The new international financial crisis and China
- By John Ross
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China.org.cn, August 9, 2011
Europe followed a similar path, but some countries – Greece and Italy – built up very large public sector debts alongside other countries – Spain – that built up private debts. Europe's situation is more structurally dangerous than that of the U.S. because the Federal Reserve has greater resources than the European Central Bank.
But none of the measures to tackle the debt problems in the U.S. and Europe will avoid severe economic pain. The intense political fights are therefore over who should suffer it. The U.S. Tea Party, the UK Conservatives and some European right wing circles advocate cutting budget deficits by reducing government spending and limiting the buildup of government debt. This is linked to a theory that the state is "crowding out" the private sector: The recession's main cause is the fall in private investment and the resources used to finance the budget deficit are not available to the private sector but if released to it they would be used to generate an economic expansion.
But this theory will not work under present conditions. Reducing budget deficits cuts demand. But resources released to the private sector will be used to pay down debt, so private sector spending will not increase sufficiently to compensate for the fall in public spending. Total demand will fall, increasing recessionary pressure.
But other than in the short term, increasing the deficit doesn't work either – and large budget deficits are financially unsustainable in the medium term. This policy of running large budget deficits is often, but inaccurately, described as Keynesian. Keynes was mainly concerned with factors affecting investment, not budget deficits. For example, U.S. economist Paul Davidson claims in The Keynes Solution that "anything that increases spending on goods and services increases the profitability of business firms and the hiring of workers." But this is false –an increase in spending on goods and services accompanied by cost increases may lead profits to fall.
Even if profit did increase, companies may not reverse the cuts in investment that are at the core of the recession. Keynes pointed out that to generate investment a price must be paid to overcome a "liquidity preference" – the safety and other advantages of holding cash and liquid assets. Under conditions of uncertainty, such as those of the present, the cost of overcoming the liquidity preference may be prohibitive.
Even more fundamentally, given excessive indebtedness, companies use resources to repay debts and not to invest even if demand increases. Therefore stimulating demand by budget deficits may prevent worse collapses in production but doesn't produce significant output increases.
Nor will low interest rates suffice. Low interest rates are necessary to prevent debt interest payments becoming unsupportable. But low interest rates will not lead to investment if companies are intent on paying down debt – because they have no intention of borrowing and are therefore uninfluenced by the interest rate.
The way out is the method successfully utilized by China in its 2008 stimulus package and which was advised by Keynes himself. The state must overcome the threat or reality of a fall in investment by organizing investment itself. As Keynes put it: "It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment."
In the U.S. and Europe, the obstacles to Keynes's or China's solutions lie in economic structure. Since its 1978 economic reforms China no longer administers its economy, but it has a sufficiently large state sector to deliver investment programs. But in the U.S. and Europe, Keynes "somewhat comprehensive socialization of investment" does not exist and therefore, unlike China, they cannot deliver an investment led stimulus program.
The economic perspectives flowing from the new financial crisis are therefore clear. The U.S. and Europe face at best very slow growth for several years. China's economy will continue to expand rapidly.
The author is a columnist with China.org.cn. For more information please visit: http://www.china.org.cn/opinion/node_7080931.htm
Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.
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