What China Can Learn From 1929

Nearly 80 years later, the roles have been reversed. U.S. overconsumption had been fed by Chinese overproduction, until the credit crisis forced U.S. households to cut back sharply on spending.

Many economists, perhaps in the belief that they are echoing Keynes's prescriptions in the 1930s, call on the United States to engineer a massive fiscal expansion to replace the collapse in household demand. But this is not what Keynes would have argued. If U.S. overconsumption was one half of the global imbalance, it cannot help much if American debt-fueled household overconsumption is simply replaced by American debt-fueled government overconsumption. The fundamental imbalance, Keynes would have argued, as he did in the 1930s, is that with Americans forced to reduce their overconsumption, China must reduce overproduction—either by boosting domestic consumption or by closing factories. If China tries its own version of Smoot-Hawley and subsidizes the export sector by lowering costs, depreciating the currency or providing cheaper financing, it will effectively make the same mistake the United States did in 1930, trying to force the adjustment abroad. This will only invite retaliation.

As it did in 1929, the world is experiencing a global contraction. It is crucially important that policymakers understand how the global balance of payments must adjust. Policies that do not take this into account will fail, and may even inspire trade war. As the key sources of the imbalance, the United States and China must recognize the roles each must play in resolving the crisis. America must reduce spending to bring its overconsumption down, and China must reduce overcapacity.

Unfortunately, each government is trying to adjust without taking into account the effect of its adjustment on the global balance of payments. China, especially, does not seem to understand that the fundamental problem, along with U.S. overconsumption, has been Chinese overcapacity. The United States should engineer a substantial fiscal expansion, not to replace permanently the decline in household consumption, but simply to give China three or four years in which to engineer its own contraction in overcapacity. If China does not, it will see the same result achieved by factory closings and rising unemployment. The global balance of payments, one way or the other, will even out.

Pettis is a finance professor at Peking University and the author of “The Volatility Machine: Emerging Economies and the Threat of Financial Collapse.”

© 2008