The world economy over the past 15 years or so has been a delicate balance between American over-consumption and Chinese over-production.
This is how the system worked. China ran up huge trade surpluses with the US. The dollars that it earned could have pushed up the local currency and thus made exports uncompetitive. So, the Chinese central bank bought hundreds of billions of dollars that were then invested back in the US financial system. That kept US interest rates low and helped its consumers carry on a borrowing binge.
Illustration: Jayachandran / Mint
That fragile arrangement is now under threat. How quickly it unravels and what replaces it has implications for most other nations in the world, including India.
The US government said on Friday that unemployment there is the worst in 26 years. The unemployment rate is 8.1%, which means around 4.4 million jobs have been lost since the recession began. Add to that the fact that US households have seen their wealth shrivel because of the approximately $12 trillion fall in the value of housing and shares in an economy that produces around $15 trillion of output every year.
Neither growing job losses nor shrinking household wealth is good news for consumption, though interest rates have been slashed. The savings rate of US households, which was zero through most of this decade, has jumped to 5%. More savings means less demand for Chinese imports.
China is facing the mirror image of the US problem. Its export engine has stalled and an estimated 20 million Chinese workers have lost their jobs, many going back to their villages in a state of anger that even the mighty Chinese communist party is worried about. Premier Wen Jiabao admitted last week in a speech to the national legislature that this will be “the most difficult year for China’s economic development since the beginning of the 21st century”.
Chinese leaders seem to believe their country’s huge fiscal stimulus and aggressive interest rate cuts are working, and that their economy is on the road to recovery. This is a claim that will need to be tested before it can be accepted.
Both US and China have moved aggressively against their economic troubles by ramping up government spending and slashing interest rates. We doubt either stimulus will work in the long run unless the basic economic models of the two countries are rejigged. The US will have to learn to consume less and China will have to accept that increasing domestic living standards is more important than big trade surpluses.
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