Twofish's Blog

February 16, 2009

Death of old economic theories and birth of new ones

Filed under: china, finance — twofish @ 9:31 am

> If it increases production relative to
> consumption, then China is actually reducing
> net demand, even while it is increasing total
> demand.

No. If the production is fed back into investment and government spending, then net demand doesn’t change. China can increase demand by increasing investment. This will lead to increases in future production, which leads to future increases in standard of living.

There are several variables here, and I don’t think that increasing the consumption variable is a good thing. The variables that can be increased are investment (although this requires effort to make sure that it ends up in efficient investment) or government spending on public goods.

One of my suspicions is that the reason that we are in this mess is that the prevailing economic theories, remove variables from the demand equation so you end up with something that doesn’t balance.

If you end up being a market fundamentalist then you can’t adjust the government spending part of the equation. If you think that the market allocates investment optimally, then you remove the investment term of the equation. If you then believe that trade should balance then net imports disappears. That gives you consumption as the only variable that you can change.

But then you run into a situation in which a demand shock causes market psychology to push consumption down, at which point you have nothing to suggest except let the economy fall apart.

You run into the same problem with the controls you use. The only two “valid” controls in Greenspanism are the interest rates and by implication exchange rates. If you argue that government spending should be minimial and trade should be balanced, that gives you only interest rates, at which point you run into problems because you have conflicting requirements (full unemployment versus efficient credit allocation) which you can’t match by fixing one number.

In a lot of ways, the prevailing economic theories have painted themselves into a corner by systematically throwing away any controls and variables that can prevent or get us out of a mess. But it’s important here to point out that this is a prison of one’s own design.

The other issue is that a lot of this is the result of trying to create a universal economic theory. If you start looking for economic controls, you will find that a lot of them are specific to one economy. For example, increasing or decreasing SOE dividends is a control that is available in China rather than the US, whereas changing the overnight interest rates on commercial paper is available to the US, but not China. None of this is available if you try to make things too abstract.

I think that the events in the world have illustrated the failure of monetarist economic theory. Yes you could argue that things would be perfect if people acted according to the theories and you didn’t have to deal with annoying things like political reality, but any economic theory that only works when people stop behaving like people can’t be that useful, can it?

Personally I think that China should go to the position that it took during the Asian Crisis and commit to peg the RMB against the dollar. I really don’t see how devaluing is going to help China, because it will lead to a round of competitive devaluations. Given China’s huge foreign exchange reserves, there is no requirement to devalue.

Also, discussions of net and total demand have to include the fact that Chinese imports tend to be raw materials, and exports tend to be finished goods. Which means that US/China trade balance may behave in ways that are radically different from those between China and the rest of the world.

Finally, there are two US-China committees. One is the CECC which I have a lot of respect for, and the other is the US-China Security Review Commission which I don’t. The problem with the CSRC is that I get the since that they’ve already decided what they are going to say, and so talking to them isn’t that useful.


1 Comment »

  1. You should take a look at China’s GDP from an income perspective, rather than the expenditure approach you reference above. They are parallel, but distinct. No government has ever been exclusively monetarist in its approach to economic management. Central banks are generally, and why not. But what they do compared with the massive levels of social spending undertaken by other branches, has very different ideological origins. The balance is not quite as neat as you imply above.

    Comment by Cochin Loco — February 18, 2009 @ 4:42 am

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