Thread by @prchovanec

I can answer Tyler Cowen’s question very simply: China’s chronic trade surplus reflect the fact that its economy is geared to produce more than it consumes. 1/ marginalrevolution.com/marginalrevolu…

This had the benefit of turbocharging investment and development. But it requires the rest of the world to consume more than it produces 2/

By 2008, it became unsustainable for China’s customers to go into deeper and deeper debt to pay for this. The result was a deep shock to China’s export economy 3/

Instead of easing back on investment and replacing foreign demand with domestic demand, accepting a slower but more sustainable rate of growth, China doubled down on investment as a growth driver. 4/

In other words, China has been investing at a level unsupported by either external or domestic demand to absorb the capacity created. 5/

The reason there has been no market correction, as Cowen expects, is that China’s financial system is not a market. Everything is “too big to fail”, losses are socialized, and thus the risk it prices is political, not economic 6/

This is why the investment that does take place is inefficient, as he notes. But it also accounts for excess investment on an aggregate level. 7/

The problem is not that there aren’t valuable things for China to invest in. It’s that this investment needs to be scaled to the ability of Chinese and foreign demand to absorb it and earn a positive return. 8/

Say’s Law says supply creates its own demand, in the long run. But not in the short or even medium run. And adjusting to a longer-run equilibrium is hindered by distortions that funnel more and more resources into capacity expansion regardless of profitability. 9/

Cowen is right in this respect: these kind of imbalances could not have piled up for so long in a market economy, without a price-driven correction. But China has failed to embrace the reforms that would enforce such discipline. 10/

At some point, producing more steel to build more steel mills to produce more steel to build more steel mills plays out, in the absence of an end customer.

And if you’re beggaring domestic consumers through artificially low interest rates, an artificially cheap currency, and other means, to build all those mills, and foreign demand can’t reliably pick up the slack, you’ve got a problem.

This reminds me of arguments that Germany isn’t over-saving cuz it has an aging population & needs to save. But the criteria for over-saving isn’t what you need, but what you get. If you’re saving so aggressively you get negative returns, you’re not providing for future needs.

And yes, China’s consumer economy has been growing. Just not commensurate with the high rate of capacity and output expansion it has tried to support.

BTW, when I talk about “low interest rates” in China, I’m talking about effective rates, not nominal or even inflation-adjusted. When you can roll over both principal and interest indefinitely, your effective rate is zero.

@GlennLuk And yes, China has an investment misdirection problem as well as an excess investment problem.

@GlennLuk To put it simply: you have a model that support high levels of investment with external demand. When you lose it, instead of striking a new balance, you double look to even more investment to make up the difference.

@GlennLuk And I’m wondering whether “business investment” is capturing a lot of the publicly-funded infrastructure investment that is directly connected to excess industrial output.

@GlennLuk The key here is to understand and apply the concept of end user demand, instead of intermediate demand created by investment itself.

@GlennLuk For every seller there is a buyer. But not necessarily an end buyer (consumer).

@GlennLuk This is precisely the way an investment boom disguises what is sustainable.

@GlennLuk I should be more specific: no end consumer at a profitable price.

Cohen says some sectors of China’s economy are under-invested, and he’s absolutely right. The irony is this: the reason they are under-invested is the same as why investment overall is too high - an economy where consumers subsidize producers.

@RambutanRed Plus I genuinely wonder what it’s counting as “end consumption”, when it comes to housing.