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The Great Piggy Bank of China
Samuel Brittan The Financial Times 22/01/10

A frequent complaint against political economists is that they hide their vision of how the world works behind complex detail and mathematical models. This charge has even been levied against Keynes who was normally a brilliant writer, but whose canonical 1936 General Theory has been subject to almost as much controversial analysis as the Bible or the works of Richard Wagner.

His vision did of course change with the years. But it was always there to find for those who knew where to look. He first burst forth on the wider public with his famous denunciation of the Treaty of Versailles in his 1919 polemic, The Economic Consequences of the Peace. It might at first sight have seemed an unlikely best seller with its tables of coal and steel production and the commodity composition of German exports and imports in the last pre-war year of 1913.

There were several reasons why it nevertheless sold so well among readers who do not normally devour such figures. First and foremost were his portraits of the Allied and German leaders. There was for instance the description of the French President, Georges Clemenceau "throned in his grey gloves, on the brocade chair, dry in soul and empty of hope, very old and tired, but surveying the scene with a cynical and almost impish air ... He had one illusion - France; and one disillusion - mankind, including Frenchmen, and his colleagues not least." Keynes was persuaded to cut down his pen-portrait of Lloyd George, which afterwards appeared in full in a separate essay. Then too there were his doom-laden warnings about the future of Europe. Such warnings usually go down well.

But what remained in the memory of readers who were not particularly interested in the German reparations problem was his preliminary chapter on Europe before the Great War, which he described as an "economic Eldorado." True that the greater part of the population worked hard and lived at a low standard of comfort ... "But "escape was possible for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts and amenities beyond the compass of the richest and most powerful monarchs of other ages." He warned that that "the principle of accumulation based on inequality" was a vital part of the order, which depended on unstable psychological conditions. But he had little doubt that it was a successful system while it lasted.

By the 1930's his vision had changed, not only in relation to the economic depression of the time; his view of the pre-1914 order had also darkened. The reader interested in this aspect should probably start with the last few chapters of the General Theory, following back references where necessary. Keynes's stark conclusion was that full employment had rarely been achieved in peacetime in any economy except in rare periods of exuberance. He formulated a "psychological law" that savings tended to rise in more than in proportion to income and tended to outrun investment opportunities. Interest rates did not or could not fall enough to bring them into line and the equilibriating factor had to be, for want of anything better, permanent slump-like conditions. American economists who embraced this version of Keynes called the doctrine "secular stagnation" and braced themselves for a big slump following World War Two.

But that slump never materialised and in the second part of the 20th century savings were more often inadequate than excessive; and as governments were reluctant to let interest rates rise to the extent required we had periodic bouts of inflation. What had gone wrong with the "psychological law" of savings? At any one time people on higher incomes saved more than those on lower incomes. But as total income rose, the curve relating savings to income rose with it. So if national income doubled over two or three decades savings did no more than double - sometimes they did less.

Yet to most people's surprise, Keynes's chronic savings surplus has come back thanks to China's phenomenal savings rate. This is probably more an example of Chinese policy than of any economic "law". On IMF estimates Chinese national savings amounted in 2009 to no less than $4.3 trillion when measured at purchasing power parity. This was 49 pc of China's own GDP and 28 pc of global savings (again at purchasing power parity). Germany also had a savings surplus, but Germany is now a much smaller part of the world economy.

The world was kept in balance by the US, which developed an abnormally low savings ratio, acting as a consumer of last resort in the company of other smaller economies such as the UK and Spain, which behaved very much as an English speaking country. The boost in US consumption was aided and abetted by the Federal Reserve's low interest policy which was justified in the circumstances. It was also enhanced by large budget deficits incurred by a supposedly strait-laced Republican Administration. Add to this irresponsible lending by financial institutions desperate for higher yield; and one must admit with hindsight that the pudding was overegged.

All this came to an end with the credit crunch and the associated collapse of bank lending. A world depression has been prevented by rock-bottom official interest rates and a leap in budget deficits in Western countries. Their total fiscal deficits have been running at around 9 or 10 pc of GDP with the US and the UK registering around 12-13 pc.

If Western countries begin slashing their deficits, as conventional opinion so loudly demands, what will supply the offset to Chinese savings? Most of the suggested answers are non-starters. It is no use lecturing the Chinese to consume more. Indeed the Chinese authorities are now reining back domestic demand for fear of inflation. It would be best to take Chinese policy as given and for the rest of us to adapt.

A rise in Western private investment is not impossible. But it is hardly likely to take off while prospects for final demand are so muted and there is still talk of a double dip recession. The best long run hope for an offset to Chinese saving is investment boom in other emerging countries that have been less hard hit by the recession than the industrial West. But that is hardly likely to develop quickly on the scale required.

It would be foolhardy to encourage a further great rise on consumer or housing debt, at least in the English-speaking countries. If there were a single Western fiscal authority, I would unhesitatingly say: let the budget deficits run for a while, if necessary financed by the central banks - which, to be fair, Gordon Brown has tried hard to achieve. In the absence of such a common front what are the real limits to how far an individual country, fortunate enough to have is own currency and borrow in it, can go out on a limb in its fiscal policy?

Financial market types worry about selling government debt; but this is not the true limit, which concerns real things. It is worth pursuing an expansionary monetary and fiscal policy until the point where the loss on the terms of trade or the boost to inflation begins to outweigh the gains to domestic output and employment. Meanwhile I can only reply o the masses of messages that the first priority of a new British Government should be to reduce the fiscal deficit: "I beg to differ." As the Bank of England Governor, Mervyn King, has just reminded us, UK output, is some 10 pc below its previous trend. If the recent upturn in UK inflation turns out not to be a blip but a more lasting response to sterling devaluation, the appropriate reaction would be to edge up interest rates but let the Budget deficit run. The fact that this would be the opposite of the conventional wisdom only reinforces my belief that it would be right.

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