China and the U.S. Can Fix the Global Economy

Economic crises have a way of concentrating minds. In the midst of recession, the United States and China have an unprecedented opportunity to rebalance their economies, one that they must seize in order to mitigate further global economic fallout from the downturn. American policymakers—and, it seems, significant parts of the Chinese policymaking establishment—do not yet fully appreciate the impact of the global crisis on Chinese economic prospects.

Although official estimates put urban unemployment in China at just over 4 percent of the workforce, most unofficial estimates are much higher—closer to 8 percent—and nearly everyone agrees that the figure is set to rise significantly in the next few months. Some credible estimates suggest that even if China were able to achieve the 7.5 percent growth projected in 2009 by the World Bank, unemployment would nonetheless double before the end of the year.

Things will get worse. China has a huge overcapacity problem, with total production exceeding consumption by about 10 percent of GDP. In the past China has been able to export this excess; now markets in the United States, Europe and elsewhere are contracting rapidly, and it will be all but impossible for rising domestic demand to plug the gap. In addition, collapsing corporate profits will put a sharp dent in new investment, nearly two thirds of which has been funded, in the past, out of retained earnings. Exports and investment have been two of the biggest sources of Chinese growth, and the outlook for both is poor.

China needs to achieve two major objectives. Domestically, it needs to increase employment. Globally, it needs to reduce the amount of overcapacity it is exporting to the rest of the world. But these two goals are at loggerheads in the short run. For example, in order to boost employment, Chinese policymakers have forced banks to increase their lending so rapidly that it will almost certainly lead to a future explosion in bad loans. But because of the structure of the Chinese financial markets, all this new lending is being channeled into the manufacturing and infrastructure sector. Although this will naturally contribute to global demand if it takes Chinese workers off the unemployment line, the consequent increase in production may easily counter this gain. China would thus continue to export too much to a world struggling with collapsing demand.

Within China, policymakers have so far been unable—some would say unwilling—to recognize China's role in the global imbalance. Policymakers who see the crisis as part of a necessary transition toward a more consumer-led economy are ferociously opposed by policymakers who want to combat unemployment by accelerating the existing, and deeply flawed, development model. They seek to maintain an undervalued currency, suppress wage increases and shift credit and resources to manufacturers and other producers of additional capacity. All this has the effect of increasing production and suppressing consumption.

But if China continues to force overcapacity onto a struggling world economy, it could easily lead to trade war. Already China is squabbling fiercely with Asian neighbors as protectionist talk around the world rises alarmingly. Protectionism would be disastrous for China. It would force the country to absorb all its production domestically and, given the limitations of its development model and its financial system, the only way it could reasonably hope to do so would be by closing factories and firing millions of workers. The social consequences could be disastrous, and could give political hard-liners a leg up.

The United States can help China and its reform faction avoid this nightmare scenario. Rather than demand that China immediately revalue its currency and stop subsidizing producers in order to cut its overcapacity, the United States should work with China over a four- to five-year period to achieve a sustainable rebalancing of both economies. For its part, the United States should continue its own fiscal expansion at a measured pace to ensure an orderly savings decline. It should also avoid protectionist trade measures at all costs.

In return, China should gradually continue to revalue its currency and allow the central bank to regain control of monetary policy. It should also continue to reform financial markets, liberalize interest rates, raise minimum wages and improve its social safety net—in particular by increasing health and education spending—in order to free up domestic savings.

All this will be difficult, but it would be much better than a catastrophic adjustment. At the end of the day, the U.S. trade deficit must decline, and Chinese domestic consumption must increase in order for the global economy to be healthy. If the two countries can work this out intelligently, the result would be a foundation for global cooperation for decades to come. If not, the world faces decades of hostility and mistrust.