THE GREAT PIGGY BANK OF CHINA / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

The Great Piggy Bank of China

By Samuel Brittan

Published: January 21 2010 21:53

A  frequent  complaint against political economists is that they hide their vision  of how  the world works behind complex models. This could hardly be said of John Maynard Keynes, who first burst forth on the wider public with his 1919 polemic, The Economic Consequences of the Peace.

What remained in the memory of readers who were not particularly interested in the German reparations problem was his preliminary chapter on Europe before the first world war. He described it as an “economic Eldorado” where “it was possible for any man of capacity or character at all exceeding the average, to rise into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts and amenities beyond the compass of the richest and most powerful monarchs of other ages”.

By the 1930s his view of the pre-1914 order had darkened. His stark conclusion was that full employment had rarely been achieved in peacetime except in rare periods of exuberance. He formulated a “psychological law” that savings tended to rise more than in proportion to income and tended to outrun investment opportunities. Some American economists called the doctrine “secular stagnation” and braced themselves for a big slump following the second world war.

That slump never materialised and in the second part of the 20th century savings were more often inadequate than excessive. What had gone wrong with the “psychological law” of savings? At any one time people on higher incomes saved more than those on lower incomes. But as national income rose, the curve relating savings to income rose too.

Yet to most people’s surprise, Keynes’s chronic world savings surplus has come back thanks to China’s phenomenal savings rate – 49 per cent of gross domestic product and 28 per cent of global savings in 2009. This is an example of Chinese policy, not any economic “law”.

The world was kept in balance by the US acting as a consumer of last resort, in the company of a few other smaller economies such as the UK and Spain. The rise in US consumption was aided by the Federal Reserve’s low interest rate policy, which was justified in the circumstances. It was also enhanced by a series of large US budget deficits. Add to this irresponsible lending by financial institutions desperate for a higher yield and, one must admit with hindsight, that the pudding was over-egged.

All this came to an end with the credit crunch and the associated collapse of bank lending. A world depression has been prevented by rock-bottom official interest rates and a leap in budget deficits in western countries. This has shown itself in a jump in their combined budget deficits to about 9 or 10 per cent of their GDP, with the US and the UK recording almost 12-13 per cent.

If western countries begin slashing their fiscal deficits, as conventional opinion so loudly demands, what will supply the offset to Chinese savings? Most of the suggested answers are non-starters. It is no use lecturing the Chinese to consume more. Indeed, the Chinese authorities are now reining back domestic demand for fear of inflation. It would be best to take Chinese policy as a fact of life.

A rise in western private investment is not impossible. But it is hardly likely to take off while prospects for final demand are so muted and there is still talk of a double-dip recession. The best hope for an offset to Chinese saving is an investment boom in other emerging countries that have been less hard hit by the recession than the industrial west. But that is hardly likely to develop quickly.

It would be foolhardy to encourage a further great rise in consumer or housing debt, at least in the English-speaking countries. If there were a single western fiscal authority, I would unhesitatingly say: let the budget deficits run for a while, if necessary financed by the central banks – which, to be fair, Gordon Brown has tried hard to achieve. In the absence of such a common front, what are the real limits to how far a country, fortunate enough to have its own currency and borrow in it, can go out on a limb?

Financial market types worry about selling government debt; but this is not the true limit. It is worth pursuing an expansionary monetary and fiscal policy up to the point where the loss on the terms of trade or the boost to inflation coming from currency depreciation begins to outweigh the gains to domestic output and employment.

Meanwhile, to the demands that the first priority of a new British government should be to reduce the fiscal deficit, I can only say: “I beg to differ.” As Mervyn King, Bank of England governor, has just reminded us, UK output is some 10 per cent below its previous trend. If the recent upturn in UK inflation turns out not to be a blip but a lasting response to sterling devaluation, the appropriate reaction would be to edge up interest rates but let the budget deficit run. This would be the opposite of the conventional wisdom and so probably correct.

Copyright The Financial Times Limited 2010