 4.4 percentage points the China’s 2007 GDP growth (11.4%), making it for the first time the biggest single contributor to Chinese growth.  If investment and exports are going to decline, we may need healthy consumption growth to moderate the impact, although I wonder if consumption can hold up in an otherwise poor economic environment.

 

On the other hand overheating has been a serious problem for the Chinese economy and if 2008 were to experience the same breakneck growth as it did last year, the adjustment will almost certainly be more difficult.  If the US slowdown is not as great as some think it might be, or if its impact on Chinese exports is less than many worry, expansionary policies in China may set off one last, crazy bull run.

 

On the inflation front the news is even grimmer.  The rate of inflation will almost certainly rise in January. To above 7% from 6.5% in December and 6.9% in November, even in spite of downward pressure put on it by recent government measures to make holiday conditions as good as possible – selling off food reserves and freezing price increases.  That almost certainly means that there will be more inflationary pressure in March and thereafter as these measures are unwound.  It would be ironic if a series of policy makes suddenly came to a head because of something for which it would be very hard to blame the government – the collapse in the weather.

 

Meanwhile divergent interest rate policies in China and the US coupled with the rising RMB will almost certainly cause a continued increase in hot money inflows, and so reserve growth will remain excessively high and monetary expansion to continue unabated.  I am hearing that increasingly think-tank and financial authorities are convinced that inflation is a monetary problem, and not a one-off food problem, although I would caution that the kind of people I am likely to hear from are not necessarily a representative sample of the policy-making class.

 

I am increasingly certain that the only thing China can do is a one-off maxi-revaluation.  However the economic environment is a lot less friendly today than it was even a few months ago.  The only thing to do is to watch CPI inflation numbers and hope they come down, but I don’t think that is very likely.