What China Can Learn from the Great Depression

Everyone knows the story. For a decade a rising superpower has drawn huge investments in new manufacturing plants, which draw millions of migrants from the countryside. The resulting productivity boom makes this nation the factory of the world, producing far more goods than it can consume. Its trade surplus rises toward an astonishing 0.5 percent of world GDP. Foreign-currency reserves surge, making it the largest holder of reserves in history, which it uses to fund the trade deficits of its export customers. Then suddenly, a global banking crisis interrupts the flow of funding, and exports fade.

This is not China in 2008. It's the United States in 1929. During the 1920s the United States exported its massive industrial overcapacity, mainly to Europe, until the stock-market and banking crashes of 1929 to 1931 undercut consumption, at home and abroad.

John Maynard Keynes argued at the time that as the nation with the largest trade surplus, the United States had to play the leading role in the global adjustment. Just as foreign overconsumption had come to an end, U.S. overproduction also had to end. There were two ways the country could balance domestic production and consumption. It could engineer massive fiscal expansion to replace declining global demand, or it could close down factories and lay off workers.

The United States saw another way. Why not create additional demand at home by discouraging Americans from buying foreign products? As part of this strategy, the U.S. Congress passed the notorious Smoot-Hawley Tariff Act in 1930, which sharply raised the cost of foreign imports. Congress hoped to increase the trade surplus, which effectively would force most of the adjustment in U.S. overcapacity onto foreigners while minimizing U.S. pain.

Not surprisingly, other countries refused to cooperate and insisted that the United States fix its overcapacity problem at home, not by shifting it abroad. They retaliated by erecting their own trade barriers, and within three years international trade plummeted by nearly 70 percent.

This pushed the overcapacity problem back onto the United States. Domestic consumption had to match domestic production. Since the U.S. government was unwilling or unable to engineer a sufficient expansion of demand, the country was compelled to close factories and learned, to its horror, that in a trade war the seemingly strong trade-surplus countries are actually more vulnerable than trade-deficit countries. The global balance of payments is very demanding. It will compensate one way or the other.

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.